Neobanks' Secret to Success and the Indian Developments (#10)
The five-part strategies that all neobanks follow, and the impending Indian takeover of digital banks
Neobanks are 100% digital banks. That is, they are free of any physical branches, and of the associated infrastructure and employee costs. And to separate a neobank from a traditional bank, this one point of distinction may seem sufficient.
But increasingly today, we see legacy banks operating without any branches in certain countries (example: ING in Australia has no physical branches), and that makes the line thinner. The differences then emerge only when we go in-depth and understand the business models of the active neobanks.
This article, in the same spirit, is an effort to highlight the core elements that define neobanks, to provide some insights on their strategies, and to cover in brief how the Indian neobanks are evolving.
Are all neobanks ‘banks’?
I looked up the proper definition of a bank and found one on Investopedia, which defines a bank as a financial institution licensed to receive deposits and make loans. There are three elements to this definition:
Licensed financial institution
Ability to accept deposits
Ability to make loans
If we assume this to be true, then not all neobanks can be said to be banks. Instead, we can divide them into two categories: full-stack and front-end-focused.
We see that the front-end focused neobanks are not really banks. They are rather technology firms that control the customer’s digital banking experience for the banks they partner with. And although they would prefer to get a banking license, some of the most successful neobanks (Chime, Revolut, etc.) do not have a banking license. So, a banking license is not a necessity. But the question still arises — what do these neobanks do differently to stand out against the goliaths?
The Strategy to Succeed
Tip: Think of neobanks as regular start-ups — faced with the same challenges — and not as financial institutions. As it is, competing against big banks is not any different from competing against the big tech. There is always a possibility of getting squashed if you wander too close to them. But if you can create something superior and differentiated, without competing head-on — there is a possibility of survival. This idea is brilliantly explained in this twitter thread by Amir — the founder of Doist, on how start-ups can compete against the likes of Google, Microsoft, and Apple.
And Neobanks follow a similar approach. They target a micro-segment and offer them features wrapped in a digital experience that is superior to what a bank such as Citi, DB, or a HSBC provides. Not that the big banks cannot do that, but creating that experience for a small set of customers is not amongst their top priorities. They don’t put their best resources on the job. On the other hand, for the neobanks, creating that experience is all that matters.
So how do the neobanks do that?
There are five main pieces to the strategy of an average neobank, and each step can separate the neobank one degree away from the competition:
I. Identify an Under-served Market
In the initial phase, every neo-bank targets a niche client audience or a micro-segment. This segment is usually a subset of the broader client group that traditional banks base their products on. Some examples:
Revolut (UK) started with solutions for frequent travellers, has since expanded, and passed > $5Bn valuation early this year
Fampay (IND) is doing the same for teenagers, and recently raised > $4.7Mn from YC, Sequoia, and the like
Qonto (FRA) targets freelancers and SMEs and managed a transaction volume of €10 billion in all of 2019
The list can go on. Every neo-bank initially diverts all its attention towards that one set of the user base. So even if this space gets crowded, we can always expect to see a new digital bank pop-up for a different niche.
II. Offer Features that Address Pain Points
The next stage is where neobanks start building the skeleton for their mobile application — by zeroing in on the affinities and pain points of that single segment. These pain points guide the features of the product. For example, for a neo-bank based around SMEs, expense and accounts management would assume a higher priority. But for offerings around frequent travellers, low foreign exchange fees and high travel rewards would rank higher. Regardless, the idea at this stage is to provide features well-targeted to that specific user-base.
The research shows that most of the features are quite common to the 80+ neobanks, and can be clubbed on a high-level:
Free Account and Low Fees: a majority of neobanks offer a basic account with no monthly or account maintenance fees. Some also allow for a fee-free overdraft (Chime, Varo Money, etc.) and no minimum balance requirements for accounts. All of these are today common customer acquisition strategies, but offering such services is costly and hits the balance sheets of the banks hard. A cost for building a large network, quite common today.
