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Five Major Hurdles Neobanks Face As The Fintech Sector Keeps Growing

Five Major Hurdles Neobanks Face As The Fintech Sector Grows

You can start a digital bank in about a month and a half using open banking, API libraries and popular banking-as-a-service models. And if you did, you’d be competing with 256 other neobanks.

Some neobanks cater to climate activists, minority communities, immigrants or the differently-abled. Others provide financial services to the unbanked or underbanked. But as digital banking infrastructure and services get commoditized and neobanks face a flurry of competition, what venture capitalists are “looking for are use cases [innovations] more than just the [demographics],” according to Ryan Falvey, co-founder of Financial Venture Studio.

Of current neobanks, few have reached the billion-dollar valuations of Revolut, Chime or Monzo and most are not expected to be profitable at all. An Accentureresearch showed that an average UK neobank loses $11 per customer per year. Besides, as the novelty of neobanks fades, legacy problems are setting in, such as increasing operational costs and low margins generated per customer.

In this article, we look at the five major hurdles that stand in the way of neobanks as the fintech sector starts to mature. In our next article, we’ll dive into themeasures neobanks can take to remain profitable.

Five barriers impeding the growth of neobanks

For many neobanks, profitability seems to be at odds with their strongest assets, like low operating costs and the ability to scale up and acquire new customers. This is often due to things like:

  1. Low customer lifetime value (LTV): By definition, neobanks that generate revenue from lower debit card interchanges have a lower LTV. And those that offer lending services often lose high-quality loans to incumbent banks, having to compete with other neobanks for the remainder. On average, the customer LTV for a neobank is €15 per customer per year.
  1. High customer acquisition cost (CAC):Many tactics that neobanks use to attract new customers – such as free services and lower fees – increases their CAC and cut into profitability. Although the CAC for neobanks is much lower than incumbent banks at €30 per customer compared to €200,-it’s still too high compared to revenue generated per customer.

A recently published article inFinextra said that even when neobanks suffer losses for several years and require funds from VCs to operate, their LTV/CAC ratio should be acceptable. As yet, most neobanks are struggling with this metric. There are a few reasons why: 

  1. Lack of customer trust: In the UK, as many as 40% of customers place their trust in traditional banks versus 10% in challenger banks. This lack of trust makes it difficult for neobanks to position themselves as primary banks. It can be tough for them to have deposits of more than a few hundred euros or develop a long-term relationship that could lead to selling more expensive financial products.
  2. Rising competition from incumbent banks: Incumbent banks have increasingly digitized their services and adopted cloud computing and agile models to serve their customers better. The pandemic, during which many were forced to close down their branches, only accelerated this effort.
  3. Big Tech takeover:Companies like Google and Apple have recently entered the field, offering the same line of services and similar benefits. With their deep pockets, these Big Techs are big competition for neobanks. 

On top of these, regulatory constraints and customer demands for localized banking products are making it difficult to scale up internationally while maintaining stable costs.

Tom Merry, managing director at Accenture Strategy, said that there are still stark challenges that need to be addressed and the current mismatch between sky-high valuations and profitability is becoming increasingly clear. Accepting that there are some examples where successful companies have foregone profit for several years, their current focus on customer acquisition comes at a significant cost.”

In our next article in this series, we address some of the measures thatneobanks can take to maintain a competitive edge.
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