Will The Neobank Bubble Eventually Pop?

The ongoing economic uncertainty and inflated valuations drastically impact fintech funding rounds. Data from the previous year paint a depressing picture; according to CB Insights, fintech firms raised US$20.4 billion in the second quarter of 2022 or roughly half as much as they did in the same period in 2021.

Is neo-banking, which flourished during the COVID-19 pandemic, about to undergo a turning point with fintech valuations and start-up funding expected to plummet in 2022, along with the threat of an impending recession?

The COVID-19 outbreak prompted immediate changes in the financial services sector, most notably the sudden and pressing demand for contactless online services. To support digital services, almost one in five (18%) banks introduced contactless payment methods, according to Statista.

A new generation of neobanks, or digital-only players, were well-positioned to quickly accelerate the digitalization of financial services as remote banking started to outline the future. But as the number of neobanks has exploded globally since 2019, new entrants need help securing their future.

Neobanks experience financial pressures.

Despite their high valuations, only 5% of today’s neobanks are thought to be breaking even, much less making a profit. This is because Neobanks rely on significant amounts of investment, but investors are issuing fewer and smaller checks as a recession approaches. In Q3 2022, global fintech funding decreased 37% quarter over quarter.

Neobanks have a difficult road ahead because less capital flows into the industry, particularly to fintech, which has yet to demonstrate capital efficiency. People may turn to their “first” bank accounts to weather the recession due to the rising cost of living. Many people have a “secondary” neo-banking account due to convenience. Still, as the recession takes hold, some may be willing to give this up to play it safe with traditional and fully licenced banks.

These two factors squeeze companies that provide financial services as costs rise and profitability declines.

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Unsustainable business strategies

The fundamental business principles of neobanks are being put to the ultimate test. They depend on high levels of stable funding because they are a cash-intensive business. However, their revenue model still needs to improve, and the cost of acquiring and keeping customers rises as the competition grows.

Most neobanks provide a debit card and a mobile application (powered by either Visa or Mastercard). They rely on low card fees and interchange revenue to draw users because they are so hyper-focused on growth and staying ahead of their rivals. As a result, they miss out on FX fees, monthly fees, transactions, and other fees of the exact nature. Instead, their business model is based on persuading customers to upgrade to a premium account, which provides additional benefits but also comes with monthly fees. Alternatively, they could upsell customers on insurance, cryptocurrency, and lending services.

The challenge is that only a small percentage of customers would upgrade to a premium account, and upselling other services is complex when all neobanks compete on the same premium services. Assuming neobanks rely on these premium services for revenue, adding these expensive products and services to their offering has a compound effect on their cost base and structure, impeding their path to profitability.

Neobanks, with their banking licence, will, by definition, be more protected from future contractions. On the other hand, those who rely on traditional banks to process transactions are analogous to a world-class F1 racing car manufacturer who must depend on competitors for tyres, driving wheels, and even the driver. Having to rely on a third party for core components makes neobanks vulnerable to external factors.

Neobanks’ compliance issues

Neobanks are currently being scrutinized more closely for their compliance systems. Regulators are checking neobanks to ensure they have the proper fraud and compliance systems against the backdrop of the cost-of-living crisis and rising financial scams.

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To ensure that their compliance programmes align with the new products they provide, many neobanks must fight an uphill battle. Since the C-suite is typically focused on quickly bringing new products to market, early-stage fintech usually needs more resources than a traditional financial institution to staff and operate internal compliance systems.

Neobanks must invest in teams that can manage these processes, increase confidence in their offering, and foster a better customer journey as regulation catches up with digital innovation across the industry. In addition, neobanks must prioritize compliance and strengthen their defences against financial crime if they want to compete on an equal footing with their physical counterparts.

Goliath’s revenge on the cards?

Neobanks increasingly face threats from established providers as traditional banks, and fintech behemoths step on their toes.

Just eight months after its launch, Chase UK, J.P. Morgan’s neobank equivalent, had 500,000 UK customers and attracted more than £8 billion in deposits. For those considering switching their finances to neobanks, fintech behemoths like PayPal have set their sights on becoming a fully developed finance app. They offer a variety of competitive features.

Differentiation will become increasingly important for neobanks looking to maintain their position as competition from established players grows. Larger companies will typically have access to a more extensive customer base, so neobanks would do well to focus on a particular market niche that established providers underserve. This could entail providing services to young people, gig workers, or financially marginalized people.

Another choice is to differentiate themselves through the use of technology. While traditional banks are entering the neo-banking market with features and incentives, neobanks’ USP lies in their capacity to provide an appealing and customized user interface. Therefore, customers will naturally prefer solutions that adapt to their needs and are slick and easy to use, even if the products delivered are the same.

The benefits of neobanks are numerous:

  1. They can maintain lower pricing than traditional banks because they have low overhead.
  2. Because technology is ingrained in their culture, they can quickly respond to threats and opportunities.
  3. It also enables them to offer cutting-edge features like budget visualization tools and a more streamlined onboarding and KYC experience.

Thirdly, they have access to a broader clientele with lowered entry barriers for clients with bad credit or those needing help to meet conventional requirements. Neobanks must cultivate these advantages and outperform their established competitors to survive.

However, embedded finance redefining the banking industry is now posing threats to both parties. When customers can access credit and other banking products directly from their favourite brands, it calls into question the relevance of traditional banks or even neobanks. As a result, non-banking brands increasingly provide their customers with financial features.

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What happens to neobanks now?

The days of “cheap” financing are over, and providing services for less than they cost is no longer feasible. As a result, neobanks must carefully consider their next move because the way they are currently set up needs to offer a quick enough path to profitability. In actuality, even the largest rounds of investment are insignificant in light of the financial capabilities of conventional banks.

If neobanks are to survive, innovation and differentiation are essential. Ant Financial is an excellent example of a neobank that has revolutionized the Chinese financial industry, which is now worth 50% more than Goldman Sachs. Its value proposition’s originality makes this possible, combining social media, e-commerce, and payments. In addition, the fact that Ant offers a return on surplus funds makes it the most significant money market fund in the world. It encourages investors to transfer funds from their current accounts to Alipay wallets.

More than ever, the level of engagement and experience provided to customers will determine whether neobanks survive. Neobanks will still have the chance to deliver a genuine shake-up as “choice architects” of potential changes to our financial services habits – or risk other players seizing this opportunity.

Expect to see the rise of technology-first businesses that use embedded finance and provide their large user base with a reimagined financial services experience as neobanks think about the future. Returning to the FS market in China, we can envision social media companies taking risky actions and integrating the FS experience layer into their services. Could Twitter be the banking sector’s next major disruptor? Let’s wait and see what lies ahead.


What are Neobanks?

Neobanks are entirely online, born in the cloud, digitally first banks with no physical locations. They only offer banking services online or through a mobile app for smartphones.

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