Easy Money Movement: the altruism on fees carries to even money transfers and FX rates. If you happen to skim through websites of neobanks, the promise of savings on FX is consistent across almost all. Another addition for neobanks is the in-app multi-currency (incl. even cryptos at times) support for payments, i.e. allowing payments in a currency other than the default with a real-time conversion.
High-Yield Savings Accounts: thirdly, the interest rate on bank account savings is always an important decision variable for consumers. Neobanks realise that, and some offer an annual percentage yield that is 1–1.5 percentage points above the average savings APY of traditional banks. This again eats into the margins of the neobanks. But, at the same time, is a great way to acquire customers and to retain their money in bank accounts for a long period. Not surprisingly, more neobanks are using this tactic today, and this is not too different from the usual price wars.
Budgeting Tools: this is perhaps the feature set where neobanks get the most innovative. Cash flow projections based on past spend, ‘savings pots’ for spend categorisation (say, food and fuel spends are categosized automatically in different tabs), setting saving goals for a trip to Thailand, and the list is endless. For neobanks competing for the same customer, the quality of spend analytics is often a point of differentiation.
Rewards: Unlike traditional rewards on cards that are complicated with multiple hidden T&Cs, the card rewards by neobanks try to bridge that gap by communicating the cashback benefits and other rewards more transparently. Moreover, since the experience is entirely on the smartphone for the customer, some neobanks also allow tiers of rewards based on spends or offer a customised list of merchants to choose from for cashback and discounts.
Add-on: apart from the above features, neobanks have come up with several innovative solutions to acquire customers and to stand out from the pack. One such example is of bunq, which plants trees on behalf of the user if the users spend a certain amount. As it is, the big banks are not the most creative entities, and often look towards fintech for innovations. This step in stage II is an opportunity for newer digital banks to form their own identities — by being creative with features.
Many of the above group of features are what the industry calls Personal Finance Management (PFM) tools and, for the digital-first customers, these tools form ~60% of the total feature set in neobanking applications today. But as bank licenses become more common among neobanks, we should expect to see banking products take the focus away from analytics tools.
III. Build Superior UX
The two stages above are essential for the ideation of how the neobank will exist — who it will serve and how. But great user interfaces and experiences have been the catapults for throwing neobanks into the mainstream. From opening a bank account 18X quicker than major traditional banks to receiving payment notifications 10X faster and controlling access to debit cards all inside the application, the convenience of banking on the mobile with a user-friendly interface has set a new bar for banking experience. In effect, neobanks are constantly pushing the traditional banks to improve their mobile applications and consumer features today.
Credits: A UX prototype for a Neobank via Juliette Lagache/Dribbble
Common across all applications is how clean, crisp, and user-friendly the interfaces are. Not only easy to use, but they are highly responsive with in-app customer support and customer-friendly FAQs. Once the idea and the UX take shape for a neobank, the MVP of the product is ready to launch.
Built for mars has done an incredible in-depth analysis on the user experience with neobanks such as Monzo, Starling, and Revolut set up against the bigger banks. I would strongly suggest a peek into their analysis if you find the time and want to understand how UX makes a big difference.
IV. Partnerships to Scale
Once neobanks identify and capture an under-served market with their features and user experience, they invariably aim to scale up. The first punt is to dabble with unique marketing strategies such as early access for superior features, or a bunq like plant-a-tree initiate. But to scale big and fast, partnerships with banks and specialised fintech players act as main catalysts.
Partnerships are essential to expanding the product portfolio, i.e. to offer insurance, wealth management, pensions, and other solutions outside deposits and savings, and to expanding the services to more geographies. As neobanks partner, they can use APIs to offer third-party services onto their platforms. These API layovers allow them to access financial data, earn commissions, increase their product offerings, and expand their user bases with relatively less effort. For example, a Revolut or Starling Bank partners with PensionBee to gain access to incredible pension systems. With a specialised fintech for wealth management services, and with different banks across countries to accept deposits in domestic currencies. Whatever the product plan may be, partnerships pave the way to go from X to 10X.
