Article

As Funding Dries Up, Can Neobanks Diversify Their Revenue Streams?

Investors are no longer satisfied with just customer acquisition, and are pressing neobanks to generate profitable revenue.

Di Beatriz Troiano e Adam Davis

First published on dicembre 21, 2022
Tempo di lettura min.


In evidenza Investors in the fintech sector increasingly look for sustainable paths to profitability rather than simply growth of the customer base. For neobanks, this means they should look beyond their recent wave of customer acquisition to find new routes to profitable revenues. Among the most promising routes are subscription services, lending, services for small businesses, and Banking-as-a-Service. Despite the pandemic-fueled spike in demand for digital services and the associated rise of valuations for many fintechs, a slowdown in funding signals that investors are moving away from a growth-at-all-costs mentality and instead are focusing on sustainable paths to profitability. CB Insights recently reported that fintech funding dropped 33% in the second quarter of 2022 to $20.4 billion, a steeper drop than that of total venture funding. Given recent macroeconomic headwinds, it is no longer an option to chase user growth at all costs. Neobanks in particular face increased pressure from investors to demonstrate how they can turn their popularity into profits. With that context, let’s examine how neobanks can diversify their revenue streams. Turning scale into revenues Neobanks have appealed to consumers by offering a seamless digital banking experience on a preferred channel, fast onboarding, and better product design. To turn customer acquisition into revenue, neobanks have traditionally relied heavily on interchange fees (charged by banks to the merchant when processing card transactions). Although some neobanks have scaled up quickly, this business model is under pressure as a route to profitability. Depending on the country, this model may generate low profit margins, which in turn have to be shared with an underlying third-party banking stack (depending on the regulatory status of the neobank). It also relies on high transaction volumes, which can decrease amid economic downturns or lower consumer spending. Current macroeconomic tailwinds affect retail banks in different ways. While we expect the net interest margin to remain steady and probably expand as rates rise, incumbent banks have an edge given their diverse deposit-backed balance sheets and hence their ability to offer higher-margin products, such as personal loans, mortgages, and insurance, at a lower funding cost. Conversely, neobanks tend to capitalize on disruptions in retail banking, such as the customer acquisition spike from providing on-ramp crypto services over the past few years. However, this business model could suffer over the medium term as the funding runway tightens. With interchange revenue no longer sufficient to sustain healthy unit economics, neobanks will want to look at other revenue levers. Subscriptions, premium accounts, and partnerships One way for neobanks to diversify revenue is to offer subscription plans, which allow consumers to choose value-add services that are most suited for them. Subscriptions and premium accounts can increase monthly recurring earnings, making revenue streams more reliable and predictable. For example, Monzo’s net subscription revenue, incorporating the Premium and Plus offerings, has risen from the 2021 launch to over £11 million by 2022, across 360,000 customers. These offerings have the added benefit of bringing together an ecosystem of partners outside of financial services, expanding brand distribution. The services increase the number of possible touchpoints between the digital bank and the customer, leading to higher engagement and stickiness. The bank could also receive additional partnership commissions from direct referrals to other providers. Lending Banking is fundamentally a balance-sheet-driven business. For many digital banks with a positive bottom line, net interest income forms the bulk of operating revenue. Credit products offer banks better monetization opportunities for both businesses and consumers. Nubank’s interest income, for example, made up over 60% of total income in 2021, driven by credit card and lending. Building a strong credit business is easier said than done. Besides requiring a large and diversified balance sheet to support lending activities, it also entails building credit models that rely on risk-based, data-driven pricing, and must be stress-tested for different scenarios and consumer segments before being implemented. Small and midsize business (SMB) banking Despite SMBs’ potential to provide higher average revenues for neobanks and increased willingness to pay fees for banking services, SMBs remain an underserved customer segment. SMBs tend to have higher cash flows and deposit volumes than retail clients, signifying larger wallets for neobanks to capture. In addition, SMBs are more likely to require higher-margin products such as working capital or receivables financing. We have seen neobanks launch SMB services by starting from the underlying business transaction account before moving into higher-value features and services, such as savings accounts, invoice financing, integrations with accounting partners, lending, and even acquiring. This allows neobanks to reinforce the value proposition for SMBs. Nubank, for example, launched NuTap, a digital point-of-sale terminal that allows sellers to use their smartphones to accept contactless debit and credit card payments, and includes a buy now, pay later feature. Investing in the customer experience The customer experience, including service and digital tools, drives a large part of customers’ advocacy of their neobank. That advocacy can then lead them to choose the neobank as their primary bank. This translates into revenue growth, because primary customers are more likely to use other products and services, more likely to recommend the brand to other potential customers, and less likely to churn, thus resulting in a higher average revenue per user. Primary customers can pave the way to healthier profit margins, as their data exhaust enables better personalization of messages and product and offerings. While a seamless digital experience is considered a key asset for neobanks, customer service remains an open question. In the US, community banks are often cited as best in class, reflecting a predominantly human, branch-based experience that has been hard to replicate digitally. Customers’ anxiety that neobanks can’t fulfill general service issues is one major hurdle to more neobanks becoming customers’ primary banks. Banking-as-a-Service (BaaS) BaaS enables third parties with or without a banking license to offer core banking functionality to customers. The third parties outsource many core services to external providers, allowing them to focus more on distribution and services closer to customers. After a lot of investment into this space, fintechs and nonfinancial institutions can now offer seamless digital banking experiences—known as embedded finance—and neobanks are starting to provide these services to other businesses. Specialized services characterize Starling and OakNorth in the UK, for example, changing their business model from being dependent only on net interest margin and fee income transactions to benefiting from recurring revenues. Neobanks will have operational, risk, and compliance considerations to consider before doing this, but they can accrue substantial benefits. These considerations include leaning on proprietary experience and, in some cases, leveraging a third-party banking license. The macroeconomic situation has changed the revenue outlook for neobanks, and investors now want to see signs of profitable growth, not simply customer acquisition. The most viable route to new revenue streams consists of some mix of subscriptions, increased lending, expanding services for the SMB sector, and offering BaaS. Podcast Series Deciphered: The Fintech Podcast \| EP4 - Neobanking Revenue: How to Differentiate in a Crowded Market In this episode, we explore what the future holds for neobanks, with so few currently profitable in the face of a current economic downturn. We’ll discuss the challenges of setting business strategies over the next couple of years, answering key questions such as whether neobanks should pursue growth at the expense of unit economics, how they can continue to differentiate their revenue streams from one another, and ultimately what they should do as rising rates pressure investors to stay clear of potentially “riskier” assets.

