Neobanks (or challenger banks, as they are called in the UK) have raised huge amounts of money since entering the fintech scene.
Much like their dotcom ancestors, private equity and venture capital funding was easy with few restrictions, flooding the space with liquidity. Profitability has been a “good to have” down the road.
And private banking startups you might never have heard of have unicorn status: the once high market valuation of $ 1 billion.
I fondly remember the days when this metric was unknown. A landmark. Now? According to CB Insights, there is more than 530 unicorns in the world.
Such is the state of the market that new orders of magnitude have entered everyday language.
A decahorn, I’m told, is a startup worth $ 10 billion, and a hectocorn that boasts a valuation of $ 100 billion. Incredible numbers like these raise the question of how early investors can expect to get a return on their money.
An obvious parallel is the story of Tesla, which amassed a market cap of $ 800 billion on the road to being ranked the seventh largest company in the world. It’s more popular than Facebook, Samsung, or even Warren Buffett’s Berkshire Hathaway, and yet Elon Musk loses money on most of the cars he makes. In fact, according to the Financial Times, the electric car giant depends almost exclusively on selling carbon credits to other automakers for its handful of profitable periods.
Maybe this is how things are now? Profits are an afterthought, a wild dream, an unnecessary requirement of bean counters and fund managers?
The same goes for neobanks. Massive valuations. And where are the benefits?
Growth vs profit
The ability of neobanks to generate more excess cash than they spend on customer acquisition has been highlighted by the pandemic.
The economic damage one would assume such a landmark event would cause the world has been mitigated to some extent by infinite quantitative easing, near zero interest rates and a stock market hopium.
But there is a big toll to come. Some economists call it the “ bubble of everything ”. When it appears, according to the theory, the veil will be lifted, the system stripped of phantom paper wealth and fundamental value will be revealed.
Nowhere is this more closely watched than with neobanks.
In October 2020, Starling Bank became the first retail neobank make a profit; all it took was a single month of positive cash flow (on the order of Â£ 800,000 in the dark) to generate global titles.
And Starling, with 2 million customers, has far fewer retail accounts than its UK rivals Monzo (5.5 million) or Revolut (13 million).
As noted by CEO Anne Boden in her Letter 2020 to investors: âGrowth is one thing. But achieving sustainable growth is another. At Starling, we have clearly defined our path to profitability from day one. “
Audit giant Accenture rated in 2019 that UK neobanks were losing around Â£ 9 per client, so Starling’s attention couldn’t be more welcome to early investors.
So what parts of Starling’s business have the best profit margins?
Typically, business banking customers hold much larger balances than the average retail customer. Starling says the numbers are more than 10 times higher, in fact Â£ 15,250 to Â£ 1,500, while additional services such as offering credit products to these customers are also more valuable.
In May 2020, he obtained accreditation also distribute loans to small businesses under the UK government’s Coronavirus Business Interruption Program (CBILS). It certainly didn’t hurt his record.
This shift in growth from retail at all costs to higher margin credit and business banking will propel neobanks from obscurity to profitability. It is laughable that Starling could become profitable with less than 2 million customers, and Revolut has failed to do the same with 13 million.
One neobank following an interesting route is the San Francisco upgrade. Despite a valuation of $ 1 billion thanks to Santander join its $ 40 million Series D fundraiser, it remains less well known than the Revoluts or N26 of this world. And even. It’s already profitable.
Since its launch in 2017, ten million customers have applied for an upgrade card or loan, with its credit products growing at a triple-digit rate every year.
The upgrade is primarily about credit, and it seems it’s that focus on early cash flow positivity that sets it apart. Certainly, as we know, credit products have a higher margin than debit cards or savings accounts.
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CEO Renaud Laplanche told TechCrunch it plans to add neobanking services at a later date and debuff Upgrade to “generate negative cash flow for six to nine months after launching its banking tools.”