V. Price for Profitability
As always, the last question is on profitability. Working in the favour of neobanks are the facts that they are completely digital, and leaner than traditional banks. The numbers confirm these advantages. Neobanks are operationally more efficient, with a cost efficiency ratio of ~46% compared to 50–60% for traditional banks, according to Finnovate. Moreover, high growth in total assets has allowed neobanks to maintain a lower cost-to-income ratio as well.
Remarkably, the customer acquisition costs are ~$1–38 for an average neobank compared to ~$200 for the legacy-based, and a distribution cost ~6% of the overall cost base compared to ~27% for the retail banking industry. These numbers and the high and fast-growing user base are definite thumbs up for the neobanks.
Despite, according to Accenture, the average neobank loses ~$11 per user today. This is largely on account of the generous features that come with the bank accounts. Luckily, there are plenty of examples of profitable neobanks (Revolut, Kakao, Nickel, among others), and the banking industry is known to attract very sticky customers, who you can always up-sell or cross-sell high-margin products to.
For profitability, two of the most common strategies that neobanks adopt rely on pricing and value-added services.
Freemium Pricing Strategy: While most neobanks offer their standard services — account, transfers, withdrawals, a debit card — free of cost, they charge for additional features such as for analysing the user’s finances or for helping them to invest their money.
Multi-tiered Premium Subscription Fees: similar to freemium pricing, but instead of features, the subscriptions are arranged across account tiers. While the standard account is usually free, the other accounts ask for monthly or yearly charges and offer an elevated set of features. Most famously, Revolut follows this strategy and offers a free basic account, a premium account for £6.99/m, and a metal account for £12.99/m.
What about the Indian Neobanks?
It is exciting to see how the neobanking space in India is developing. And I say developing because there is already a list of diverse and promising (re: well-funded) neobanks in the country. Most of it has filled up only in the last couple of years, and we can expect many other bubbling and forming under the ground as we speak.
The entrepreneur’s optimism is not unreasonable. There is, without a doubt, great potential to bring banking to the unbanked or the young on their mobile phones. And enough neobanking models exist outside India for us to take inspiration from. Moreover, the UPI blow-up and Jio’s entry have helped the case by making digital payments and internet commonplace — something that more advanced countries than ours would also envy.
On the subject, I only sparingly cover how some of the neobanks are building in India today, and the table below should give us a good picture of that.
Source: Company websites and YourStory
We see quite a few neobanks target the SMEs and millennial segments — both troubled by the complications of the traditional banking and increasingly getting used to the digital lifestyles. Also, the distrust on large banks also presents an opportunity for smaller and specific use-case banks to jump in.
That said, few retail-banking challenges still loom large for neobanks. With the UPI interchange fees (MDR) cut to zero, an important source of revenue for fintech players has been doused. Moreover, the laggard regulations in India ensure that banking licenses are years away for most of the neobanks and that they would have to rely on partnerships to offer banking services.
Either way, this is a promising time for digital banking, and it would be interesting to imagine the Indian banking landscape in the next 3–5 years as more banks challenge the incumbents. But before I end, a few predictions are in order:
Expect the neobanking space for millennials to get crowded soon, with the battles fought over cashback and discounts
Partnerships with business and consumer platforms such as Netflix, Slack, Byju’s, Teams and the like for rewards on digital accounts and spend would become quite common
Neobanks will see more acquisitions from technology firms such as Jio, Paytm, and CRED in the next three-five years than they would from big banks
For all we know, I could be wrong on all three counts, but we will have to wait and see how it all unfolds!
Hope the article was informative. If you have any thoughts to share, let me know in the responses or over LinkedIn. Have a great day!