Neo Bank is one of the hottest topic to talk about in tech, startup, VC, and fintech circles. I began exploring this topic a couple of years ago but it was really the last six months when I took to doing in depth research on the same. I did not get to invest in any of the companies in the ecosystem, partly because we could not get to the right deals, and because I could not get my head around what it really means to have a neo bank in India.
With that pretext, I began writing this piece. I trace the genesis and the need of neo banks in Europe, the current regulatory framework in India, and consequently available business model choices for Indian neo banks. Hope you find this useful.
Why were Neo banks needed/created?
Back in 2010, when Britain was still part of the European Union (EU), the UK financial services regulatory agency PRA came out with groundbreaking regulations that made it easier (for example, revised minimum capital and liquidity requirements) for new firms to enter banking. There had not been a new bank in the UK for the last 100 years, and in summer of 2010 Metro Bank first opened its door to customers. It was a high street bank and even today Metro boasts 70+ branches across the UK. Soon many other EU countries followed suit — regulations overhaul — especially, Germany.
It was only a few years later in 2015–16, as technology became more permissive, entrepreneurs leveraged these new wave of regulations in EU to launch digital-only bank offerings — neo bank or challenger bank. It was then Atom, Monzo, Tandem, and N26 were born. These banks are really banks — they are licensed to accept deposits and lend from their balance sheet. N26, founded in 2013 as Number 26, only started calling itself a bank (N26 Bank) after getting the banking license from German regulators (something for Indian counterparts to think about when they easily take the liberty of calling themselves neo banks, albeit informally).
These banks were solving very genuine needs. In a multi-currency economic zone that EU is, traditional banks charged hefty charges for people to exchange currencies, withdraw money from a different bank ATM/international ATM, even to do a balance enquiry, and many other hidden charges that banks were and are known to be notorious for. (See, for example, the fee schedule of Santander Bank today in 2021). That is exactly what these neo banks anchored to solve for — no/low, and transparent pricing, possible because of digital only operations, and yes, amazing consumer experience as an added advantage.
Banking is one of the biggest (and powerful) sectors to be in. It is no surprise when entrepreneurs and investors caught the wind, neo bank became one of the hottest sectors. In 2020, Neo Banks raised more than $4.5B in capital globally. While the Indian ecosystem has seen a tiny fraction (less than 1%) of the global interest, it sure has caught up in all the talk.
Neo Banking funding globally | Source: Tracxn
There is lot of chatter in the Bangalore these days about neo banks, and what does it really mean. It was something that piqued my curiosity as well, and that is why this piece.
Indian Neo Banks are technology layers and not banks
It is important to make the distinction that Neo Banks in India do not have licenses or a regulatory framework to accept any deposits and then lend. They are merely a technology layer — and not a neo bank — sitting on top of current (partner) bank infrastructure. This has a huge bearing on what they can and can not do, their business model, and viability of unit economics. More on this in the next section.
The chatter in the VC industry is that regulations are just around the corner. Meanwhile, there is another camp which is gambling on banking being banking, and that, if and when, regulations do come around, early movers will benefit massively. Only time will tell, but there are some signals we can take cues from.
It is a risky proposition for sure. The Reserve Bank of India (RBI) has other battles to fight, than taking care of the banking experience of high-income Indians. I wonder how many officers in RBI empathise with someone who could be charged high fee for using her credit card to withdraw money from an ATM and among other things, with someone not considering her banking app experience equivalent to Uber.
If history is any indicator, RBI is more focussed towards driving inclusion, making digital payments cheaper (launching UPI), increasing retail participation in equity markets (allowing direct purchase of mutual funds), and more recently, increasing insurance penetration (decreasing minimum capital required to manufacture insurance).
A case could have been made for giving out neo banking licenses to drive banking penetration, similar to SEA and Brazil, where adult banking penetration has been low. The govt. and regulators are, however, aggressively driving that through PMJDY scheme where already 420M+ people have opened a new banking account. Furthermore, recent fault lines discovered in established Yes Bank and smaller banks like PMC Bank should have tightened RBI`s positioning on neo banking licenses even more.
