Do neobanks deserve to survive?

When they first emerged – and for a while after – neobanks were the best since the expense report. Enabling customers to do much of their day-to-day banking through smartphone apps, with free accounts and minimal difficulty, it has grown tremendously during the pandemic period, when traditional face-to-face banking have become either impossible, or at least extremely difficult.

But the idea of ​​neobanks has always had a golden whiff of leprechauns – the feeling of being too good to be true. Now, as conditions tighten towards the second half of 2022 and into 2023, there is more of a feeling than ever that if something seems too good to be true, it may be so.

This meaning was highlighted by the casting of Digit.

Algorithm logic

Digit is a fintech company that offers traditional banking services online. Going beyond the allocations of many neobanks, it offers a tool to automatically allocate part of its customers’ deposits to a savings account, in order to help them achieve their investment objectives. It also comes with a “no overdraft guarantee”.

Digit has just been hit with a $2.7 million fine from the Consumer Financial Protection Bureau for misleading advertising on this no overdraft guarantee.

The problem arose when the algorithm used by Digit to transfer funds into its customers’ savings accounts did not take into account the level of funds in the checking account, which meant that it could blithely empty the account. current and trigger the overdraft fee that it guaranteed not to apply.

What is probably at least as damaging to the reputation of Digit and neobanks in general is the fact that even though nearly 2,000 customers were overcharged, and even after customers complained about non-compliance with the promise of no overdraft guarantee, Digit failed – or refused – to reimburse its customers for the fees they were charged.

It’s clearly not in the tradition of good financial citizenship that mainstream banks like to tell the world they represent, but that’s no surprise. Technically, most neobanks are not “banks” in the traditional sense at all: they are technology companies linked to a traditional bank, but very 21st front-end of the century, allowing customers (approximately 23 million customers in the US alone, expected to reach 50 million by 2025) automatic electronic access to their money.

Right now, there are around 60 neobanks operating in the US – but the problem is that they have a non-traditional way of operating, and it’s starting to bite them.

Challenger Banks – Challenged

Where traditional banks charge for traditional banking services – deposit loans etc. – neobanks (or challenger banks, as they are also called) generally only make money by charging merchants a fee when their account holders use their debit cards.

That in itself is a very slim revenue stream compared to established banks and even some of the major megafintechs like Paypal.

And while neobanks have found it easy to get large numbers of customer accounts through their simple, branchless electronic offering, this thinness of revenue stream is already starting to hit home. Rapid expansion, even without a physical branch network, has led to soaring costs, and several prominent US neobanks, such as Varo Bank and Money Lion, have encountered problems generating enough cash to maintain their position at the top of the neobank. world, given their low income stream. Even Chime, which is currently the first neobank in the United States, had to delay its IPO after stock valuations in the fintech sector fell significantly in the first half of 2022.

An unprofitable target?

Part of the problem with neobanks is their target market, which is usually young adults, who easily adopt a high-tech solution, but who, for the most part, don’t have a lot of savings or income. This means that neobanks can easily win their business from traditional banks with their low-cost, no-fee, and easy-to-access offering, but may struggle to convert many customer accounts into a meaningful revenue stream.

Meanwhile, the neobanks themselves face what could well be a perfect storm in the next two years.

First, many of them are short on venture capital ready to fund their launch and expansion. Venture capitalists want a hard cash return on their investment, rather than just bragging rights for having developed a new banking paradigm.

Second, traditional banks and megafintechs have so far been relatively inactive in dealing with new entrants, but now traditional banks in particular are looking to develop their own neo-bank-like front-end accounts, while offering all the stability of traditional banking institutions – with all the capital reserve benefits that come with it. This means that neobanks are facing a real challenge for the first time in their short lives. And while they’ve grown rapidly through account accumulation, very few of them (in the US, at least) have found a way to profitably grow their revenue streams in order to mount a real defense of their territory.

Third, as in the case of Digit, banking and financial regulators are beginning to treat them with the adult seriousness with which they treat other financial institutions, and penalize them when they fall short. The CFPB said earlier in 2022 that it would roll out a “largely unused statutory provision to review non-bank financial companies that pose risks to consumers”. It was a statement to neobanks specifically – get your house in order, we’re coming to call you.

The perfect storm?

And finally, it is not at all clear that even the large neobanks in the United States box put their homes in order, especially as we approach 2023, when it now seems clear that there will be at least some form of recession, as the impacts of the pandemic shutdowns and in particular the invasion of Ukraine by Russia are forcing a restriction of monetary flow and an increase in retail prices.

The combination of a low revenue stream model, reduced venture capital support, a real threat of competition from traditional banks, an investigation of labor practices by regulators, coupled with fines, and the approach of a recession, which means cutting spending and even cutting their existing revenue streams could mean that many of the first wave of neobanks find it increasingly difficult to survive for the next 2-3 years.

Making algorithm errors and then souring existing customer relationships by not correcting the error, let alone incurring multi-million dollar fines, as in the case of Digit, is in no way going to reassure neobank customers nor the stock exchange on the fact that they deserve to survive.

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