Neobanks: Disruptive technology, elusive profits

Neobanks are having a lot of success getting customers to open accounts, but very few are making any money.

Christoph Stegmeier from the global consultancy Simon-Kucher joins us to discuss profitability challenges and other findings of their 2022 study on neobanking.

A few takeaways from the conversation:

    • While there are around 400 neobanks globally that collectively have opened one billion customer accounts, fewer than 5% of them are profitable.
    • Neobanks have a growth approach similar to tech startups, but he predicts customers will walk away when neobanks try to raise today’s low prices.
    • One of the areas of banking subject to the most disruption so far is payment services, which represents a serious threat for incumbent institutions.

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Christoph Stegmeier, senior partner in Simon-Kucher’s global banking practice, welcome to the BAI Banking Strategies Podcast.

Thanks, Terry, for having me.

Christoph, let’s begin our conversation with a little more background about Simon-Kucher, and particularly the sort of work you and the firm do in the banking space.

Simon-Kucher is an originally German strategy consultancy, now present in around 30 countries, 40 offices. We’re around 2,000 consultants. We started as a pricing and marketing specialist, and now really focus on everything related to growth, be it strategy, sales, marketing, products or launching new ventures. That is particularly in the banking space, and now related to launching a fintech or a neobank.

My role there is in the digital banking space, and I’ve worked with several of the neobanks in this world in both launching them, growing them and, on the monetization strategy for them, of how to make money on these customers that they have acquired.

You are one of the coauthors of a Simon-Kucher report published earlier this year on the state of neobanking globally. What are some of the key conclusions that you and your research partner reached in that report?

Maybe it’s worth starting with the definition of neobanks and who we looked at, and that really we define banks that are based on a new technology stack, and particularly important, that follow a clear disruption path. So if the bank doesn’t disrupt a specific product or process, and just does anything copy-paste of what others have done, we wouldn’t call it a neobank. We also categorize them as banks that are focusing mainly on the mobile channel and banks that are really eyeing the primary relationships. That’s probably the biggest difference for us between a fintech and a neobank. Fintechs very often optimize a single product or process, while the neobanks really go after the full relationship, and hence are competitors of the larger incumbent banks. Now, you mentioned the report. I think there’s probably four key facts that are worth sharing. The first one is the growth of the industry. That has been phenomenal. We are now counting around 400 neobanks globally. In the peak years in 2019, 2020, we saw roughly 100 new neobanks launching in any of these given years, which basically means at two per week some were launching in the world. So growth clearly have been fantastic. That growth came along with now roughly one billion customer accounts being within these 400 neobanks. One billion clients, the valuation of these banks is now at around $300 billion. That’s the third big number. So $300 billion for a one billion account industry. That roughly means that every client is valued at roughly $300, at the time being. Clearly, valuations have gone down a little bit since we’ve run the study earlier this year, but we’re still expecting the number to be in a similar range today. And then the final fact, the number that I wanted to share, and that’s one that usually causes a lot of interest and discussion, is the fact on profitability. Because what we found is that out of these 400 neobanks, less than 5% today are profitable. And that, of course, sparks an interesting discussion around whether or not these banks will reach their breakeven any time soon.

So that early focus on top-line growth that you were talking about, it sounds a lot like the approach taken by many tech companies going back to the ‘90s, and of course, more recently, by so-called disruptors. Is this growth-first mentality how we should be looking at neobanks, who’ve barely been around for a decade?

You mentioned an important point, and it’s absolutely true that the growth-first mentality is something we are seeing a lot with the neobanks. I think it’s coming predominantly from the fact that many of those are owned by VCs, so the VCs are using the same mindset for the neobanks that they’ve used in the tech industry before. So while that comparison is true, I think there’s something important to consider. I would not want to compare one of the neobanks with the tech companies, the Amazons and PayPals of this world. Particularly Amazon is used quite often as a comparison of saying, “Look, Amazon hasn’t made any profits for, I don’t know how many years, and it really got them into the position they’re in. Now they’re reaping the benefits. Isn’t that the same thing that will happen with the neobanks?” My answer to that would be that the banking industry is so sufficiently different from the tech industry that while you can focus on scale for a long time, it’s going to be just much, much harder to move from scale to profitability. Because imagine you’re a client with one of the neobanks. You get your free or very cheap offers for a long time. The moment the bank changes prices, the first thing you do is you switch to your bank number two or bank number three. That’s clearly something where an Amazon or a Netflix or other companies had a much better hold on their customers after that time. The comparison is right, but I think the outcome or the answer to that is a different one. For my personal opinion, I would have expected to see more neobanks already being profitable. Many of them are in their year 6, 7, or 8 of existence. My ambition level, it would be to get those banks profitable in year 4 or 5. That’s something that, unfortunately, we haven’t seen so far.

