As we start this new decade, individuals (more than any era in the past) are ready and open for digital change that improves their financial lives, which has yet to come from 30+ year relationships with big banks. The gig economy has not only arrived, but its here to stay as the freelance workforce in the US is now over 56M. Consumers (especially from Gen Z) are increasingly launching their own businesses and side hustles, and the maturing millennial population continues to turn towards digital options in their daily lives.

Regulation around the world has created “open banking” policies that require large banks and established financial institutions to allow their data to be accessed by 3rd parties (upon account holder request). This open banking movement in the financial services industry, in which fully digital banks known as neobanks or challenger banks have emerged, has led to new banking options that compete directly with legacy institutions. These newcomers are open for business around the world and serving the markets in need of new banking models and access the most.

With the addition of these digital, branchless banks, how will banking look and feel in the next few years? What customer problems will financial services providers need to solve? Which large bank or challenger bank will best execute on deep customization to become the organization that truly knows you?

neobanks rally to serve the UNDERSERVED

Across the globe, virtual banks without a physical presence are launching every year, slowly chipping away market share from incumbent banks. Offering the latest in innovation and access, these entities are meeting the needs of underserved market segments such as unbanked and underbanked, immigrants, freelancers and independent contractors, and small businesses. These user segments have endured monthly and annual fees due to low account balances or lack of direct deposit, and lack proper advice from large banks and their “one-size-fits-all” model.

Neobanks are using the wealth of customer data to be truly innovative – launching new products, partnerships, and ways of engaging customers — for benefit of their clients. The emergence of these challenger banks is in parallel with the rise in mobile usage of smartphones and apps from the last 15 years. Identifying that apps are the primary platform for individuals to do their banking activity, neobanks are at the forefront of the mobile banking revolution - especially when considering seamless design and features. For the majority of 18-24 years olds (43%) and 25-34 year olds (40%), banking via an app on a smartphone is the method of choice; those aged 35-44 (46%), 45-54 (49%), 55-64 (64%) and over 65 (67%) all did the majority of their banking online through a PC or smartphone.

This emerging force in financial services is about being nimble, agile and responsive to the ever-changing needs of clients, consumers, and regulators. A well-known example is the initiative of sharing data for analysis of budgeting, spending habits, and savings progress towards long-term financial goals. This level of advanced support for a client’s financial health encourages customers to deepen emotional bonds to their financial service provider. It’s also the type of service consumers would be willing to pay a premium for – creating the potential to quickly acquire new relationships and generate additional revenue.

Building a NEOBANK

Summing up the evolving needs of customers, lack of financial wellness support from banks, open banking policies by governments across the globe (discussed later), and the mobile banking revolution — there are still two critical components missing in creating challenger banks: infrastructure and technology. There are two options available in the industry that provide a blended solution to both pieces: Banking-as-a-Service (BaaS) partnerships or direct integration with a bank partner.

Banking-as-a-Service has become a dynamic solution in FinTech to digitally deliver a customer-centric bank into market quickly. BaaS providers have been able to provide a banking infrastructure through APIs (application programming interfaces) that can be implemented and launched in months without monetary licenses (for most use cases) or extensive rounds of capital. APIs can be visualized as Lego blocks that fit together to form a banking core framework — through a series of API calls a user profile and account can be created, and transactions executed. Further customization is then layered on top to set up direct deposit, issue debit cards or credit cards, and process loan applications. These calls are synced to a bank partner that serves as the entity that holds the accounts and funds. Some examples of BaaS platforms are Synapse, Cambr, Bankable, and Treezor.

The second option is a direct-to-bank integration. Multiple banks around the world have opened themselves up to partnerships with fintech companies, or have even developed their own BaaS-type platforms as a separate division. In a similar way, APIs are used to fulfill customer-initiated onboarding, account funding, and other banking activities. The neobank would have greater responsibility in building out compliance, implementation, and end user support when partnering with banks directly. The timeline for approval, integration, and launch tends to be longer as well. Some examples of top banks in this area are BBVA, Fidor Bank, and GreenDot.

