This article has originally been published in the Open Banking Report 2018 by The Paypers.
Over the past years we have witnessed a steady rise of challenger banks, or neobanks, in Europe. These newly established retail- and SME banks are competing with (or ‘challenging’) the established banks with modern banking propositions tailored to the digital world. Starting from zero, they collectively managed to secure their position in the market and make a sizable impact.
One of the biggest success stories is UK’s Revolut. The company was founded in June 2013 and launched in July 2015 with foreign exchange services. Over time it gradually expanded its offering including current accounts, crypto currency and others. Nowadays it boasts a client base of 3 million customers across Europe (Techcrunch, 6 September 2018), and is valued at USD 1.7bln (per it latest funding round in April 2018, Crunchbase).
Another success story is the German N26, founded in 2013 by two friends with the goal to reimagine retail banking for the mobile phone. It offers a free current account including overdrafts, savings and others, and with various additional services such as instant money transfers and mobile payments. Since its initial launch in 2015, it achieved over 1 million customers from Germany and other markets (N26 blog, 4 June 2018).
These success stories do not stand on their own: there is a large number of innovative neobanks that collectively capture a gradually growing market share across Europe. Most neobanks are from the UK and Germany, but neobanks have appeared all over Europe, for example Compte Nickel (France), Hufsy (Denmark), Bunq (Netherlands) and Holvi (Finland).
These neobanks share some important commonalities. First of all, they have a strong focus on the digital world, with advanced mobile apps and modern banking features – often only exclusively available through a mobile app. Not only the front-end, also the back-end is largely automated, with minimum human interaction.
Second, they offer great customer experience with modern banking features. The account opening process is simple and quick, daily banking service are easy to use and intuitive, and pricing is simple and transparent. In addition, many offer additional services for simple financial management (e.g. financial overview, savings tools) and payments (e.g. intant P2P payments, mobile payments). Neobanks tend to focus on a specific customer segment or product with a better solution, typically areas underserved or overpriced by incumbent players. Monese for example enables migrant workers to easily open a bank account, without the need of a postal address.
Third, they typically offer very competitive pricing to compete with incumbent banks. For example, many offer a free payment account, free- or at minimal margins international money transfers and travel money, and top rates on lending and deposits.
As opposed to incumbent players, challenger banks are not hindered by legacy IT systems, large organizations or physical distribution networks. Neither are they subject to the same regulatory requirements, as they often only provide a subset of banking services or operate under an e-money license (instead of a full banking license). In addition, they bring a fresh view and new culture to banking. This allows them to operate lean and mean, with a high focus on customer experience.
A new era of opportunities with open banking
The introduction of PSD2 and the rise of open banking provides the neobanks with many new opportunities to reach more customers and better service them.
It enables neobanks to better service their customers; they typically only offer a subset of banking services, which enables them to provide better service and operate at competitive prices. Leveraging open banking, neobanks can more easily insource third-party services or data to offer a more complete banking experience. Starling Bank, for example, offers a financial marketplace of third-party apps, integrated within the mobile banking app. This enables customers to enrich their banking experience with a variety of solutions such as money management, savings and pensions.
Moreover, it provides neobanks with an additional distribution channel, to sell and integrate their services within the banking environment of partners. Thereby they can reach and service customers of other banks. Transferwise for example has partnered with many (neo)banks to offer international money transfers at competitive pricing.
Overall, open banking puts the neobanks, with a smaller existing customer base, at a more level playing field with incumbent banks.
The future of banking
While we have witnessed a wave of neobanks in the past years, and open banking offers them better opportunities as well, the future is not without challenges.
First of all, neobanks must compete with existing banking infrastructure and banking relationships. Churn-rates in banking are rather low, depending on the market, on average around 4% per year. Customers need a large incentive to switch banks, being a better service or better prices. Also many customers still prefer to be able to visit a branch with face to face interaction.
Most challenger banks struggle to secure the primary customer relationship, which is the most sticky and most profitable one, and offers the best opportunities for cross-sell. Instead, customers typically use the neobanks as secondary accounts for specific features or services.
Second, related to the first point, most neobanks are (yet) unprofitable. They are still in their early phase, operating at subscale. They still require large IT investments to build the company and marketing to attract customers. Also revenue per customer is often lower due to competitive pricing and the use of freemium models (e.g. the basic services are for free).
This may spark the question whether these neobanks are worth their high valuations and whether they will be able to survive in the long-run. Indeed it seems unlikely that all neobanks will succeed in the long-run, failing to achieve sufficient scale and become profitable. Neither is it likely for them to gain a majority market share, but rather stay more of a niche, similar to the first wave of internet-banks from about 20 years ago.
Yet the neobanks are making a permanent impact on the market. As challengers they are driving innovation on the market. Incumbent players are gradually following suit with similar modern banking apps and improvements in the customer experience.