Ominous signs have been appearing for challenger banks.
A recent study by consulting firm Simon Kucher found that of the 400 neobanks in the world, less than 5% are breaking even. U.S. challenger banks Chime and Varo have hit bumps in the road,
And challenger banks, like many other types of fintechs, have seen their equity overvalued. All of this is likely to give neobanks’ backers pause as the economy tightens.
Three hundred of the 400 challenger banks that exist today will not exist in five years, predicts Christoph Stegmeier, senior partner at Simon Kucher.
“They're doomed to not survive just by the type of business model and market segment that they're going into,” he said. “There's too many me-too banks that are not doing anything specific, just a good user experience and no real product innovation. That's not going to work out. For many of them, the business model is wrong.”
Yet new challenger banks emerge almost daily.
“Soon we'll have 500 to 600 neobanks,” Stegmeier said. “Not all of them will be successful.”
Culling of the herd
So-called challenger banks, which are also known as neobanks, are fintech startups with well-designed smartphone apps that make banking easy and often low-cost.
They have been successfully growing their user bases. A billion accounts have been opened in digital banks worldwide and neobanks gained close to six million customers in the last quarter alone, Stegmeier said.
“That is not a niche anymore,” he said. “It's a huge business opportunity. So for those that will succeed, I'm very optimistic.”
In the U.S., there are about 50 challenger banks. Chime now has more than 12 million users, MoneyLion 9 million. Dave added 340,000 net new members in the first quarter, bringing its total to 6.4 million. Varo and Current have 4 million members each.
A big question is how quickly all these neobanks can move from scale to profitability, Stegmeier said. Startups that just focus on growing ultimately will run out of funding.
In the U.S., Stegmeier predicts some challenger banks will go out of business, but others will merge and reduce their cash burn and funding needs, out of necessity.
“In 12 months, we'll see a significantly increased pressure on valuations,” Stegmeier said. “We'll see pressure on profitability of the neobanks. And we'll see takeovers, significantly more than we've seen in the past.”
Need for revenue
Many challenger banks depend on the revenue they get through interchange fees. Every time a customer swipes a Chime debit card, for instance, Chime gets part of the fee the merchant pays for the processing of that transaction.
While interchange fees are not necessarily going to go down, the costs of acquiring new customers, running the underlying technology, and paying people remain high, noted Alex Jimenez, managing principal at the consulting and technology services company EPAM. This all makes profitability a challenge.
Some venture capitalists have worried about this from the beginning of the neobank movement, pointed out Jay Reineman, general partner at Propel VC, a venture capital firm that was started within BBVA and spun out in 2016.
“We saw firsthand the challenges of the early and iconic Simple Finance,” he said. “Profitably acquiring and retaining customers with only a debit interchange business model has limitations. Simple had a cult following that lowered its cost of customer acquisition, but most neobanks have been acquiring sub- and near-prime customers at the higher traditional-bank-like acquisition costs, while having a single revenue model: debit interchange.”
And though it’s become easier than ever to start a new neobank with the rise of other fintechs like Railz or Synapse that provide white-label solutions, using these solutions reduces the neobank’s margin, Reineman said.
To survive, challenger banks will need to quickly evolve to be more like traditional banks, providing not only payment solutions but also credit and investment products, he said.
“Unfortunately many of the neobanks do not have the DNA for these other products,” Reineman said. “And they are too consumed with growth and customer acquisition to make up for customer churn and scaling issues like customer service to think about new products.”
Neobanks tend to use “hook products” like no-fee overdrafts that help them acquire customers, but are loss leaders, Stegmeier noted. Traditional banks are now encroaching on this advantage as more drop overdraft fees under pressure from the CFPB, which is on a campaign against “
They need to focus on problems where customers are willing to pay for that solution, Stegmeier said. For instance, remittance fintechs like Wise (formerly TransferWise) and Remitly remove the high transaction costs of sending money abroad. Neo brokers like Robinhood eliminate brokerage fees.
“If you find the model to make that profitable, that's a good pain point to solve,” Stegmeier said.
Some neobanks focus on credit. But these have to constantly chase cheap enough capital to fund their next loans, Reineman noted.
“That is, if they are able to find a profitable customer segment to serve,” he added.
Some challenger banks offer wage advances through a connection to the user’s employer, a business model of which Stegmeier approves.
“You have the client already and you lend to that client,” Stegmeier said. “You minimize the risks you have on the book because with a good cash flow prediction model, even though the customers might be near prime or subprime, you know if in the last six months that customer had the flow coming in, and you can predict pretty well.”
A few neobanks, including Aspiration, Dave and Solo Funds, have a tipping model, where users are encouraged to pay a tip to the provider and, in Solo’s case, to the individual who funds a loan. The jury is out on whether these tips, which in some cases are mandatory, will survive regulatory scrutiny. Connecticut banking regulators recently said Solo’s tips were too high, and slapped the company with a cease-and-desist
More recently a new option has emerged: selling cryptocurrency services.
But all these business models will work only for neobanks that keep marketing costs low, Stegmeier cautioned.
Some neobanks, including Upgrade, SoFi and LendingClub, offer a range of products including loans and basic banking.
This seems to be the most successful approach. Jimenez says he does not worry about SoFi.
“They didn't start as a neobank,” he said. “They started with student loans and then moved on to a full suite of banking services. So they have a more diversified model. The same is true for LendingClub.”
Investors getting restless
The future for many challenger banks hinges on the venture capital firms that fund them, noted Jimenez.
“If the VCs say, you know what, the next round we're not going to participate, some of [the challenger banks] are going to find themselves in trouble because many of them are not profitable,” Jimenez said. “If the VCs that focus on fintech continue to focus on the ones that have a more well-rounded business model, then the ones that are more monoline are going to be in trouble. If folks are saying, we're going to be looking at the SoFis of the world and step away from Varo, they could kill it.”
The bar to obtain venture funding lowered in the past two years, Reineman noted.
“Founders raised much bigger rounds, at riskier, earlier stages and at higher valuations,” Reineman said. “Many VCs were chasing founders that were only good storytellers. It was too easy for founders to raise capital and then throw that money into unprofitable customer acquisition to meet growth expectations.”
All of this needs to change, Reineman warned.
“The mediocre ideas and teams will not get funded and hopefully VCs will be more diligent about helping founders focus on profitable, scalable business models,” he said.
