Can neobanks take on the old guard?


Author: Alex Katsomitros, Feature Film Editor

August 15, 2022

When Mariano Pennello, a 58-year-old welder from the small French town of Bédoin, deposited €22,000 into a savings account he opened through German digital bank N26’s mobile app, he didn’t know that he would be engulfed in a Kafkaesque nightmare. At four percent, the interest rate seemed attractive compared to what conventional banks were offering, he said.

When he tried to withdraw the amount in April, he realized that was not possible. The firm no longer responded to emails and phone calls, until his account was frozen without any explanation, while the application had been blocked. Radio silence: “I don’t even know if my account has been hacked.

They won’t respond to my emails,” he said. He sent all the relevant documents to the company’s headquarters in Germany and is now considering filing a complaint with the French police unit in charge of cybercrime. “If {N26} is really a bank, it should have policies and staff in place for this type of technical issue,” Pennello says. “It is not normal.”

Bank for a new generation
Pennello is far from alone in his situation. N26 has faced a flurry of customer complaints about abruptly closed accounts in several European countries. In a public statement, the company said it was part of a crackdown on fraudulent accounts. Many other digital banks have encountered similar problems. Resolver, a UK online complaints service, reported a total of 1,850 similar complaints last year, most related to account freezing.

However, these are just start-up issues for a burgeoning industry of fintech firms, known as “neobanks” or “challenger banks,” offering services traditionally provided by banks to retail customers. They are all committed to “unbundling” the banking sector, i.e. breaking down its value chain and retaining the profitable elements, as other digital disruptors in their sectors have done. Currently, there are about 400 worldwide, serving about one billion customers, with the market size reaching $47 billion in the United States (see Fig 1). Grand View Research, a market research firm, expects the global market to reach $722 billion by 2028.

One of the reasons for the success of challenger banks is the seamless digital experience they provide. Unlike traditional banks overloaded with outdated infrastructure, they build their databases from scratch, which allows them to develop new services. Their fast, bot-powered customer experience is tailored to the needs of young digital natives. And as digital-only businesses, they don’t have to open expensive branches, instead offering lower fees, higher interest rates, and quick sign-up processes. According to Dylan Lerner, fintech analyst at Javelin Strategy & Research, an American market intelligence provider, another difference with traditional banks is that they provide personalized services, rather than one-size-fits-all products. “A neobank won’t just give you a credit card. They will help you build your credit,” he says. The result, according to Lerner, is that traditional banks are losing their grip on customers, leading to a fragmentation of their relationship with them. “For traditional banks, it’s death by 1,000 cuts,” he says.

The pandemic has accelerated this trend, pushing depositors to turn to digital banking. In the United States, neobanks have won new customers by offering early access to federal stimulus checks. Eversend, a neobank that caters to the needs of the African diaspora, grew its transaction volume from $800,000 in 2019 to $253 million in 2021. “Lockdowns have forced people to stay home and embrace financial services technologies,” says company founder Stone Atwine. “It was a horrible time for humanity, but it accelerated technology adoption.” Neobanks have also won hearts and minds by offering services that have become popular during the shutdowns, such as cryptocurrency trading and peer-to-peer payments, according to Dan Dolev, fintech analyst at Mizuho Securities, a Japanese investment bank. Traditional banks are keen to meet these challenges. Some attempt to replicate the digital experience offered by neobanks, offering perks such as virtual card display, fast mobile onboarding, digital wallets, and payment-related rewards. Some rushed to acquire neobanks; Société Générale has acquired Shine, a neobank targeting entrepreneurs.

Others have set up their own digital-only services. Cogni, a blockchain-powered neobank, is the brainchild of Barclays’ accelerator program. Goldman Sachs launched Marcus Invest, offering an app-based investment banking experience. However, such experiences can be short-lived, as the digital ramifications must be integrated into existing infrastructure. Neobanks will always have the upper hand when it comes to digital services, says Dolev: “You only need one car. If one of these neobanks takes on this role, then the old bank becomes a back-office lender,” he says, adding, “The concern is that banks are becoming marginalized, unknown and unbranded lenders.