In evidenza

Investors in the fintech sector increasingly look for sustainable paths to profitability rather than simply growth of the customer base.
For neobanks, this means they should look beyond their recent wave of customer acquisition to find new routes to profitable revenues.
Among the most promising routes are subscription services, lending, services for small businesses, and Banking-as-a-Service.

Despite the pandemic-fueled spike in demand for digital services and the associated rise of valuations for many fintechs, a slowdown in funding signals that investors are moving away from a growth-at-all-costs mentality and instead are focusing on sustainable paths to profitability. CB Insights recently reported that fintech funding dropped 33% in the second quarter of 2022 to $20.4 billion, a steeper drop than that of total venture funding.

Given recent macroeconomic headwinds, it is no longer an option to chase user growth at all costs. Neobanks in particular face increased pressure from investors to demonstrate how they can turn their popularity into profits. With that context, let’s examine how neobanks can diversify their revenue streams.

Turning scale into revenues

Neobanks have appealed to consumers by offering a seamless digital banking experience on a preferred channel, fast onboarding, and better product design.

To turn customer acquisition into revenue, neobanks have traditionally relied heavily on interchange fees (charged by banks to the merchant when processing card transactions). Although some neobanks have scaled up quickly, this business model is under pressure as a route to profitability. Depending on the country, this model may generate low profit margins, which in turn have to be shared with an underlying third-party banking stack (depending on the regulatory status of the neobank). It also relies on high transaction volumes, which can decrease amid economic downturns or lower consumer spending.

Current macroeconomic tailwinds affect retail banks in different ways. While we expect the net interest margin to remain steady and probably expand as rates rise, incumbent banks have an edge given their diverse deposit-backed balance sheets and hence their ability to offer higher-margin products, such as personal loans, mortgages, and insurance, at a lower funding cost.

Conversely, neobanks tend to capitalize on disruptions in retail banking, such as the customer acquisition spike from providing on-ramp crypto services over the past few years. However, this business model could suffer over the medium term as the funding runway tightens.

With interchange revenue no longer sufficient to sustain healthy unit economics, neobanks will want to look at other revenue levers.

