Is the neobank bubble about to burst?

Ongoing economic uncertainty and inflated valuations are having a dramatic impact on fintech funding rounds. Figures from the past year paint a depressing picture – according to CB Insights, fintech firms raised USD 20.4 billion in Q2 2022, which is roughly half the amount raised in Q2 2021.

With fintech valuations and startup funding plunging in 2022, coupled with the threat of a looming recession, this begs the question – are neobanks, which came into their own during the COVID-19 pandemic, facing a watershed moment?

The outbreak of COVID-19 required immediate changes across the financial services industry, particularly the new and urgent demand for contactless online services. According to Statista, almost one in five (18%) of banks launched contactless payment methods to accommodate digital services.

As external banking began to chart its way forward, a new generation of neobanks – digital-only players – were well positioned to rapidly accelerate the digitization of financial services. But with the number of neobanks worldwide exploding since 2019, new bank participants face new challenges to secure their future.

Neobanks face financial pressure

Despite their lofty valuations, only 5% of neobanks today are thought to break even – let alone make a profit. Neobanks rely on high investment levels, but with a recession around the corner, investors are writing fewer and smaller checks. In fact, global fintech funding fell 37% quarter-on-quarter in Q3 2022.

With less capital flowing into the sector – and particularly into fintechs that have yet to prove capital efficiency – neobanks face a tough road ahead. Meanwhile, the rising cost of living may cause people to retreat to their “prime” bank accounts to ride out the recession. The pull of convenience means many people have a ‘secondary’ neobanking account, but some may be willing to give this up to play it safe with traditional and fully licensed banks as the recession starts to bite.

These two factors are putting pressure on financial services companies, with costs up and profitability down.

Unsustainable business models

Neobank’s underlying business models are put to the ultimate test. As a cash-intensive business, they rely on high levels of consistent funding – but their revenue model remains vulnerable, and customer acquisition and retention costs also increase as competition increases.

Most neobanks offer two things – a mobile application and a debit card (powered by either Visa or Mastercard). Because they are hyper-focused on growth and staying ahead of the competition, they rely on low card fees and interchange revenue to attract users and thus miss out on exchange fees, monthly fees, transactions and the like. Instead, their business model is built on pushing customers to upgrade to a premium account that provides additional benefits – and incurs monthly fees. Alternatively, they can upsell customers on services such as insurance, crypto and lending.

The challenge is that only a small subset of customers will upgrade to a premium account, while upselling other services proves difficult when all neobanks compete on essentially the same premium services. Given that neobanks rely on these premium services for revenue, the very nature of adding these expensive products and services to their offering represents a compounding effect on their cost base and structure, hindering their path to profitability.

Neobanks with their own banking license will naturally be more protected from future contractions. Meanwhile, those who rely on a traditional bank to process transactions are akin to a world-class F1 racing car manufacturer that has to rely on competitors for tires, drive wheels and even the driver. Relying on a third party for core components will naturally make neobanks vulnerable to external factors.

Compliance issues for neobanks

Neobanks today also face increased scrutiny of their compliance systems. Against the backdrop of the cost of living crisis and rising financial fraud, regulators are scrutinizing neobanks to ensure they have the right fraud and compliance systems in place.

Many neobanks face an uphill battle to ensure that their compliance programs evolve in line with the new products they offer. Early-stage fintechs generally lack the resources of a traditional financial institution to staff and operate internal compliance systems, with the focus of the C-suite typically on driving new products to market, quickly.

But as regulation catches up with digital innovation across the industry, neobanks need to invest in teams that can manage these processes, build greater trust in their offering and drive a better customer journey. If neobanks are to walk on the same footing as their brick-and-mortar counterparts, they must place due emphasis on compliance and strengthen defenses against financial crime.

Goliath’s revenge on the cards?

The competitive threats to neobanks from existing providers are also multiplied, as traditional banks and fintech giants begin to step on the toes of neobanks.

Chase UK, Morgan Stanley’s own neobank equivalent, attracted more than £8 billion in deposits and reached half a million UK customers in just eight months after its launch. Meanwhile, fintech giants such as PayPal have set their sights on becoming a complete financial app, offering a range of competitive features for those considering moving their finances to neobanks.

As competition from established players increases, differentiation will become the key for neobanks that want to cement their position. Larger businesses will naturally have access to a larger pool of customers, meaning that neobanks will do well to target a specific market niche that is poorly served by mainstream providers. This could mean catering to those who are economically marginalised, gig workers or young people.

Another option is to stand out through the digital experience. While established banks are wading into the neobanking space by offering features and rewards, neobank’s USP lies in their ability to deliver an attractive and personalized user interface. The products delivered may be the same, but customers will naturally gravitate towards solutions that can bend to their needs and are smooth and intuitive to use.

Neobank’s advantages are manifold. First, they have minimal costs, so they can maintain lower rates than traditional banks. Second, technology is in their cultural DNA, which means they can react more quickly to threats or opportunities. It also means they can deliver a more streamlined onboarding and KYC experience, along with innovative features like budget visualization tools.

And third, they have access to a wider customer base, with lower barriers to entry for customers with lower credit scores or those who cannot meet traditional requirements. To survive, neobanks must nurture these advantages to outperform their incumbent counterparts.

Yet both sides now face threats from embedded finance, which is redefining the banking space. Non-bank brands are increasingly offering their customers financial functions, which calls into question the relevance of traditional banks, or even neo-banks, when customers can access credit and other banking products directly from their favorite brands.

Where does this leave neobanks?

Gone are the days of “cheap” financing, and offering services at a price below cost is no longer sustainable. The way neobanks are set up fails to offer a quick enough path to profitability, and the amount of relative capital means they have to think carefully about their next move. Indeed, even the largest investment rounds pale in comparison to the financial resources of traditional banks.

Innovation and differentiation are key if neobanks are to survive. Ant Financial is a good example of a neobank that has disrupted the Chinese financial space, now worth 50% more than Goldman Sachs. This has been made possible by the uniqueness of the value proposition: combining social media, e-commerce and payments. Ant is the largest money market fund in the world, and the cherry on top is that it provides returns on surplus funds, meaning consumers move money from their checking accounts to their Alipay wallets.

More than ever, the survival chances of neobanks will depend on the experience and engagement offered to customers. As “architects of choice” of potential changes in our financial services habits, neobanks will still have an opportunity to deliver a real shake-up – or risk other players taking that opportunity.

As neobanks consider the future, expect to see the emergence of technology-first companies that leverage embedded finance and offer their vast user base a redesigned financial services experience. Going back to China’s FS market, we can imagine social media companies making some bold moves and adding the FS experience layer to their services. Could Twitter be the next big disruptor for the banking industry? Let’s see what the future holds.