In our previous blog post we looked at examples of banks that are ‘doing digital well’. In this post we outline the evolution of digital banking and the types of services available.
Radar Payments recently published a comprehensive guide to building a successful digital bank. In order to understand what is required to achieve scale in this sector it is important to first understand how these entities emerged and the market segments they are targeting.
Money and banking have existed in many forms over the course of history and their development is closely intertwined. In the same way that money has existed in a variety of forms with the purpose of facilitating exchange of goods and accumulation (storage) of wealth, banks also have taken a variety of forms and roles from record-keepers of agricultural trades to administrators of cryptocurrency.
Throughout this time, however, the core role of banks has remained the same - to safeguard money, facilitate transactions, and advance payments ahead of future proceeds.
‘Modern’ banks can be traced back to medieval times. Banking practices developed considerably between the 17th to 19th centuries but it is only in the last half century or so that banks have faced serious competition for payment services with the emergence of card schemes such as Diners Club and Mastercard in the 1960s.
Fast forward to the end of the 2010s and the explosion in smartphone usage facilitated the emergence of digital banks offering streamlined services designed to be easily accessed on small screens.
The experience of the global financial crisis of 2008 was a key factor in the development of digital banks. The founders of these new institutions recognised that there was deep dissatisfaction among many customers over how they were treated by their bank and a willingness to embrace a new banking model focused on improving their customer experience.
These new digital banks made the most of the absence of expensive physical premises to focus on niche markets and target a demographic that had already shown an appetite for service disruptors.
Over the last five years in particular the number of digital banks operating around the world has grown rapidly. It is estimated that there are around 400 independent digital banks operating in markets from North America to Asia offering services to in excess of half a billion customers.
This geographical diversity is one of the most impressive aspects of the evolution of digital banking – neobanks have gained traction in countries with sizeable underbanked or unbanked populations as well as established financial markets.
Data from Kantar Finance indicates that one third of Brazilian consumers have an account with a digital bank, a proportion that rises to half in India and a staggering 93% in China. In our previous blog we highlighted some of the most successful digital banks and the strategies they have followed.
Discussion of the strategies adopted by these banks is especially significant since they have not only changed the way consumers use financial services and their expectations of service providers – they have also forced incumbent operators to raise their game. Indeed, some incumbents have gone so far as to establish their own digital bank entities.
One of the biggest success stories among neo banks is Revolut, founded in 2013 in the UK. The company launched in 2015 with foreign exchange services and over time has gradually expanded its offering to include current accounts and cryptocurrency trading.
Another success story is Brazilian challenger bank Nubank, founded in 2013 with the intention of introducing simple and efficient financial services to consumers while reducing fees and unnecessary complexity.
Operating models vary
The diversity of the digital banking sector in terms of target markets, financial backing and level of competition is reflected in the variety of operating models, core propositions and business models adopted by these neobanks.
Licensing requirements differ from country to country. In the European Union, payment services can be offered under a payment institution, electronic money (e-money) or banking licence and there are other markets where there is more than one option for obtaining a licence to provide services.
Speed to market has been accelerated by the availability of outsourced services. This concept is well established in the IT space where complete infrastructures with front-end to back-end solutions are available, but new entrants can also buy-in business services.
The UK neobank Monese, for example, was built around a white label debit card and EMI licence from PrePay Technologies, allowing it to offer card payments and money transfer services to customers across Europe.
One of the most time consuming exercises for any financial services provider is onboarding new customers and this is yet another example of a service that can be bought in to enable the digital bank to operate as a very lean internal organisation.
There are some areas of commonality, however, especially in relation to target audience – which is almost exclusively retail consumers and/or small business clients – and the range of services offered, which typically includes card payments, foreign currency exchange, trading and savings, and lending.
The starting point for any aspiring digital bank is the minimum viable product or MVP, which can be defined as a version of a product with just enough features to be usable by early customers who can then provide feedback for future development.
In the digital banking space these MVPs have included credit card or payment services for consumers; investment services for non-professional investors; and foreign exchange and international payment services for expats and migrant workers.
When it comes to business models it is hardly surprising that many digital banks have looked at the success of companies such as Facebook and Google and decided that the road to success lies in offering basic services free of charge. The thinking here is that by attracting large numbers of customers quickly they will have a large potential audience for paid services down the line.
Proponents of the freemium approach include Chime, N26 and BNEXT. But while this model supports rapid scaling, many neobanks run the risk of merely adding costs the larger they grow.
Another option is to only offer paid-for services. While this approach weeds out a lot of low value customers and those motivated only by cost, it also presents the not inconsiderable challenge of persuading customers to sign up for paid services with an institution that has little or no track record.
A third option is a hybrid business model that incorporates elements of both freemium and paid-for services. These hybrid models aim to combine the best of the freemium and premium business models, limiting hurdles for sign-up while driving up business volumes.
Regulators have fostered competition through initiatives such as regulatory sandboxes, the objective of which is to create a safe space for collaboration on new products and proof of concepts in an ‘off-market’ environment without reaching live consumers.
Open banking is another development that has boosted the scope for new entrants to the financial services market. Open banking enables third party financial service providers – for example, developers of budgeting apps or tools for managing cash flow – to gain access to customers’ financial data securely.
The likely customer base for new digital banks depends on the jurisdiction where they have set up. In markets where a sizeable percentage of the population are outside the formal banking system there is the scope to introduce large numbers of people to financial services for the first time.
In more mature markets where most people are familiar with basic and even advanced account services, digital banks are seeking to take business from the incumbent banks.
Looking at the digital banking market on a region-by-region basis, there is no denying that Asia Pacific (and China in particular) is the global leader. Chinese fintech giants Tencent and Alibaba have successfully leveraged their existing customer bases to sell financial services through their digital banking arms WeBank (Tencent) and MyBank (Ant Financial).
In Europe and North America, digital banks have gained traction by providing a superior customer experience at the lowest possible cost, with most opting for the freemium business model at least initially.
In the Middle East the leading digital banks are mostly standalone operations of incumbent banks and have been boosted to regulatory efforts to move away from paper-based services.
Despite the emergence of major players such as Nubank and Uala, Latin America still has a lot of untapped potential for digital banking growth as a consequence of strong inequality of wealth distribution, poverty, a young population, and high smartphone penetration.
Despite being a hotbed of innovation in mobile money and remittances services, Africa boasts relatively few digital-only banks, reflecting the challenges of operating on a continent with many different societal and regulatory environments.
In the next blog in this series we will look at the key elements of a viable business plan, from problem statement to testing and refinement of the value proposition. We will also consider how to move from value proposition to business model.