Banking is a tough business. In a country like India, where cronyism is widespread and often unchecked, Neo Banks shall definitely make RBI nervous, especially when it is about (extremely) hard-earned money of the Indian middle class people which can have their lives` savings wiped out, should a neo bank fail.
Banking experience is overrated. Banking trust is underrated
If regulations are not favourable near to mid term, it is then imperative to know if consumers will pay for this banking experience — when a tech layer sits on conventional banking infra.
There are three important questions everyone should ask. I have given my answer alongside these questions and maybe they are different for you.
- Is my banking application like Uber or Amazon? No!
- Could it be better? Sure. It could definitely use an UI/UX uplift for sure.
- Will I move all my money into a neo bank (or that tech layer) for just better experience? Maybe Not.
In my opinion, banking in India is not that bad. I have been banking with ICICI Bank (2nd largest private bank in India) for last 7 years and I have not gone to the branch even a single time. With 10M+ installs, ICICI Bank is rated 4.3 on Google Play Store — a rating most new-age consumer companies strive very hard to maintain. Like I said, it is not that bad.
Besides, the bank views me as an important customer and provides me a relationship manager (RM) who proactively calls me to make sure I get whatever I need. I have asked this question to many of my VC and entrepreneur friends who bank with some of the top private banks in India and I have got similar answers. Plus, I and these top customers have so many relationships with our banks — credit cards, investment accounts, loans, bank lockers, overseas investment accounts, etc — which are difficult to get out of.
That these top customers who certainly value experience and convenience will move ALL their money and relationships to neo banks is a tall claim. They sure value experience when buying iPhone or grocery but when it comes to money, trust takes over.
While I might keep a neo banking account as a secondary account but for it to become my primary account, where 80% of my revenue pool is, Trust will become important. It takes years to build trust. Wonder if that fits in the venture funded models (Neo Banks) which prize scale and aggression, often, at the expense of doing things the right way.
I recently came across a product market fit framework at Bessemer and I increasingly felt that neo banks that are building for high income Indian consumers for banking experience could be easily places into the “sexy story” quadrant as shown below
What about “catch em early” strategy?
There is actually some merit to Acquire young / new to bank customers and grow with them story only if you can solve for distribution & cross-sell.
Top private banks in India thrive on the most prized deposit class of the salaried customer. They have built trust (relationships) with corporate sector by being bankers to them in multiple aspects of their business — think, credit, payments, treasury, international banking, current account banking, etc. These relationships allow them to sell, for example, zero balance salaried accounts, often at loss — a great New to Bank acquisition channel — to corporate employees. After acquiring these customers, banks sell a variety of products to these new customers — demat accounts, credit cards, fixed income deposits (PPF) etc.
Thus, these technology layers, or so called neo banking experience providers, shall be at the mercy of their banking partners for distribution and cross-sell. (1) Great, but what is the leverage here? And, even if someone manages to build a leverage with the banking partner, (2) how does one make money by just being a technology layer, or euphemistically, a distributor? Plus, there is this question of (3) Who owns the customer? neo bank or conventional banks?
There is a lot to prove. Honestly, I dont have all these answers but in comparison with building for high-income customers, I feel this strategy has more arms and legs.
Someone could get the next wave of high income customers — currently in high school and colleges — and become a gateway to banking for them. It could become a powerful business. One, which could evolve into different revenue streams just for this 10x customer experience.
What could be interesting is a possibility of subscription revenue — a percentage of users valuing this banking experience and paying a premium for additional features such as better rates, loyalty program, superior service. What could be critical here is a neo bank`s ability to co-create a product with a bank — higher share of profit pool and not just remain a distribution — the (1), (2), and (3) problem. Neo banks will have to show banks that they cannot serve a TG of customers directly or there could be additional revenue streams (subscription) for them by creating a product experience like this.
To pull this off, massive category creation and education will be possible. Credit cards can provide some inspiration in this area. They are probably the only financial services (on a widely adopted basis) where consumers pay annual subscriptions in form of annual fee, at least in India. There are a few companies targeting the student segment in India and they could emerge as winners here.
