Neobanks emerged after the financial crisis to challenge traditional banks. These banks are best known for operating entirely online. Their customers use an app to access banking services instead of visiting an ATM or talking to a human teller. Neobanks don’t have extensive branch networks and high-profile buildings in the financial district. These banks are designed for younger customers who are comfortable with using a smartphone to apply for a loan or deposit their paycheck. But the online experience isn’t the only thing that’s different about neobanks.
I learned a lot about how neobanks work by talking to fintech founder Thish de Zoysa, whose gift card startup is similar to a neobank. These banks don’t start out by providing the broad range of services that traditional banks normally offer. In fact, they might not even technically qualify as banks as all. What a neobank offers its first customers and investors is the idea of a bank.
Starting a new bank is very difficult, whether it’s in the US, the United Kingdom, or elsewhere. It may take several years to apply for a banking license, and the central bank might not approve it. Banks must comply with many financial regulations to prove that depositors’ money is safe. And a new bank might need to show regulators that it has millions of dollars in deposits and equity. But neobanks found a way around those rules.
Neobanks often begin providing their services as money transfer companies. Examples of these firms include PayPal and TransferWise. A money transfer firm helps customers send money to each other, especially across international borders. And that’s one of the core offerings of neobanks. They provide debit cards that can be used anywhere. And while banks normally charge high fees for international transactions, neobanks often pay these fees for their customers with investors’ money.
It’s much easier to apply for a money transfer license than it is to apply for a banking license, but obtaining a money transfer license still allows the neobank to begin building its customer base. The disadvantage is that a money transfer license doesn’t allow the neobank to offer several key banking services. These firms can’t make loans themselves or even hold money for their customers for extended amounts of time. But the neobanks also found a way around those problems.
Neobanks often partner with licensed banks that provide the services they can’t offer themselves. Traditional banks such as Cross River Bank, Live Oak Bank, Celtic Bank, and WebBank provide lending services for neobanks. If a fintech startup offers loans on its website, the small print at the bottom of the page often explains that one of these banks is actually making the loan.
The neobank provides a user experience that’s optimized for younger customers who use their smartphones to interact with the bank. The fintech startup may have a better iPhone app than a bank that expects its customers to meet with financial advisors and lending managers in person and isn’t as focused on the online experience. By focusing on this market, the neobank intends to sign up millions of users, allowing it to raise more money from venture capital firms. Then, the neobank will eventually gain the financial resources it needs to apply for a traditional banking license. Once it gets that, it can end its partnership with the third-party bank and provide banking services directly.
Varo Bank is an example of a bank that accomplished this goal in the US. Originally, Varo provided banking services through its partnership with The Bancorp Bank. But Varo also applied for a national banking charter, which was granted in July 2020, so now it will be able to provide banking services directly. That’s important, because neobanks are at a disadvantage if they can’t provide the services that banks normally use to earn money, such as making mortgage and business loans.
Neobanks often have a customer base that includes younger and poorer customers. These customers may not use the neobank as their primary bank, either, and may still deposit their paychecks in a traditional bank. When customers do use a neobank as their main bank, they may choose it because it doesn’t charge low-balance fees. So neobanks’ customers often aren’t very profitable for the bank. The idea is that the customers will eventually get promoted, earn more money, and continue using the neobank, helping it earn a profit several years from now.
As for whether these strategies work, right now neobanks are experiencing a difficult environment. The pandemic has made it more difficult for neobanks to raise money because of economic uncertainty. Some banks are raising money at much lower valuations. Some prominent neobanks have also built up large customer bases but still lose money on each customer, so they’re experimenting with new business models such as offering premium accounts. And as for the neobanks that have obtained banking licenses and started making loans directly, the pandemic also makes it uncertain whether these loans will be repaid. Neobanks may need to adopt better business models and focus on earning a profit much earlier in the business cycle to survive the current crisis.