What do you think accounts for that surprisingly low number, so few of them having achieved profitability by this point? Do you think them getting into the black is just a matter of needing more time? Maybe year 4, 5, 6, 7, maybe that wasn’t enough? Or are there more fundamental issues standing in the way, like perhaps there are simply too many competitors, and that maybe some consolidation may be in order?

I think the answer here is quite clear. More time doing the same will not get them into the black. So it really requires a shift of gear, a shift of focus. That focus that I mentioned on scale versus profitability is going to be extremely important if those banks want to move into the profitability zone. The key issue here, if you look at profitability, you look at both sides of the equation, the revenue side and the cost side. In fact, the cost side, most banks are doing a reasonably good job in getting costs per customers to low levels. They’re reaching scale. That’s not an issue to what we’ve seen in the numbers for many of these banks. The issue really is on the income side. You could guess what’s the average level of revenues per customers in these neobanks. Our analysis shows we’re talking about ranges of somewhere between $20 to $30 per customer. If you compare that, that’s probably a type of revenues Uber would get from one ride of a customer. That’s the amount of revenues you pay at your neighboring restaurant. That’s the same type of revenues the banks that you’re dealing with the entire year is getting from you. So there’s a big, big issue, and it’s really a multiple lower of what traditional banks are seeing from their customers. If the banks are not able and capable of increasing that number sufficiently, we think three things will happen, and we’re already seeing that in the market. The first is that some of the neobanks will merge, so some of the larger ones will say, “We can’t do it by ourselves.” We are seeing that already in other parts of the world. There has been a quite notable merger of two of the largest SME neobanks in Europe recently, a French bank Qonto taking over German bank Penta. We’ll see more of that in many countries. Secondly, we will see more acquisitions of neobanks by incumbent banks. And thirdly, I think we’ll also see more neobanks, unfortunately, throw in the towel. Again, over the last few weeks and months, we have already seen that happening. I think Volt in Australia has been one of the key examples in that.

Christoph, we’ve been talking about neobanks globally up to this point, so I want to narrow in more on neobanks that are operating in the U.S. Are your findings about these banks, the ones that are working in the States, are they in line with the global trends? And if they’re not, if they diverge, how are they diverging?

They are broadly similar in terms of the challenges, so growth, really, is okay. They’re on a good growth path, but monetization is not. I think that’s the big story in the U.S. as well. But I think it’s worth differentiating a bit further. So if you’re looking at the U.S., and if I compare the banks here to their international peers, I think in terms of those focused on the investment business, and if we span the definition of neobank a bit wider, we’ll have quite a few of those in the US, like Robinhood, or Acorn, or Stash, for example. I think they’re ahead of the curve, so we see a lot of international players looking at them as their best practice peers. Now, if we move to the next segment, I would call them the classic consumer neobanks, with the big ones being Dave, Chime, Aspiration and Varo, and so on. We do see them pretty much at par with their international peers. In fact, in terms of innovation, they’re probably can move it up a notch in order to be at par with some of their new peers in the Asia-Pacific region, which there are lots going on in that space. But overall, I think they’re doing all right. Their big question is now monetization. Where we are seeing a bit of a gap in the country is on the small business and freelancer side. Those markets are more developed in other nations than in the U.S. We still have 12, 13 SME neobanks in the country, some of them starting to accelerate their growth, but we haven’t seen the same level of disruption in the small business sector that we have seen elsewhere.

You’re talking about the segment targeting of these neobanks, but when you look more deeply, maybe, at that small percentage of neobanks that have managed to generate a positive bottom line for themselves and for their VC investors, do they have certain characteristics, structure-wise or strategy-wise, that you think accounts for their better performance?

The number one criteria for being successful is, first of all, finding not any pain point with their customers, but finding a pain point that customers are willing to pay for. That’s a big, big difference. We have a lot of these banks that are not successful. Pain point, yes, they get customers, but are customers paying for that? No. So finding that, and that is more often in the space of credit and lending, that’s more often in the space of investments. But it’s not so easy to find that pain point with a high willingness to pay in the classic account payment card space, I would say. If you look at our data that we have gathered on the revenue mix of neobanks, we still find about 70% of the revenues sitting in interchange fees and account fees. That’s just very, very difficult to make that a profitable model. It’s the winners, what do they do differently? They have a different mix of products, they’re focusing more in balance sheet, they’re focusing more on investments. They are also more innovative than others. We have seen quite a lot of the neobanks being innovative for their MVP, but then actually they’re starting to lack innovation when it comes to product 2, 3, and 4. These are the clear differentiators, I would say finding the right pain points, focusing on the right product mix, constantly innovating, important. And then there’s a few hygiene criteria, like customer acquisition costs, bringing those down, modern tech stacks, digital mindset, and so on. But that’s the hygiene we’re seeing with pretty much all of the banks, so just getting your customer acquisition costs down is not going to make them profitable.