There could also be some threat for neo banks from neo credit card companies such as One Card, and Uni Card. They could very well join the party with a much more fundamentally strong credit card business that makes (a lot of) money. Yes, credit card is a highly profitable business — SBI Cards opened my eyes, see below.
And, unlike savings accounts, credit cards are what banks find it harder to be into this business. The current market is largely controlled by 5/6 banks and other banks are desperate to be into this business and are hence willing to share a higher percentage of an higher profit pool than savings account products. I am very excited to see how it plays out.
There could be an angle in the under-served banking population
I will start with a simple example of a customer profile, Mr. Rajkumar, here. Mr. Rajkumar is 35 years old and works as an accountant at a small factory in Noida and earns ₹25,000 per month. This factory has a relationship with the public bank SBI. As a result, Mr. Rajkumar opened an account with SBI when he joined the organisation 10 years ago as an executive.
While, Mr. Rajkumar has been banking with with SBI for more than 10 year SBI, still does not extend array of products (specially, unsecured credit including credit cards) to him because one, the cost to serve him is very high and there is no mindset to actively build products (that work) for this segment.
The above picture (in a general way) illustrates that. The most important realisation I had was the fact that banks actually participate in the middle income economy in an indirect way. While Mr. Rajkumar gets 4% on his savings from SBI, he gets the same money lent to him through multiple credit hops, SBI will lend to a Tier-1 NBFC which will lend to a Tier-2 NBFC, which will lend to a fin-tech, reaching the same Mr. Rajkumar at 20–22%, for example.
It turns out to be expensive for banks to serve a middle income customer at lower price points. I have talked about these credit hops in my last article here. My ex-boss Bala Srinivasa at Arkam Ventures has extensively written on this topic of low price point and high cost for middle income customer, as well.
The insights or questions here are:
(1) Can neo-banks plug this gap and create a plumbing layer or a channel to make the same underlying banks lend (or serve other products) to people like Mr. Rajkumar directly, reducing the end cost?
(2) Can these banks build a middle-income-product layer that is missing?
An approach like this would allow neo bank layers to create newer revenue and profit pools such as those with credit and insurance which banks currently find it hard to tap into with middle income consumers. Neo banks could add digital-only workflows to traditional bank`s balance sheet to reduce customer acquisition and transaction costs, and make it viable for banks to serve their under-served customers at lower price points.
To me, this approach feels the most straightforward of all we discussed so far. It is sure hardest of all. But who said, building and healthy and profitable company was easy! Teams should approach things segment from a long-term mentality. They should bring in a different level of product thinking to the table as these consumers behave and transact different.
Where is the money? or is there?
A bank makes money by mobilising money. When we deposit money in a bank in India, we get 4–6% interest rate, which becomes a cost of capital for the bank. This money is then given out in form of loans say between 9–12%, this is called yield. The difference between yield and cost of capital is called Net Interest Margin (NIM)- typically 4–5% in India. This is the core business of bank and the real money in here
Unlike that possible globally, Indian Neo Banks dont (yet) have any licenses to have money deposits and then lend. Thus, this fundamental revenue opportunity disappears. Thus, a few choices make themselves available as seen in the table below.
The above table must only be read in relation with the type of TG a neo bank is targeting. For example, getting an NBFC license is doable but the biggest question there is how will that neo bank be competitive with banks if it is indeed targeting high income customers. I have written about this in the past here.
Likewise, other revenue streams possible also have a set of challenges that are described above and difficult to address. There are a few opportunities possible as I have discussed in the above sections as well. For example, for neo banks with catch`em early strategy, subscription revenue could become meaningful in form of annual membership fee, the way credit cards work.
It is really not that straightforward
This article in no way was meant to question the innovation that neo banks are bringing to the ecosystem. This to more to reflect on what are some of the available business model choices they could be thinking about.
Banking will always have a local context as it is the core of any economy. Naturally, it will have some sort of regulatory overload. When I was studying engineering, my physics professor would say this about ‘Rolling Motion,’ one of the toughest topics in Kinematics
Don`t make the mistake of thinking you have mastered the game. Rolling Motion has the tendency to hit you on the back of your head, telling you, that the rules of the game just changed.
This quote aptly applies to building a neo bank in India.
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