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Neobanks have received significant attention and massive investments from venture capital firms. Despite the global economic slowdown, they raised more than $12 Billion in 2021. The number of digital-only banks has risen from 250 in 2020 to 333 in 2021.
One cannot help but wonder – how are neobanks going to evolve? What pushed the neobanks to grow at an astronomical rate? What global trends will carve the future of neobanks?
The Rise of Neobanks
The whole BFSI industry has undergone a massive transformation in the last two years than in the previous decades combined and will continue to do so. Pandemic presented immense opportunities to the Finance/BFSI industry. On one side, it forced people to
stay indoors but, on the other hand, asked banks to rethink their modus operandi.
Economic uncertainties, increased competition from digital-only banks, rapidly changing customer requirements, and fast-developing technology completely changed the banking ecosystem, forcing traditional banks to reprioritize their long-term vs. short-term
goals.
However, what underpins a conventional bank has become part of the resistance to required transformations such as high operating costs, the burden of back-office operations, limiting banking processes, and outdated systems.
“Pandemic fallout has made the traditional retail banking environment even more demanding. For incumbents to remain relevant, now is the time to embed finance within customer lifestyle and embrace platform-based models — procrastination is no longer an option.”
– John Berry, CEO of the European Financial Management Association (EFMA) in
World Fintech Report 2021.
Neobanks – a new hope in turbulent times
The 2008 recession gave birth to Aldermore Bank, a technology-driven bank. 2009 saw the inception of Aldermore bank, an SME-focused financial services company that got a banking license by acquiring Ruffler Bank. Though they were the first challenger bank,
the media recognized them later in 2015 before First Rand Bank acquired them in 2017. These banks were fintech with banking licenses and provided banking services over the internet. They were called the challenger banks.
2010 gave birth to a new crop of fintech. They called themselves the
Neobanks. They focused mainly on the underserved population and provided banking services through licenses from conventional banks.
When the pandemic hit the world in 2019, conventional banks had to launch or improve the services of their pre-existing digital-only subsidiaries.
When you look at the above situation, there are three ways to create a digital bank. They are:
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Greenfield: A completely new entity with new infrastructure and a banking license offering innovative products and services called Challenger Banks.
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Bluefield: A new entity using a mix of new and acquired infrastructure offering a blend of products and services. They are more likely to leverage the banking license of a traditional bank. They became the Neobanks.
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Brownfield: A traditional bank subsidiary leveraging its resources to digitally deliver products and services to its customers. They became the digital subsidiary of conventional banks and are essentially digital spin-offs of traditional
banks.
The Opportunity
Many traditional banks lacked digital transformation capability due to their inflexible underpinnings. Customers began to incline towards fintech solutions that allowed them to integrate their existing conventional bank accounts and perform all the banking
functions in one place.
“42% of bank executives polled said that they were unsure about how to integrate and streamline office functions effectively from back to front, and 46% said they are unsure how to embrace open banking, orchestrate the ecosystem or become a truly data-driven
organization.” – World Banking Report 2021
The gap between the services offered by conventional banks and what customers expected out of them widened. The disparity between banks and customers became more evident during the pandemic.
Neobanks such as Chime, Open, and Affirm offer innovative solutions with the help of their partner banks. Partner banks such as Celtic Bank, ICICI Bank, and Green Dot Bank lead the pack in working with neobanks to deliver banking solutions.
The Growth
The reason for the astronomical rise of the neobanks is the vast opportunity of the underserved left by traditional banks that were up for grabs during the pandemic. Most of these were freelancers, gig workers, and independent creators.
For example, if you take the US, the gig workforce makes up
35% of the US workforce, i.e., 60 million gig workers and freelancers. They have seen a 700% increase in transactional value since the pandemic’s beginning, according to a
report from Upwork. Rising inclination towards gig work and increase in transactions from the gig economy makes it a lucrative target market for the neobanks. Many already cater to them, e.g., Open, Lance, Lili, and Novo, target freelancers and gig workers.
In 2020, the valuation of the global neobanking market was at $34.77 Billion. According to
grand view research, the neobanking market expects to expand at a compound annual growth rate (CAGR) of 47.7% from 2021 to 2028. By 2028, the estimated market size of the neobanks
will be $722.60 Billion.
Source: Exton Consultancy
ABI Research
predicts that the top 57 neo and challenger banks worldwide could potentially jump from 155 million customers in 2020 to 590.6 million in 2026. Neobanks will continue their growth spurt. They will continue to evolve while setting up new trends to carve
their future.
Current trends across major markets
Neobanking is going through a massive transformation. Developed markets such as Europe, the US, and the UK are going through regulatory changes that create a favorable environment for the neobanks. New players are now targeting ultra-niche segments of the
market, such as the LGBTQ segment, artisans, and teenagers. Neobanks are adopting leading-edge technologies, thus nudging traditional banks to reinvent themselves to serve the customers better and increase customer retention.
We will look into each of the above trends in-depth and later explore the future of the neobanks.
Regulatory Changes
Neobanks take the same risks, have unique product offerings, and follow similar processes as traditional banks, so regulators enforce identical rules on neobanks. However, the modus operandi of neobanks is different from the conventional banks. Neobanks
are more digitally inclined than traditional banks. Ideally, the rules that apply to conventional banks need not apply entirely to the neobanks.