Subscriptions, premium accounts, and partnerships

One way for neobanks to diversify revenue is to offer subscription plans, which allow consumers to choose value-add services that are most suited for them. Subscriptions and premium accounts can increase monthly recurring earnings, making revenue streams more reliable and predictable.

For example, Monzo’s net subscription revenue, incorporating the Premium and Plus offerings, has risen from the 2021 launch to over £11 million by 2022, across 360,000 customers. These offerings have the added benefit of bringing together an ecosystem of partners outside of financial services, expanding brand distribution. The services increase the number of possible touchpoints between the digital bank and the customer, leading to higher engagement and stickiness. The bank could also receive additional partnership commissions from direct referrals to other providers.

Lending

Banking is fundamentally a balance-sheet-driven business. For many digital banks with a positive bottom line, net interest income forms the bulk of operating revenue. Credit products offer banks better monetization opportunities for both businesses and consumers. Nubank’s interest income, for example, made up over 60% of total income in 2021, driven by credit card and lending.

Building a strong credit business is easier said than done. Besides requiring a large and diversified balance sheet to support lending activities, it also entails building credit models that rely on risk-based, data-driven pricing, and must be stress-tested for different scenarios and consumer segments before being implemented.

Small and midsize business (SMB) banking

Despite SMBs’ potential to provide higher average revenues for neobanks and increased willingness to pay fees for banking services, SMBs remain an underserved customer segment.

SMBs tend to have higher cash flows and deposit volumes than retail clients, signifying larger wallets for neobanks to capture. In addition, SMBs are more likely to require higher-margin products such as working capital or receivables financing.

We have seen neobanks launch SMB services by starting from the underlying business transaction account before moving into higher-value features and services, such as savings accounts, invoice financing, integrations with accounting partners, lending, and even acquiring.

This allows neobanks to reinforce the value proposition for SMBs. Nubank, for example, launched NuTap, a digital point-of-sale terminal that allows sellers to use their smartphones to accept contactless debit and credit card payments, and includes a buy now, pay later feature.

Investing in the customer experience

The customer experience, including service and digital tools, drives a large part of customers’ advocacy of their neobank. That advocacy can then lead them to choose the neobank as their primary bank.

This translates into revenue growth, because primary customers are more likely to use other products and services, more likely to recommend the brand to other potential customers, and less likely to churn, thus resulting in a higher average revenue per user. Primary customers can pave the way to healthier profit margins, as their data exhaust enables better personalization of messages and product and offerings.

While a seamless digital experience is considered a key asset for neobanks, customer service remains an open question. In the US, community banks are often cited as best in class, reflecting a predominantly human, branch-based experience that has been hard to replicate digitally. Customers’ anxiety that neobanks can’t fulfill general service issues is one major hurdle to more neobanks becoming customers’ primary banks.

Banking-as-a-Service (BaaS)

BaaS enables third parties with or without a banking license to offer core banking functionality to customers. The third parties outsource many core services to external providers, allowing them to focus more on distribution and services closer to customers.

After a lot of investment into this space, fintechs and nonfinancial institutions can now offer seamless digital banking experiences—known as embedded finance—and neobanks are starting to provide these services to other businesses. Specialized services characterize Starling and OakNorth in the UK, for example, changing their business model from being dependent only on net interest margin and fee income transactions to benefiting from recurring revenues.

Neobanks will have operational, risk, and compliance considerations to consider before doing this, but they can accrue substantial benefits. These considerations include leaning on proprietary experience and, in some cases, leveraging a third-party banking license.

The macroeconomic situation has changed the revenue outlook for neobanks, and investors now want to see signs of profitable growth, not simply customer acquisition. The most viable route to new revenue streams consists of some mix of subscriptions, increased lending, expanding services for the SMB sector, and offering BaaS.

Podcast Series

Deciphered: The Fintech Podcast | EP4 - Neobanking Revenue: How to Differentiate in a Crowded Market

In this episode, we explore what the future holds for neobanks, with so few currently profitable in the face of a current economic downturn. We’ll discuss the challenges of setting business strategies over the next couple of years, answering key questions such as whether neobanks should pursue growth at the expense of unit economics, how they can continue to differentiate their revenue streams from one another, and ultimately what they should do as rising rates pressure investors to stay clear of potentially “riskier” assets.