🏧 The future of neobanks
+ the evolution of neobanks
Hey hey 👋,
Welcome back to Consumer Startups!
One area I have been exploring a lot is the future of consumer fintech. I believe there will be more tools and platforms that will empower people to create more income streams, invest better, and improve their financial wellbeing. Last time, I talked about how fractional investing is democratizing access to alternative asset investing. This week, I will be diving into the future of consumer banking - specifically, the future of neobanks.
Special shout out to Ken Lian (co-founder of Cheese) and Harry Kioko (Investor at Canapi) for chatting with me for this piece.
In August of last year, Chime raised a new round of funding, which valued the company at $25 billion. Multiple sources reported that Chime is looking to IPO this year, seeking a valuation of $35-45 billion. Chime is one of the neobank players that has really exploded over the last few years.
Neobanks, also known as challenger banks, are digital banks that don’t have any physical branches and promise to deliver a more user-friendly experience with better economics for their customers. Most of them are not actually banks; they operate by partnering with chartered banks to provide banking services to avoid regulatory hurdles often encountered by an actual bank.
The origin of remote banking services can be traced back to 1989 in the UK. The first bank that offered remote banking services was First Direct. It was launched as a 24/7 telephone banking service, catering to the growing number of people who either didn’t like going to bank branches in person or didn’t have the time to do so. It attracted hundreds of thousands of customers within two years of its inception. Its massive success incentivized many other banks to follow suit. In the two decades after the launch of First Direct, the entire banking industry continued to evolve, leading to the rise of telephone and digital banking.
The main catalyst for the birth of the first wave of neobanks was the 2008 financial crisis. The consumer sentiment towards traditional banks tanked to an all-time low. Several fintech startups, such as Chime, took advantage of this resentment by creating an alternative solution for consumers that was cheaper, more convenient, and more secure. One key advantage to this neobank model is that a digital-only bank has a much better cost structure than a traditional bank.
According to Bain, neobanks could have a cost base that is 60-70% lower than a traditional bank. Traditional banks spend a ton of money serving their customers in person. It’s expensive to operate physical branches due to the real estate costs and labor costs involved with many manual processes, such as opening an account and verifying identity. Furthermore, many traditional banks operate on a legacy technology system, which is not only more cumbersome but also more expensive to maintain. Neobanks embrace a much better cost base by having a lean operational structure and a more advanced tech stack.
Fast forward a few years, a lot more players entered the industry around 2019. The second wave took place as more people started to notice the success of Chime and many early entrants, who quickly reached scale and amassed millions of users. The early success attracted a ton of venture capital money. In Q3 of 2019 alone, there were 25 deals amounting to ~$1.3 billion raised.
Another driver behind this second wave is the rise of B2B fintech, which tremendously lowered the barrier of building a neobank. During the first wave, building a neobank was challenging because companies had to build the entire digital banking infrastructure from scratch. With the rise of fintech infrastructure startups, new entrants can now create a neobank much faster and cheaper. For example, neobanks can use Alloy for new user identity verification (KYC) and user onboarding, use Plaid for funding accounts, and Galileo for card issuing. What’s even crazier is that there are companies, such as Unit, that focus on banking-as-a-service which allows any company to quickly launch a neobank in minutes. Giorgio Giuliani from Fintech ruminations has a great chart on neobank stack:
The world of neobanks
The vast majority of neobanks are not really banks. They are the UI layer/the middleman between end consumers and the chartered bank.
So… why are those neobanks valuable for consumers?
I believe they have three main value propositions:
Better UX and UI
Better economics for consumers
Value-added services
The first two are straightforward. Neobank products tend to have slick designs and an intuitive user experience. It is incredibly fast and easy to open a bank account. Most of them don’t have fees and offer higher interest rates on savings than traditional savings accounts. Many of the first wave of neobanks rose to fame because of these first two value propositions. However, over the past few years, these two value propositions have become table stakes. Many traditional banks are upgrading their digital offerings by creating a better UX experience and removing fees like overdraft fees to adapt to the competition.
