Neobanks (or challenger banks, as they are known in the UK) have raised staggering amounts of money since they first arrived on the fintech scene.
Just as with their dotcom forebears, private equity and venture capital funding have been easy with few restrictions, flooding the space with cash. Profitability has been a ‘nice-to-have’ punted down the road.
For example, Britain’s Revolut is Europe’s highest-valued neobank at $5.5bn, but its losses tripled in 2020, and it only broke even for the first time in November last year.
Additionally, privately-held banking startups that you may never have heard of boast ‘Unicorn ’ status: the once-lofty $1bn market valuation.
I fondly remember the days when this metric was unheard of. A landmark. Now? According to CB Insights there are more than 530 unicorns in the world.
Such is the state of the market that new orders of magnitude have come into common parlance.
A decahorn, I’m told, is a startup worth $10bn, and a hectocorn is one that boasts a $100bn valuation. Incredible numbers like these do beg the question of how early investors can ever hope to get a return on their
Maxim Bederov
investment.
One obvious parallel is the story of Tesla, which has amassed an $800bn market cap on the road to being rated the seventh-largest company on earth. It is more highly valued than Facebook, Samsung, or even Warren Buffett’s Berkshire Hathaway, and yet Elon Musk loses money on most of the cars he makes. In fact, according to the Financial Times, the electric car giant relies almost exclusively on selling carbon credits to other automakers for its handful of profitable periods.
Perhaps this is just now the way of things? Profits are an afterthought, a foolish dream, a superfluous requirement of bean counters and money managers?
So, it is with neobanks. Massive valuations. And, where are the profits?
Growth vs Profit
The ability of neobanks to generate more surplus cash than they spend on customer acquisition has been brought into stark focus by the pandemic.
The economic damage that one would assume would be wrought on the world by such an epoch-defining event has been assuaged to an extent by infinite quantitative easing, near-zero interest rates and stock market hopium.
But, there is a great reckoning coming. Some economists call it the ‘everything bubble’. When it pops, so the theory goes, the veil will be lifted, the system stripped of phantom paper wealth and fundamental value will be revealed.
Nowhere is this more closely watched than with neobanks.
In October 2020 Starling Bank became the first retail neobank to turn a profit; all it took was a single month of cashflow positivity (in the region of £800,000 in the black) to generate worldwide headlines.
And Starling, with 2 million customers, has far fewer retail accounts than its UK rivals Monzo (5.5 million) or Revolut (13 million).
As CEO Anne Boden noted in her 2020 letter to investors: “Growth is one thing. But, achieving sustainable growth is another. At Starling, we’ve been very clear about mapping out our path to profitability from day one.”
Audit giant, Accenture noted in 2019 that UK neobanks were losing around £9 per customer, so Starling’s focus could not be more welcome for early investors.
Margin Call
So which portions of Starling’s business have the best profit margins?
Its lending unit supplies personal loans, business loans and overdrafts, for a start. And, it has already swiped a 4.4% share of the UK’s small business banking market.
Typically, business banking customers hold far bigger balances than the average retail customer. Starling says the numbers are over 10 times larger, in fact, £15,250 to £1,500, while the add-on services like offering credit products to these customers are more valuable too.
In May 2020 it won accreditation to distribute loans to small businesses under the UK government’s Coronavirus business interruption (CBILS) scheme, too. That certainly did its balance sheet no harm.
This focus shift away from retail growth at all costs to higher-margin credit and business banking will propel neobanks from obscurity to profitability. It is laughable that Starling can become profitable with less than 2 million customers, and Revolut has failed to do the same with 13 million.
One neobank following an interesting route is San Francisco’s Upgrade. Despite amassing a $1bn valuation thanks to Santander joining its $40m Series D funding round, it remains less well-known than the Revoluts or N26s of this world. And yet, it is profitable already.
Since launching in 2017, ten million customers have applied for an Upgrade card or loan, with its credit products growing at a triple-digit rate annually.
Upgrade is credit-focused first, and it appears to be this focus on early cashflow positivity that sets it apart. Certainly, as we know, credit products are on a higher margin than debit cards or savings accounts.