Therefore, many regulators across the globe are coming up with newer regulations to support the new breed of banks or neobanks. The USA is developing
new regulatory frameworks for banks focused on understanding various partnerships between banks and fintech.
The FCA’s regulatory sandbox in the UK that started 7-8 years ago also works with digital banks. In August 2021, the regulatory sandbox from FCA moved to “Constantly Open,” allowing neobanks to submit their applications throughout the year. Neobanks can
now access the testing environment and services of the regulatory sandbox at the beginning of their development lifecycle to maximize the benefits of live market testing for progressing their innovative models.
Similarly, the
NITI Ayog in India has recently recommended a similar approach for digital business banking. The participating fintech solution providers will receive a restricted Digital Bank license and operate as a Digital Business Bank in the sandbox. They will be
monitored on matrices such as customer acquisition cost (CAC), volume and velocity of credit disbursed to MSMEs, technological capability, level of compliance, etc. The sandbox restrictions will be relaxed progressively based on their performance, and the
licensee will receive a Full Stack Digital Banking license.
New entrants
The neobanking industry is seeing new players every day. Most of them are creating a micro-niche such as
Nerve, a new neobank that aims to serve the unique needs of professional musicians.
Verizon is entering the neobanking space with an offering specifically for kids and youth called “Family Money,” much like another network operator competitor
T-Mobile.
What are the global neobanking players up to?
Top neobanks across the globe are constantly making news. 2020-21 has been a year of M&As and exploring markets.
India seems to hold a high market potential for foreign neobanks due to the market’s sheer scale. Revolut and Tide are starting their operations with their state-of-the-art payment solution for freelancers. Stripe acquired Recko for its payment tracking
and automation. Zip has made a $50 Million Investment in an Indian neobank. Open, Asia’s first neobank, has received Google and Temasek funding.
According to CB Insights, the number of neobank deals (65) declined by 12% from Q4’20 to Q1’21, but funding soared by 25%. It was the first time deal activity fell since Q4’19.
What will impact the future of Neobanks?
Undoubtedly, neobanks will evolve to a point where they can be seen as an alternative to traditional banks. However, one cannot deny that neobanks will be those partners of conventional banks that will profit from serving the underserved.
Elevated customer experience will be the key differentiator
Customers choosing fintech over traditional banks are looking for a better customer experience and are ready to try new things. Moreover, according to
research by Alan Mclyntre, Senior Industry Director at Accenture, neobanks have been more receptive and empathetic than conventional banks during the pandemic.
Additionally, advancements in technology have only brought banking services closer to customers. Neobanks have been continuously striving to provide better banking services digitally to earn their customers’ trust. Physical interaction with customers is
not the only way to build trust; providing the right CX digitally also goes a long way.
Embedded Finance and future of the neobanks
A discussion on the future of the neobanks is incomplete without embedded finance and the kind of key it holds to the future. Embedded finance is a fintech model where brands can leverage APIs to integrate banking and financial features into their apps and
ecosystem.
It opens new opportunities for fintech and brands. They can add financial services to their existing product portfolio. The embedded finance service providers can lease licenses and provide access to specific banking stacks to fintech and brands. It reduces
compliance and development costs, thus enabling the neobanks to create more customer-specific solutions.
Embedded financial services make space for improved efficiency, seamless integration, and an intuitive flow by eliminating intrusions in a platform’s customer journey.
Moreover, the essential characteristics of these services are credit affordability and customized, in-context financial offerings. The recent
EY study states that 63% of people would ‘highly value’ open banking and embedded finance solutions to create personalized experiences due to ease of use.
To understand better, we can have an example. Suppose an eCommerce brand has integration with an embedded finance solution. Most customers research products they wish to buy, make a list, and end up buying a small fraction of the list due to budget constraints.
By analyzing the purchase pattern, transaction messages, and other factors, the brand decides the customer’s creditworthiness and extends a small loan or a buy now pay later (BNPL) offer to the customer. The customer will most likely buy most of the products
on the list to pay later.
The above example is only the tip of the iceberg of what brands can achieve with embedded finance. There can be millions of use cases based on the brand, what they sell, their customers, and their customer journey. This story also holds for SMEs.
According to a recent study by
Accenture, 41% of SMEs hold a positive attitude toward receiving and using banking services from digital platforms without switching between multiple apps. 47% of them are willing to pay a premium to avail embedded banking services on the digital platform.
It is an excellent time for the digital platforms offering embedded banking services. It is also worth noting that the embedded finance market for SMEs will be worth $125 billion by 2025.
Walmart recently announced that it will provide financial services with its financial technology investor Ribbit. Ikea announced that it is purchasing 49 percent
of its banking partner. These are some of the many decisive moves large brands are taking to embed financial services into their existing portfolio of products. More brands in B2B and B2C categories will follow suit to deliver a seamless customer experience
and offer a complete customer journey on a single platform.
Conclusion
The number of choices customers will have for choosing a banking solution for themselves will be huge in the future. And these options will only keep on increasing. While it might seem like traditional banks are struggling to keep up with neobanks, that’s
not the case. Neobanks will be leveraging their partnerships with the banks to offer banking services to new niches. The coming years will see an influx of new innovative neobanks targeting particular target segments.
Financial Services