Starting with a profitable business, then looking for market share later? What madness is this? I’m joking of course.
At the root of the problem is that traditional banking services like savings accounts and transactions are simply not profitable. Most neobanks generate income from interchange fees on debit cards and with interest rates so low, it is not a long term strategy.
Some have tried to generate what is called “lifetime value” by throwing ideas at the wall until something sticks.
âA constant in the fintech world is to offer more services to existing customers, helping to increase their lifetime value and thus making their acquisition cost more acceptable,â writes former CrunchBase editor Alex. Wilhelm.
This assignment can include everything related to money management tools integrated into the applications and trading services. The pressing question now is: who offers the quickest route to profitability?
Challenge the challenger
This growing demand has claimed recent victims.
Tom Blomfeld, the founder of digital banking darling Monzo, transitioned from his role as CEO to a more relaxed one of chairman in March 2020. Less than 12 months later, he left banking entirely.
“I stopped enjoying my role probably about two years ago,” he told TechCrunch in January 2021.
“[T]looking for a bank that has three, four, five million customers and turning it into a bank with 10 or 20 million customers and making it profitable and going public, I think these are huge exciting challenges, but honestly not the ones I found I was interested in or particularly good at.
In his place as CEO, the former head of VISA, Citi and Standard Bank TS Anil, who now faces the dilemma of converting customers to cash.
Incidentally, Monzo has added Â£ 175million in funding since the start of the seemingly endless pandemic.
Founders of more disjointed startups will likely leave the companies they’ve created because investors demand a faster return on their capital.
Go down (under)
Newly neutered Australian neobank Xinja warns of the pitfalls of naked market share grabbing that exists without fundamentally profitable income streams.
It started offering a high yield savings account in January 2020, paying 2.25% on deposits even when the Reserve Bank of Australia’s official cash rate was 0.75%. After successive rate cuts to 0.5% and then to 0.25% in March of that year, Xinja was forced to retreat. Mobile-first digital banking finally succumbed in May 2020, falling to 1.8%. âWe thought it was the right thing to do to protect our current customers rather than looking for new ones,â said CEO and Founder Eric Wilson.
Then, despite an investment of AU $ 433 million from Dubai-based investor Emirates World Investments in March 2020, Wilson was forced to surrender his Australian banking license just eight months later.
At the time, the CEO blamed the pandemic for Xinja’s bank failure, as well as “the challenge of raising funds for a capital-intensive business in this environment.”
Xinja’s fall from grace showed how close these large-scale startups can be, enjoying no profit with rapidly shrinking capital.
Wilson said Xinja’s focus would shift away from transactions and savings products in favor of its US Dabble stock exchange product. But that too has hit the roadblocks and has been delayed several times compared to its deployment in August 2020. This is a common theme with the profitability of neobanks.
There are brighter signs for sites that have started stock trading and investing as part of their business model.
Revolut’s stock trading feature, for example, allows clients to buy fractional shares in US companies, thereby diverting market share from similar popular investment apps eToro, Trading212, and Freetrade. The most successful neobanks should consider moving in this direction.
Let’s not forget that JP Morgan’s astonishing fourth quarter 2019 results were built on rising trading numbers, which Bloomberg reported fueled the most profitable year of any U.S. bank in the world. ‘history.
And in the banking sector more broadly, the success of the investment and trading desks of the largest US banks has masked significant losses in other areas of their business.
The problem for neobanks is that the giants that these little challengers were looking to disrupt are quickly catching up.
JP Morgan announced plans on January 27, 2021 to launch its own digital-only bank in the UK. Don’t make mistakes. It’s an existential threat to Revolut, Tide, Monzo, and the others.
The conclusion? The âgrowth at any costâ strategy could easily cost Revolut and its neobank brethren more than a few quarters of losses. With bigger fish now swimming in the same pond, this could be the end of unprofitable neobanks for good.
Maxim Bederov is an investor and an entrepreneur.