At Starling Bank in the U.K., Chief Financial Officer Declan Ferguson expects that at the end of the year, the company will have 150 million pounds of before-tax profit (that's about $174 million in U.S. dollars).
"We are profitable and very much growing in terms of profitability from a return on equity perspective," Ferguson said in an interview. ROE for the month of July was 21.5%; Ferguson hopes to reach 30%.
This makes it an anomaly among neobanks: A recent study found that fewer
San Francisco-based Upgrade made $50 million in GAAP net income in the second quarter. At the end of the year, it expects to have $750 million in revenue, an 83% increase over 2021.
Dave in Los Angeles was profitable until a recent hiring push raised its operating costs; its founder and CEO says the company is on track to become net positive again.
A look at how these three challenger banks worked their way to profitability provides some insight into the neobanks most likely to survive and continue taking market share from traditional banks.
All have had to find a way to go beyond the revenue source most challenger banks depend on: the interchange fees generated each time a customer swipes a debit card.
"A debit-interchange-only revenue model is likely insufficient to run a profitable banking operation," said Brian Graham, partner and co-founder of Klaros Group, an advisory firm, in an interview. "If it were sufficient, every community bank in the country would be making money hand over fist, because they're all positioned to take advantage of the Durbin Amendment and could be making a ton of money there."
The
Upgrade and Starling profit from lending
"Lending generates a lot of top line revenue and it's capital intensive," Graham noted.
"It doesn't surprise me that lending fintechs are able to generate a lot more economics than folks who have tried to shy away from lending."
One challenge: the market to buy those loans is unpredictable.
"The way to think about neobanks is if they're lenders, they can make it work, so long as they don't run into enough market or credit disturbance to affect the fact that they're not [traditional] banks and they can't rely on deposit funding," said Todd Baker, senior fellow, Richman Center at Columbia University, and managing principal at Broadmoor Consulting. "That's why it worked really well for LendingClub and SoFi to buy banks, because they were already lenders."
Upgrade, the challenger bank founded by Renaud Laplanche, the original founder of LendingClub, has been profitable for two years. Laplanche says this is largely because his company emphasized credit products from the beginning, rather than starting with an app and a debit card the way most neobanks do. Upgrade offers personal loans and auto refinance loans that are made by bank partners. It offers personal credit lines and checking accounts issued by Cross River Bank and cards issued by Sutton Bank. It has two million customers.
"Credit is hard to put in place," Laplanche said in an interview. "It takes a lot of infrastructure, a lot of data to get started, for instance to build a track record of credit performance."
But once a credit model is established, it's easier to monetize than a pure debit business, he pointed out. While neobanks can receive 1.4% of each debit card transaction in debit interchange, the interchange revenue on credit transactions is 2.4%.
Upgrade also sells credit balances to banks, credit unions and asset managers at a four-point premium. So if a customer has a $1,000 credit balance, Upgrade can sell that balance to a bank or an asset manager for $1,040. On top of that, Upgrade collects a 1% servicing fee.
Upgrade's credit card is a bit unusual: it requires customers to pay off expensive items in a predetermined set of installments.
"You don't run the risk of getting into a revolving debt trap," Laplanche said of the card. "It's a fixed-rate, fixed monthly payment. And I think that message of more responsible and lower cost [credit] is appealing to a greater number of consumers, especially with inflation being what it is."
A recent report found that less than 5% of challenger banks are breaking even. Will these startups be able to achieve profitability before investors’ patience wears thin?
Upgrade sells loans and credit card receivables to a network of 175 community and regional banks and credit unions. Financial institutions are risk averse and tend to pull back when there are signs of credit trouble in the market, Baker warned.
At Upgrade, offering a combination of mobile banking, credit cards and loans also helps the company cross sell, Laplanche said.
Starling Bank, which was the first U.K. challenger bank to launch in 2014, has also been profitable for two years. It's a licensed bank with about three and a half million customers. (As a point of reference, the entire U.K. population is about 67 million.)
Starling gets about half its revenue from lending, specifically from mortgage and small business loans. In this sense, its business model is similar to a traditional bank's.
"The play is not trying to be something different to what banks have done in terms of revenue stream," said Ferguson. "But we're doing that on a cost base that is dramatically different to what other banks can do."
Because of its bank license, Starling Bank gathers deposits and lends off its balance sheet. Starling has more than 10 billion pounds in deposits and 4 billion pounds worth of loans, giving it a loan-to-deposit ratio of 40%. A year ago, Starling Bank bought specialist buy-to-let mortgage lender Fleet Mortgages for 50 million pounds. Over the next three years, Ferguson expects 70% to 80% of the bank's lending to consist of mortgages.
Subscriptions, fees and tips
Challenger Bank Dave, which was founded by CEO Jason Wilk in 2017, was profitable in 2018 and 2019, Wilk said.
"With that comes fraud teams and infrastructure teams," Wilk noted. It grew its head count from 70 people to close to 300. Dave has seven million users.
"Our path to get back to profitability is a very clear one," Wilk said. "We have many diversified revenue streams compared to most neobanks that only have interchange. And because of that, we feel well positioned that we're back on that path toward profitability with fast growth, too."
The company's strongest revenue source is ExtraCash, a short term loan of up to $500 with no interest, no fees and no credit check. Customers repay the money from their next paycheck.
"That product was meant to be a better version of what big banks have for their overdraft solution," Wilk said.
Customers only pay a fee for ExtraCash when they send the money to an external debit card instantly. If they're willing to have the money sent to them via ACH, it's free.
ExtraCash users can pay Dave an optional tip for the service. About half of users pay a tip, with an average tip size of $4, Wilk said. The company also makes money from interchange fees on debit card swipes and a $1 monthly subscription fee.
Like Dave, Starling Bank also attributes some of its profitability to fee income; it gets half its revenue from fees. It obtains interchange fees from debit card swipes. Like most European banks, it's capped at 20 basis points on debit transactions and 30 on credit.
Starling also gets subscription income from ancillary products like a card for children that their parents can fund, monitor and freeze. And it offers banking as a service to other fintechs.
"Our international strategy will be more of a software-as-a-service play, where we will license the technology to other third parties, both banks and nonbanks, to basically build components of their own styling on our technology platform," Ferguson said. "And we'll charge them for doing that."
Upgrade has not tested a subscription model.
"There's probably more appetite for that kind of subscription model for lower income, lower credit quality customers," Laplanche said.
Keeping costs down
A hurdle for challenger banks that seek profitability is that their costs tend to be high, especially for customer acquisition.
Upgrade has kept costs down by being disciplined, Laplanche said. Only 25% of the company's engineers are in San Francisco. The others are fully remote or in a development office in Montreal, where the cost of living is considerably lower. Its operations are based in Phoenix, which is also a much lower cost location than San Francisco.
Upgrade also uses automation in operations and customer service to keep those expenses low, he said.
Starling Bank keeps operating costs down by developing and operating its own technology, Ferguson said, giving it a cost advantage over other U.K. banks that rely on third-party vendors.
"You get genuine operating leverage when you build your own technology platform from scratch," he said.
The company recently reviewed the digital acquisition platforms it uses and turned some off to save money. It's spending about 25% of what it was spending on digital marketing two years ago.
Dave is focused on growth, rather than cutbacks, Wilk said.
"You can cut your way to profitability, or you can grow your way to profitability if you have good unit economics," Wilk said. "Our plan is to continue to grow our way to profitability."
In the second quarter, Dave signed up 600,000 new customers, he said.