To differentiate from their competitors, many neobanks are focusing on value-added services. It is particularly true for the second wave of neobanks. There are two main approaches to this - featured-based approach and community based approach. Feature-based approach means creating a unique offering that is novel and attractive for users. Community-based approach means creating services that matter to an underserved community. Most neobanks enter the market by creating an initial product that fits into one of those two categories and over time slowly expand product offerings to increase the LTV.
Below is an incomplete list of neobank players in the US and their initial product:
Feature-based approach - Yotta Savings
Yotta Savings is a neobank that started by offering prize-linked savings accounts.
There were a few insights behind this idea. First, Americans don’t save much but they are really into buying the lottery. In fact, 40% of Americans can’t come up with $400 in an emergency while the average American household spends over $640 every year on the lottery. Second, lottery-based saving products, such as Premium Bonds, have been proven to be really useful in motivating people to save in the UK. Third, Congress had just passed a law a few years prior that legalized prize-linked saving accounts. These insights led to the concept of Yotta Savings, which is an FDIC-insured savings account that gives you the chance to win prizes from $0.1 up to $10M weekly through random number draws. The more you save, the more lottery tickets you can get per week.
Yotta Savings has been growing incredibly fast and has acquired over 350K users. It has worked out really well for Yotta Savings because they are able to find a killer feature that is novel and resonates with many consumers.
The main disadvantage of this approach is that having a new feature is not a moat. It might work for a period of time until the novelty factor wears off and more competitors start to offer the same feature. To increase the stickiness of its platform, Yotta Savings has since launched multiple new features, such as the prize-linked debit card that gives you lottery tickets for each time you use the card.
Community-based approach - Cheese
Cheese is a neobank for AAPI/Asian immigrants.
Asian immigrants are underserved by the traditional banking system. First, it is challenging for them to get a credit card since many don’t have a social security number. Language barriers can also be a challenge for them to get adequate support from traditional banks. In addition, anti-Asian hate crimes increased 339% nationwide last year and many people from Asian communities are looking for a way to give back to their community.
Cheese is able to attract many consumers in the community by addressing their pain points. For example, Cheese offers customer support in English and other languages (e.g. Chinese) to help with language barriers. To encourage buying from Asian-owned businesses, Cheese offers up to 10% cashback at 10K+ Asian-owned businesses and restaurants. In addition, to directly give back to the community, it also has a fund that donates to NGOs that support the Asian community every time a new user signs up.
There are many growth opportunities ahead of Cheese. The company can continue to build more products to solve problems for the Asian community and also expand to other immigrant segments. I am a fan of this community-focused approach because it is an authentic way to build trust and create a strong brand.
Some closing thoughts
Despite the growing list of neobanks, traditional banks are unlikely to go away anytime soon. Many of them are still killing it. For example, Chase has over 60 million users in the US and over 25% of them use 2 or more Chase products. However, the bad news is that due to the archaic structure of those incumbents, they will have a very hard time innovating quickly, which provides room for disruptions. I believe they will start to see much slower new user growth and even lose market share among their existing users as neobanks mature and launch new products to lock consumers in their ecosystems. I wouldn’t be surprised if many users, especially younger generations, start to switch their primary banking accounts from incumbents to neobanks.
To address this potential downfall, many traditional banks are already partnering with neobanks to offer innovative products to their existing customers by leveraging their scale. For example, Chase partnered with Greenlight, a neobank for kids, to offer a whitelabeled product under Chase First Banking. The goal of this card is for both kids and teens to manage their money under their parents’ supervision. This type of neobank-traditional bank partnership will become more and more common. Many neobank startups will likely have a business model with both D2C and B2B channels.
What do you think about this neobank space? Feel free to directly respond to this email. I would love to hear from you!
See you soon 🤙,
Leo