CEO Renaud Laplanche told TechCrunch he plans to add neobanking services at a later date, and that it would debuff Upgrade to “run cash-flow negative for six to nine months after the launch of its banking tools”.
Starting with a profitable business and then moving for market share later? What madness is this? I jest, of course.
At the root of the problem is traditional banking services like savings accounts and transactions just are not that profitable. Most neobanks generate revenue from interchange fees on debit cards and with interest rates so low this is no long-term strategy.
Some have attempted to generate what’s called ‘lifetime value’ by throwing ideas at the wall until something sticks.
“One constant in the fintech world is the offering of more services to existing customers, helping drive up their lifetime value and thus making their cost to acquire more palatable,” writes former CrunchBase Editor in Chief, Alex Wilhelm.
This mission stretch can include offering everything from in-app money management tools to trading services. The urgent question now forming is this: which offers the fastest route to profitability?
Challenging the Challenger
That intensifying demand has claimed some recent victims.
Tom Blomfeld, the Founder of digital banking darling, Monzo, switched away from his CEO role into a more hands-off position as President in March 2020. Less than 12 months later he left the bank entirely.
“I stopped enjoying my role probably about two years ago,” he told TechCrunch in January 2021.
“[T]aking on a bank that’s three, four, five million customers and turning it into a 10 or 20 million customer bank and getting it to profitability and IPOing it, I think those are huge exciting challenges, just honestly not ones that I found that I was interested in or particularly good at.”
In his place as CEO is former VISA, Citi and Standard Bank exec, TS Anil, who now faces the quandary of how to translate customers into cash.
Incidentally, Monzo has added £175m in funding since the start of the pandemic, seemingly with no end in sight.
More scrappy startup founders will likely leave the businesses they created as investors demand a faster return on their capital.
Going Down (Under)
Recently neutered Australian neobank, Xinja offers a warning of the pitfalls of the naked market share land grab that exists without fundamentally profitable revenue streams.
It began offering a high-yield savings interest account in January 2020, paying 2.25% on deposits even when the Reserve Bank of Australia’s official cash rate was 0.75%. After successive rate cuts to 0.5% and then 0.25% in March that year, Xinja was forced to retreat. The mobile-first digital bank finally succumbed in May 2020, dropping to 1.8%.
“We thought it was the right thing to do to protect our current customers rather than chasing new ones,” said CEO and Founder Eric Wilson.
Then despite landing an A$433m investment from Dubai-based investor, Emirates World Investments in March 2020, Wilson was forced to hand back his Australian banking license just eight months later.
At the time, the CEO blamed the pandemic for Xinja’s banking failure, along with “the challenge of raising funds for a particular capital intensive business in this environment.”
Xinja’s fall from grace brought home just how close to failure these high-scaling startups can be, subsisting on zero profits with rapidly diminishing capital.
Trading Up
Wilson said Xinja’s focus would turn away from transactions and savings products to its US share trading product, Dabble. But, that too has hit roadblocks and has been repeatedly delayed from its August 2020 rollout. It is a common theme with neobank profitability.
There are some brighter signs for those venues that have instigated stock trading and investing as part of their business model.
Revolut’s stock trading feature, for example, allows customers to buy fractional shares in US companies, siphoning market share away from similar popular investing apps like eToro, Trading212 and Freetrade. The most successful neobanks must consider moving in this direction.
Lest we forget that JP Morgan’s stunning Q4 of 2019 earnings results were built on surging trading numbers, which as Bloomberg reported, fuelled the most profitable year for any US bank in history.
And, in the banking sector more broadly, the success of the investment and trading desks of the largest US banks have disguised large losses in other areas of their business.
Adding to the issue for neobanks is the fact that the giants these small challengers sought to disrupt are catching up fast.
JP Morgan announced plans on 27 January 2021 to launch its own digital-only bank in the UK. Make no mistake, this is an existential threat to Revolut, Tide, Monzo and the rest.
The conclusion? The ‘growth at all costs’ strategy could easily cost Revolut and its neobank brethren more than a few quarters of losses. With larger fish now swimming in the same pond, It could be the end of unprofitable neobanks for good.
Maxim Bederov is an investor and entrepreneur.