Some of the biggest U.S. banks are moving into the neobank space in a high profile way, Marcus from Goldman Sachs probably being the best known of this bunch. Like with so many of the digital upstarts, profits are proving elusive. I just saw an estimate that Marcus is expected to lose more than a billion dollars in 2022 alone. What’s the strategy here in trying to create something from the ground up, given that these banks could easily buy out a neobank and its clientele, as you mentioned before in this conversation?

I really think there’s three strategies. So before I get back to the question of buy versus build, I think from a strategy perspective, any bank should have what I would call a digital bank strategy in place. All of the banks do have a digital strategy these days, but a digital bank strategy really means, “Should I build one? Should I buy one? Or should I just defend against the upcoming threat of the neobanks?” For the first two, it isn’t very important what’s your strategic rationale of having these speedboats, as we would call them. There’s typically three ways of going about it. The first one is you want to have a speedboat for attacking a new geography. That could be within the country, or it could be outside of the country, an international plan, such as what JPMorgan is doing with Chase in Europe, for example. The second option is that you are going after a new segment or a segment that your existing brand is not very successful so far. There’s some good examples, mostly globally, but also few in the U.S. that have done that successfully in establishing that speedboat. And then the third option is really going head-to-head against your mother brand with the speedboat. That typically is the more difficult strategy because that obviously comes with all the cannibalization topic behind. Once you figure that out, and then come to the point, “Do I build or do I buy?” I would say building a speedboat is very easy these days – building a profitable one is not so much, the reason for that being that the large banks typically don’t have these, I would call them, the startup teams within. So we’ve seen some of the banks just spending too much money upfront, and then it’s very difficult building something from scratch, but having a budget that’s in the hundreds of millions. It’s keeping costs in line with the increase in revenues. And so for those banks, I think acquiring one is a very viable second option at the point in time, particularly as the valuations has come down a bit. We’ll see a lot more of these acquisitions to come, I’m quite sure.

Looking more long term at the future of neobanking, is it a positive indicator that established players feel compelled to get involved in the space? Should incumbents be worried that these digital competitors will disrupt banking in the same way as Amazon, as you mentioned before – Zappos is another good example, the way that these companies disrupted retail.

I think there’s a piece of good news for the banks. Disruption in banking is just not happening as quickly as it is happening in the retailer space. We are seeing disruption. I mean, undoubtedly so. What the big techs are doing, what Apple is doing in the space, what the PSPs are doing. Stripe, to name one of them, I think they’re actually one of the big threats to the banks overall because they’re disrupting more and more parts of the value chain. We’re seeing the embedded finance topic that I think will be one of the major topics in the years to come. So we do see disruption, but we’re not seeing it at the same speed as we’ve seen it in other industries. And so that extra time just gives banks more time to prepare. If they don’t do anything, disruption will destroy them. If they take the right countermeasures, they still have a good chance to counter that disruption.

Christoph, let’s say you get tired of being a consultant someday soon, and you decide to start up your own neobank in the U.S. Knowing what you know about the neobank business, what niche within the space do you think has the most upside potential, either because of fewer competitors or better scale opportunities or whatever reason?

First of all, I think there’s still a lot of gold to dig in that space, so I’d be absolutely up for that type of role or challenge. I would mention two segments. The first one is the small business segment. I think there’s a lot to disrupt and to gain in the space in the U.S. But maybe there’s another one that would be even more of my favorite, and that is, I would call it, the 50-plus generation, the more affluent generation. That has quite surprisingly been not addressed by almost all neobanks. Almost all of them have been going after the digital natives. My explanation for that is that, as founders are typically young, they go after the younger generation. But that is part of why monetization is so difficult. It’s a more harder to monetize segment. I think what we’ll see, and where I put my money on, is the 50-plus neobank. The generation is almost as digital as the young generation, and probably much faster time to profitability than the segments we’ve seen so far.

Christoph Stegmeier, senior partner at Simon-Kucher, many thanks again for joining us on the BAI Banking Strategies Podcast.

Thanks so much, Terry.