Charter or Partnership? The Possible Future of Neobanks

Digital-only, unchartered banking alternatives are winning younger consumers and posing both a threat to—and an opportunity for—traditional banking institutions

Key Takeaways:

• Digital-only neobanks are growing rapidly, with 145 million users estimated by 2024.
• Neobanks can reach new segments of users, including those currently “unbanked” or with limited access to brick-and-mortar services.
• As of August 2020, NuBank (Brazil), Chime (US), and Revolut (UK) were the highest-valued neobanks in operation worldwide.
• Because neobanks in the US have difficulty obtaining banking charters, a popular strategy is to establish a chartered bank partner. 

A neobank is a fintech-enabled, online or app-only banking solution. Neobanks are growing rapidly, commanding huge amounts of venture capital funding, as startups race to compete for an estimated 145 million users in North America and Europe by 2024.

This increasingly crowded field of “challenger banks” provides partnership opportunities for leaders of traditional institutions. With their agility, leading-edge technology, and low overhead, neobanks can reach previously inaccessible “unbanked” customers by providing services to anyone with a smartphone. But neobanks that remain unlicensed in the US can offer insured deposits only by teaming with an established, chartered financial institution. 

In his annual letter to shareholders, JPMorgan Chase Chairman and CEO Jamie Dimon warned that “the competition will be intense, and we must get faster and be more creative” to keep up with big technology and fintech startups. He added: “Acquisitions are in our future, and fintech is an area where some of [our] cash could be put to work.” 

The growing neobank landscape 

The neobank market is relatively new, gaining traction only within the past decade. The US market has lagged behind Europe’s, as Europe’s open banking regulations proved more amenable for digital-only banking providers. Revolut (UK) and N26 (EU) are two examples of global mobile-banking apps that arrived on the scene earlier than any of their US competitors, in 2015 and 2013, respectively.

As of August 2020, NuBank (Brazil), Chime (US), and Revolut (UK) were the highest-valued neobanks in operation worldwide, according to CB Insights. In the US, Chime is followed by SoFi, Upgrade, and Dave. Notable competitors include Aspiration and Zibo. Along with their increasing popularity with consumers, signs that the US regulatory environment is becoming more hospitable to neobanks is behind the escalating interest of deep-pocketed investors and traditional banking institutions.

A simple way to classify neobanks is by the service levels they offer, which are determined by whether they are chartered. Not to be confused with the digital banking arms or Banking as a Service (BaaS) capabilities of established institutions, the term neobank is used to define 100-percent digital, freestanding companies that may partner with chartered banks. 

• A full-stack neobank has a banking charter, can provide a full range of services, and controls front- and back-end operations. Examples are Tandem (UK), NuBank (Brazil), and Varo (US).

• A front-end-focused neobank has no banking license and operates as the digital customer interface (front-end) for a chartered, legacy bank partner. These neobanks often use APIs to connect customers to service from numerous providers. Examples are Chime (US), Revolut (UK), and Moven (US). 

Front-end neobanks are essentially apps that offer a slicker, feature-rich user experience for managing common financial transactions. 

The fight to obtain a banking charter in the US is still long and difficult for fintech startups. Until federal and state regulations loosen, partnering with established banking institutions is the best route to viability for most neobank startups. 

The advantages and shortcomings of neobanks

Neobanks allow consumers the flexibility to bank from their smartphones using technology that is often more sophisticated than a traditional bank’s online services. And because neobanks don’t maintain brick-and-mortar locations, their overhead is lower, enabling them to offer lower-fee options.

Neobanks have found eager early adopters among younger people, who have come of age expecting to access most services via their phones, along with “underbanked” groups who lack access to traditional services. By offering no-interest payday loans and business accounts to gig-economy workers, some neobanks have developed user bases in communities currently untapped by more established financial services companies. 

During the COVID-19 pandemic, neobanks provided a way to get government-issued stimulus checks to recipients early, gaining the trust and business of new users. 

But these strengths may also contribute to a lack of profit. The cost of developing and marketing tech features to attract new users is high—especially in what is becoming a saturated marketplace. Startups are experimenting with multiple pricing models, including freemium and subscription-based options, in search of a path to profitability. 

Neobanks also can’t offer the industry tenure and security of traditional institutions. And conventional banks provide in-house interactions, the opportunity for face-to-face negotiations, and the depth of services and lending options of established community businesses.

The implications for traditional banking institutions

Given current US banking regulations and the long and costly road to obtain a banking charter, neobanks will struggle to be viewed as traditional banking institutions in the eyes of authorities. As unchartered entities, neobanks cannot insure deposits, putting their customers’ money at risk should they go out of business. 

A partnership between a neobank and an established chartered institution can be advantageous for both parties. In exchange for legitimacy and security, neobanks offer their traditional partners the opportunity to expand into new consumer markets. Neobanks can extend both the geographic and demographic reach of financial institutions and give their customers a new set of high-tech tools.

One recent example is Greenwood Financial, a digital banking platform targeted specifically toward Black and Latinx customers who have been denied access to “mainstream” financial services. Greenwood is backed by heavyweight establishment partners, including Wells Fargo, Bank of America, JPMorgan Chase, and Mastercard.

Chartered financial institutions probably should not fear that neobanks will replace them—it seems there will always be a need for the services of traditional banks. One way for conventional financial institutions to remain relevant is by acquiring neobanking startups with customer-friendly front ends and an established following of younger users. 

These two types of financial services providers may find profitable, mutually beneficial ways to combine forces.

The attorneys at Johnston Clem Gifford routinely advise companies on issues related to securing capital and regulatory compliance. Our Financial Services teamworks with the world’s largest institutions as well as smaller and middle-market banks, neobanks, and other finserv players. Contact us online or by calling (214) 974-8000.