There is a less common alternative of a FinTech company gaining appropriate licenses (or national bank charter) on their own, to become an independent bank from the ground up. Some of these pure challenger banks have been able to license their own proprietary platforms to regional banks and other fintechs in need of innovative banking.

“Making bank” as a challenger bank

Financial institutions have historically earned their revenue in three ways: bank fees, deposit interest margin (i.e. paying deposit holders a smaller share of interest than what they earn as an institution), and loan interest income (from issuing and servicing personal, auto, residential, and commercial loans). There is a (more modern) fourth method of monetization that comes from card interchange revenue, which has become a challenger bank‘s initial driver of growth.

The debit cards that are issued by a neobank are being used daily by clients to make purchases both in-person and online. In each purchase, there are merchant processing transaction fees that deduct from the total of the final authorized purchase. The purchaser isn’t paying anything extra, but the merchant that provided a good or service is paying a percentage of the sale to the parties involved — specifically the card network (e.g. Visa, MasterCard, American Express, Discover) and neobank (as the issuing bank of the card used in the transaction).

As challenger banks mature and scale, additional services are added as ‘Phase 2’ such as high-yield savings, payroll advances, personal loans, and credit lines. The overall goal is driving primary banking relationships, in which each client actively uses 3+ products or services — making them more “sticky” and less likely to go to a competitor.

how traditional banks respond to Challengers

Despite the wave of customers moving to fintechs for financial services, banks and institutions still have the advantage of consumer trust — consumers were asked (by Bain & Company in 2018) about their willingness to share more data to get a better product offering: 78% said they would share with their primary bank, 63% with another bank, and just 43% with a nonbank (of fintech). Notwithstanding the Financial Crisis of 2008, this innate level of trust stems from banking regulation that protects the interests of clients. Additionally, concerns about data protection and sharing between fintechs and other affiliates has customers hesitating on choosing a non-bank provider to hold their primary relationship.

Instead of standing on the sidelines, financial institutions can utilize similar capabilities to compete with challenger banks in three key ways:

1. Moving faster to develop and deliver similar high-value experiences;

2. Partnering with complementary fintechs to expand their own services;

3. Becoming “the bank behind” the Fintech,by offering Banking-as-a-Service (BaaS) to fuel the tech company’s banking functionality (discussed above).

BaaS is not only a way for traditional banks to minimize disruption by tech companies, but also a major opportunity for these institutions to access new distribution channels for banking services, and attract revenue from a source other than their book of clients. Regional banks can accelerate digital transformation by boosting adoption of digital channels — which scales relationships, revenue, and retention through:

• supporting expansion into new markets (thereby increasing deposits and fueling lending);

• the ability to share data and charge fees to 3rd parties based on volume, type of data aggregated, the number of requests for data, or quantity of transactions completed;

• passing a portion of the fee to customers;

For financial institutions evaluating how to become open — its not as straightforward of a process to integrate. Poor implementation of open APIs can lead to lackluster integration full of open security gaps, and push an institution backward. Some critical best practices for improving integration:

• Availability of complete data sets in industry-recognized standard formats, such as those established by Afinis (previously IFX or Interactive Financial Exchange) and the Banking Industry Architecture Network (BIAN);

• Utilizing modern formats such as JSON and RESTful APIs as simpler, flexible and requiring less bandwidth – making them ideal for a mobile-first world.

Concerns with security of a consumer’s private information are connected to the uncontrolled methods of data sharing happening today. Many third-party data aggregators (such as Plaid) ask customers to share online banking user credentials and then use screen scraping to gather data. Ultimately, customers are at risk as they lose sight of how their data is used.

open banking regulation fuels neobanks

Born from regulation pushing traditional banks to open access of client data to 3rd parties, open banking has spawned the popular independent banking brands we see today such as Revolut, Chime, and Monzo. Globally, neobanking is in stages of development influenced by a varied regulatory landscape:

• Europe: THE pioneer in open-banking, Payment Services Directive (PSD) and its 2nd amendment (PSD2) were landmarks introduced in November 2015. With established standards for an ecosystem of regulation, infrastructure, and authorizations favoring 3rd-parties, there were no early barriers to open banking;

  • Top neobanks in Europe: n26, Atom Bank, Monzo, Revolut, Starling Bank, Tide Bank, Bnext;