Emerging Markets
Neobanks are particularly successful in markets where most people have never had a bank account. Last December, Brazil’s Nubank became South America’s most valuable financial company with a valuation of nearly $50 billion and more than 50 million users, following its IPO in New York. Digital banking is the future in a region where half the population is unbanked or underbanked, but more than seven in 10 people own a mobile phone, says Romina Simonelli, director of payments at Ualá, an Argentinian-backed neobank by SoftBank and Tencent. The company launched “Aula Ualá”, a platform deciphering the intricacies of personal finance for the layman through downloadable materials, videos and free courses.

As digital-only businesses, they don’t have to open expensive branches, instead offering lower fees, higher interest rates, and fast registration processes.

Some neobanks completely ignore developed economies to focus on emerging emerging markets. TymeBank, a South African neobank, has raised $110 million to fund its expansion into Southeast Asia. Paytm, India’s largest payment service with over 450 million registered users, plans to expand into credit. Companies like Eversend have revolutionized the booming remittance industry. “It’s nice to sit in Paris and send euros to my grandmother in western Uganda instantly, using one app,” says Atwine. “With traditional banks, this process takes two to five days, costs a lot more and requires my grandmother to travel to town to withdraw cash.”

Regulatory risks
For regulators, neobanks pose a problem. The plethora of new players brings much-needed competition to a sector notoriously resistant to innovation.
However, their disruptive force has raised concerns about money laundering and fraud. Last April, the British financial regulator questioned the effectiveness of the mechanisms put in place by certain neobanks to fight against financial crime, following an upsurge in suspicious activities. Established banks have an advantage in this area by spending billions to monitor transactions, according to Javelin’s Lerner, while neobanks lack the necessary infrastructure. But it could lead to more innovation, he argues, with “reg-tech” start-ups helping neobanks meet their compliance needs. Rapid international expansion, as in the case of N26, has also upset customers: “We are in Europe and I think French laws should be as valid as German laws,” says Pennello whose N26 account has been frozen. . “I have always been banking with French banks and have never had any problems.”

US regulators have taken a tough approach, forcing neobanks to partner with traditional ones. Chime, America’s most popular neobank, has been ordered by California authorities to remove the word “bank” from its marketing materials. Regulators can also reduce their profits from debit exchange and instant deposits, predicts Dolev. In Europe, many neobanks have obtained banking licenses, thus being able to develop in credit, investment and net interest margins.

The European Payment Services Directive has forced banks to open up access to customer data that digital startups can use to develop their products. “In the United States, conventional banks have greater lobbying power,” explains Nathalie Janson Calamaro, expert in banking regulation and teacher at NEOMA Business School. But even in Europe, neobanks have only obtained “light licenses” with certain limitations; As soon as European banks sense a threat, there will be more pressure to restrict competition and effectively stifle innovation, Calamaro argues.

In search of an economic model
The biggest concern about the future of neobanks is that most will never make enough money to stay afloat. Currently, only five percent of them are profitable, according to a report by Simon-Kucher & Partners. Few have been allowed to offer full-fledged credit services, the riskiest but also the most profitable part of banking, and are instead stuck with low-spending customers. In most cases, “freemium” pricing models that rely on customers paying monthly subscriptions to access additional services have attracted a small number of applicants.

Banking remains a very localized market due to cultural and regulatory differences, unlike other sectors which have seen digital pioneers rapidly expand across the globe. The recent failure of European neobanks to penetrate the US market is a good example. Multinationals with large pockets may also intensify competition in the future. Telecoms giant Orange and IKEA owner Ingka Group are expanding into banking, while Apple and Amazon have launched payment services that could signal bigger ambitions. Decentralized finance companies like Compound could also offer credit-hungry customers an even more sophisticated digital alternative to neobanks.

Neobanks face the same problems that other pioneers had to solve before becoming the new mainstream. Even the term “neobank” remains controversial. Some of these digital upstarts avoid it altogether, fearing regulatory scrutiny. Others embrace it openly, although they offer only a fraction of the services provided by traditional banks. For his part, Pennello thinks they should be treated like normal banks: “Governments and regulators should supervise them a little better,” he says.