The new challenger banks: ‘A lot of these are going to fail’

There has been a wave of challenger bank startups in 2020, fueled by generous investments from venture capital firms.

The big question is: Can the market support them all given the plethora of fintechs?

Many of them have similar features: low-cost or no-fee accounts, a debit card, early access to wages, the ability to set and track a budget as well as credit-building tools that report rent payments and other alternative information to credit bureaus. Some offer automated savings, too.

Several of the companies hope to distinguish themselves by catering to niche audiences. Greenwood aims for African Americans to be its core customers, Daylight seeks to meet the needs of the LGBTQ customers, and Step is designed for teens.

But specialization doesn’t guarantee survival, and many challengers won’t make it, observers say. Here’s why investors are so bullish on these startups and what could separate the winners and losers, according to the experts.

The Chime effect

Brad Leimer, co-founder of Unconventional Ventures in San Francisco, pointed out that the success of Chime, Varo and MoneyLion and other neobanks that racked up millions of users and millions of dollars in funding this year could be drawing investors’ interest.

“There is a rush to back teams and ideas that could be the next Chime,” Leimer said.

Sumi Das, a partner at CapitalG in Mountain View, Calif. — the independent growth fund of Google’s parent company — also sees Chime, which has raised $2 billion since its inception in 2013 and is now valued at $14.5 billion, as a beacon for investors.

“What Chime has proven to the market is that the demographic of customer that’s willing to adopt the challenger bank is a lot larger than anyone would have expected five or seven years ago,” Das said. “And because they’ve been able to continue to grow and scale quickly, while maintaining a fairly attractive economic profile and customer-acquisition costs, that’s been huge for confidence in the next generation of companies that’s currently building. And we know that this is not a kind of winner-take-all market structure. There should be several other companies that can succeed.”

He also points to vertical customer bases that are not well served by traditional banks. “You’re seeing a wave of challenger banks and other fintechs that are building specifically for these niche populations,” Das said.

Several of the companies are trying to capitalize on the trend toward automated financial services, he said. “You’re seeing folks like Tally and Albert, in which we are invested, that are trying to add a layer of intelligence and automation on financial services,” Das said. “You’re seeing folks get excited and invest behind that vision as well.”

Robert Le, senior analyst of emerging technology at the Seattle-based research firm PitchBook, agreed that investor interest is strong in challenger banks that serve niche markets.

“The new crop of neobanks fits into the verticalization trend that is occurring within fintech right now,” Le said. “Many fintech companies are going to market by targeting a specific industry, business type or demographic.”

The trend started within payments, Le said, with providers like Toast (which serves restaurants), Mindbody (which focuses on fitness studios) and Squire (which has carved out a niche in barbershops) all raising tens to hundreds of millions of dollars to deliver payment services to distinct business sectors.

“We expect the neobank space to follow that verticalization trend,” Le said. “Along with readily available banking infrastructure and low overhead costs, these banks can potentially become viable businesses without having to attract a massive customer base like a generalist bank.”

Das also pointed out that the coronavirus pandemic has given a push to challenger banks because traditional banks have closed many branches and digital channels have become paramount.

“You could kind of say that there’s a gold rush, but there’s a strong rationale, a long tailwind for it and a long runway” for challengers, Das said.

Investors have taken note that it’s easier to build a challenger bank built now than it was 10 years ago.

“We have layers and layers of application programming interface infrastructure, banking as a service and connections to the card networks that are operating at scale with some of the bigger challenger banks,” Das said. “So some of the risks that might have been inherent in the category 10 years ago are less severe today.”

How it all got started

In trying to envision the future, it’s important to recall why challenger banks came to be: The financial crisis of a little over a decade ago provided fertile ground for challenger banks to grow.

“When we started in 2014, we must have gotten a hundred pitches around how much everyone hates their bank,” said Hans Morris, managing partner of Nyca Partners, a venture capital firm in New York. “Banks were dealing with a massive reregulation process. They could not spend the money on tech. They disbanded a lot of their innovation groups. And so they were in many cases put in the position of defending what were obviously not good practices, like hidden fees and mispriced transactions that were too expensive, that didn’t reflect on the line cost or risk.”

Customer experiences were “demonstrably poor,” he said.

“If you’ve ever gotten a mortgage, you would say this is ridiculous,” Morris said. “Any person would react that way. Banks were easy to criticize.”

Yet the early challenger banks, like Moven and Simple, struggled because the cost of customer acquisition was high and the revenues were low, he said.

“Most of the models were not very attractive, he said.

In the past ten years, banks have improved their digital offerings and some have started their own digital banks.

“But there are still groups that are not well served by the existing banking system,” Morris said. These include immigrants, poor people, people whose income levels fluctuate (like gig workers), teens and college students.

Why it’s harder now

However, Das said, some of the new challenger banks may be overvalued.

“My expectation is that some of these companies will be very successful because they have products that are of high value to particular demographics of customers and others are probably on the margin overvalued,” Das said. “There will be some separation of that as we go along, though it feels like there’s good reason to be excited about the sector in general.”

Morris put it more boldly: “A lot of these are going to fail,” he said. “The economics are skinny, so your costs have to be really low.”

Some, such as those that help immigrants get credit cards or teens get checking accounts, may have only temporary appeal, he said.

“Once you’re creditworthy, you don’t want the immigrant credit card, you want the Chase Sapphire Preferred,” Morris pointed out.

Le also said he expects there will be many failed neobanks and significant consolidation in the future.

“However, for now, the market can support the newcomers because it’s really the community and regional banks that are being displaced as banking continues to move online,” Le said. “So you can think that the storefronts for these community and regional banks are going to be the neobanks.”

Keys to survival

Das noted that there are brand advantages to being first and scaling up.

“And there are technology advantages: The faster you get big, the more you can invest in technology, which then allows you to move more quickly and faster than some of the smaller companies,” Das said.

It’s hard to predict which will survive, Morris pointed out, but the CEO’s role is critical. He gives Chris Britt CEO of Chime, Ethan Bloch at Digit, Noah Kerner at Acorns and Adam Moelis at Yotta Savings full credit for their companies’ growth. “These are CEOs who understand consumer behavior, Morris said.

Yotta, for instance, offers people a virtual lottery ticket instead of interest.

“You get the emotional rush of buying a lottery ticket, but it’s building up a savings account,” Morris said. “The insight of the founder, Adam Moelis, was, why do poor people spend $500 a year on lottery tickets when they don’t have $400 a year in savings?”

Another factor in Chime’s success is its business model, Morris said.

“They delivered a service at a much cheaper cost than the banks had figured out,” Morris said. Robinhood and Square did the same. “Low customer-acquisition costs are essential,” Morris said, partly because revenue is low.

Winning the customer’s primary account, the one in which the paycheck is deposited, is also critical.

The best banks and financial services providers meet three standards, Morris said: Is it relevant to you? Is it fair and transparent? And is it seamless?

Leimer pointed out that tech companies like Amazon and Google are presenting competition to traditional banks and the new challengers.

“The next decade will be a battle of efficiencies for acquisition and market share, when it would be nice if it were a competition for value proposition,” Leimer said. “It’s the time to rethink the first principles of banking — what’s in it for the customer — and I’m totally here for that.”

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