• Africa: Due to the critical need for the industry to have widespread, mobile-based reach in underserved and remote areas, national regulation has impacted both telecommunications and financial services. Nigeria (and other neighboring countries) launched an Open Technology Association to develop API standards for open banking;

  • Top neobanks in Africa: Bank Zero, Barko Financial Services, Bettr Finance, Discovery Bank, PostBank, TymeBank;

• Asia: Hong Kong’s monetary authority released reporting on open APIs for the development of an open banking ecosystem. Also, Japan has made several revisions to banking laws in 2017 that will require collaboration between banks and fintechs using APIs, by end of 2019;

  • Top neobanks in Asia: Neat, MYBANK, Kakao Bank (Korea), Jibun Bank (Japan);

• Mexico and Latin America: Mexico passed FinTech laws requiring banks to create open APIs. In South America, Brazil and Chile have also developed new rules for open banking;

  • Top neobanks in Mexico and Latin America: Albo (in Mexico), Banco Original (Brazil), NuBank (Brazil);

• United States: Having multiple agencies highly regulating banking at both state and federal levels, innovation from non-bank financial service providers has sputtered. The Securities and Exchange Commission (SEC) is the leading agency responsible for the majority of regulatory enforcement, with other responsibilities monitored by the Financial Crimes Enforcement Network (FinCen) and the Office of the Comptroller of the Currency (OCC). Large banks have taken the lead in forming independent groups to review revisions for open banking, but have no impulse to make changes quickly;

  • Top neobanks in the US: Chime, Simple, NOVO, AXOS, Aspiration, VARO;

• Canada: The Department of Finance launched a separate Advisory Committee on Open Banking to gather information on how to drive necessary changes for growth;

  • Top neobanks in Canada: Koho, ATB Brightside, EQ Bank, Impak Finance, Mogo, Motusbank, NorthOne Business Banking, QuestBank, Stack, Tangerine;

• Australia: Despite not having PSD-type regulation, the country has still made strides for banks to open access to accounts and data by end of February 2020, and debt-type accounts (e.g. personal loans, mortgages, other asset-based financing) by July 2021;

  • Top neobanks in Australia: Tyro Payments, Xinja, UP, 86400, Volt Bank, Judo Bank, Douugh.

Overall, the United Kingdom (including the greater EU), and Australia are early adopters and drivers of a neobanking environments. Due to transparent regulatory conditions allowing 3rd party access of bank data, and clear ownership of an individual’s personal information — these regions continue to lead the pack globally. As of September 2019, there were 143 financial services providers (monitored by UK’s Financial Conduct Authority, aka FCA) registered for open banking.

Despite having an established reputation for financial services innovation, the United States and Asia are considered industry laggards due to the lack of regulatory guidance and infrastructure. Once these regions move away from a ‘wait & see’ approach towards action on neobanking initiatives, the global leadership ranks will change quickly.

the future OF neobanks

Fintech challengers have been slowly eroding banking relationships for years. Beyond the companies that are pure challenger banks — non-bank brands like PayPal, Venmo, Mint, and Rocket Mortgage offer customers easy ways to make payments, understand their finances, and get approved for a home loan. As companies known for mobile card processing and e-commerce seek approval for banking charters or partnerships, additional businesses outside the traditional banking realm make similar bids – opening the door to a new sector of businesses turned banks.

Beyond general banking offerings (of a deposit account, debit card, and payments), the sector will start to focus on customized features by specific target groups in 2020:

• freelancers — need additional support with tax calculations, withholding, and employee benefits;

• immigrants — assist in quickly opening accounts online as a newcomer, and having access to savings & credit;

• small businesses — support needed in managing accounts receivable and payable, and expense monitoring;

• minor / kids — an education-based bank for learning how to effectively budget, save, and build credit;

• elderly / ‘at-risk’ adults — customized support on access by power of attorney, custodianship, familytrust, wealth preservation, retirement benefits, and insights on healthcare;

• travelers — ability to use a global account and card without additional fees or challenges.

The outlook is bright and expansive for established neobanks and new arrivals offering a personalized experience for niche user segments.

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