Tilman Ehrbeck
Partner
&
Alexandre Lazarow
Principal, Investments
&
Sarah Morgenstern
Principal, Investments

Neo-Banks Aim to Improve Consumer Financial Health

November 30, 2017
A rich body of consumer research has driven home one consistent refrain over the past few years: the majority of Americans are not financially healthy. Recent studies have illustrated how families struggle with all facets of their finances, from managing day-to-day income and expense volatility, to building up a ‘rainy day’ cushion and saving for retirement. These challenges are particularly pronounced amongst socioeconomically disadvantaged communities.

Notionally, banks could play a vital role in helping families navigate this battery of stressors, serving as natural allies and trusted advisors for strained US households on critical financial decisions.

In practice, however, large traditional retail banks have yet to rise to the occasion, and in truth, have often made things worse. Expensive legacy infrastructure has contributed to business models that rely on costly hidden fees and high minimum balances — features that disproportionately exacerbate the financial stress of low-to-moderate income households. The Center for Financial Services Innovation estimates that underserved consumers spent $24B on overdraft fees alone in 2015. The picture is similar in other advanced economies internationally, and traditional banks in emerging markets don’t even reach most of their compatriots outside of the wealthy, urban enclaves.

The need for a “good bank” — one whose core competitive advantage and business model are anchored in advancing household financial health — has never been greater. A new group of entrepreneurs has taken up the cause. Leveraging the increasing ubiquity of smartphones, the availability of new sources of data, and the insights from behavioral economics, these entrepreneurs are creating a far superior, 21st century retail banking experience through what many are calling neo-banks — digital-only, mobile-first players that re-bundle financial services in new, scalable ways to enhance customer experience. While not all are technically banks, we call them neo-banks, because they essentially do for retail consumers what banks have traditionally covered.

From a consumer vantage point, basic transaction services — the financial heartbeat of consumers — are typically the core product of neo-banks. Value-added features are then added on top. For example, neo-banks can aggregate data to provide a unified view of people’s financial lives; they offer spending analytics and advice, they provide savings nudges and robo-automated investment guidance, and they seamlessly integrate with third-parties for specialized or other big-ticket items such as home mortgages.

In the US, we are beginning to see the impact of this model in action as an ambitious breed of startups are paving new ground to reimagine how a "good bank" could look from the ground up. For example, Chime focuses on younger, lower-income households, offering a checking account through partner Bancorp that is entirely free for the user, with no overdrafts, no monthly fees, and no commissions. It combines that with a personal financial management dashboard and plans for partnerships with other FinTech services, such as automated investing or marketplace lending.

Similarly, Aspiration is building a unique banking and investing firm designed for socially conscious US consumers. By partnering with an existing regulated bank and asset managers, Aspiration offers a mobile-first, high-yield checking account, a “pay what’s fair” pricing model, and access to sustainable investing funds. Aspiration has also introduced a tool which enables customers to track the social impact of their monthly spending.

In emerging markets, neo-bank models can help reach mobile-first consumers, overcoming the limitations of traditional brick-and-mortar banks. From Brazil to Pakistan, neo-banks are introducing innovative approaches to customer acquisition, viable economics, and user experience, bringing core products such as investing or insurance to untapped markets.

What binds all these innovators is their unrelenting customer-facing focus on fundamentally reshaping, and improving, the role that banks play in their customers’ lives.

Under the hood — and largely out of view from the consumer — this growing global community of "good banks" is experimenting with a variety of different operating structures, driven by regional differences in regulatory approaches. In the UK, for example, the relative regulatory ease of applying for a bank license is leading innovators to build full-stack banks without branches. Neo-banks such as Tandem can take deposits, pay interest, and lend money directly to customers. While this allows them to control the full experience and economics, it also comes with regulatory constraints and higher capital requirements.

Neo-banks in other jurisdictions (e.g., US and India) are focused on building front-end customer acquisition platforms. They look like their full-stack counterparts, but the customer money sits elsewhere within a regulated bank. While more capital efficient, the dependency on backend partners can sideline user experience, increase operational complexity, and limit revenues.

At Omidyar Network, we are bullish on the "good bank" model, and keen to support a variety of visionary entrepreneurs tackling this space. As evidenced by these early market leaders, there’s no one-size-fits-all formula for neo-banks. However, here are six factors we typically look for as strong indicators that a new entrant is well-positioned to achieve commercial success and deliver on its full impact potential:

  • Differentiated financial health consumer value proposition: Our first question for aspiring neo-bank entrepreneurs is simple but revealing: how does your business improve customers’ financial health? In a mobile-enabled world, there’s tremendous potential for product innovation and creativity on this front, ranging from clever ways to help households save, reduce expenses, and increase income in the short-term, to new approaches for long-term wealth building and risk mitigation.
  • Commercial incentives that align with long-term customer well-being: Of equal importance, we scrutinize whether the startup’s business model encourages positive consumer outcomes. Chime, for example, has generated strong unit economics via a debit card interchange model, while Aspiration has earned customer trust by adopting its “pay what’s fair” pricing model. Others are embedding thoughtful credit card economics into a cash management offering.
  • Customer-centric organizational design: Historically, banks have been organized around balkanized product lines (e.g., checking accounts; credit cards; mortgages), making it difficult to embrace a holistic approach to serving customers. Unencumbered by legacy constraints, neo-banks have an opportunity to reinvent this dynamic, through data architecture and org structure choices that put customer needs — rather than product categories — at the heart of the business.
  • Focus on an attractive, initial market segment: As many consumers in highly developed markets already have a primary, traditional bank relationship, neo-banks must develop a strong hook to attract attention from a meaningful initial market segment and get traction: for example, digital-native consumers entering the workforce looking for an integrated view of their earnings and the ability to spend and save; or micro- and small business owners looking for low-cost, seamless ways to track transactions and manage cash and back-office administration.
  • Thoughtful ‘build versus buy’ product and IT architecture: Building a fully-integrated experience in-house is costly, so neo-banks need to decide which products to design and own versus which to source. Once a neo-bank has proven its success with its core product, it can integrate with a broader range of services from third parties. Capital-conscious startups will also have to decide which parts of their technology stack they need to own versus what they can source off-the-shelf on a variable cost basis. In the emerging markets, India has created a uniquely enabling environment. Leveraging its public, open-architecture technology stack, Indian neo-banks can compete at the application layer while benefitting from the low-cost unique identity utility and the national retail payment interface.
  • Optimized regulatory approach: Neo-banksneed to be mindful of the licensing and capital implications of their go-to-market product roadmap. Startups that directly manage customers’ money from the outset (i.e., via in-house deposit accounts, insurance, and/or investment products) are subject to an appropriately high degree of regulatory scrutiny, resulting in capital-intensive models that may not be well-suited for venture capital funding. Entrepreneurs should be deliberate about choosing the product(s) they are regulated for at launch, and devise their fundraising strategy accordingly.

The emergence of neo-banks has the potential to fundamentally improve the way people take control of their financial health and meet consumers’ needs better than the industry has ever before — in both emerging and developed markets.

 

 

Aspiration, Chime, and Tandem are investees of Omidyar Network in the financial inclusion portfolio.

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