Digital banks have exploded in popularity in recent years, with millions of customers flocking from traditional banks to a more modern version. This fact has naturally made many people curious about what digital banks really are and if they’re even banks at all.
These are all valid questions that we’re answering in this article. But first, here’s the short version and a clear answer to ‘are digital banks real banks’:
In the US, digital banks are generally not proper banks but financial technology companies that have partnered with established banks to offer banking services and FDIC deposit protection. Regulators outside the US are leading the way in providing exclusive digital banking licenses, fintech bank charters, and e-money licenses with less rigid regulations.
What are digital banks?
Digital banks offer financial services through mobile apps or even browsers and can be operated by both brick and mortar banks (traditional banks) and online-only banks.
And, while legacy banks use their mobile apps as a simple extension of their existing service that they have on offer in branches across the country, online-only banks offer a much more feature-rich environment in the palm of your hand. If you have the need for these features is a different question.
I can tell you from my experience that even in 2021, my traditional bank’s mobile app lacks some basic functionalities like analytics and budgeting, not to mention real-time notifications that every single digital bank out there has as default.
And this brings us to the major problem that legacy banks have when they start to offer digital banking to their existing customers. Their systems are old and not easy to upgrade.
On the other hand, challenger banks are much more agile and have a proprietary technology that is specifically designed for online banking and have many modern features already built in.
How are digital banks regulated?
Digital banks have to conform to many government agencies and laws, depending on the scope of their financial services.
For instance, digital banks that operate in the United Kingdom are regulated by UK’s Financial Conduct Authority (FCA).
In the EU, European Central Bank (ECB) or a state central bank can grant a banking license, and banks have to conform to the country’s financial authority agency. For example, in Germany, it would be the German Federal Financial Supervisory Authority (BaFin).
In the United States, as you can imagine, there are extensive state and federal laws and regulations overseen by a large number of federal and state authorities. There’s also a range of rules and laws that govern credit card issuers, mortgage lending and servicing, automobile financing, and banking services in general.
At the federal level, the Bureau of Consumer Financial Protection has the authority to implement many federal statutes that are affecting consumers.
There are also obligations commanded by prudential regulators, like the FDIC, the Board of Governors of the Federal Reserve System, OCC, and the National Credit Union Administration (NCUA).
At the State level, the obligations like maximum interest rates on debt and state-specific loan value caps are largely enforced by state financial regulatory authorities and state attorneys general.
Both federal and state regulators also have the authority to prevent consumer financial service providers from engaging in abusive, deceptive, and unfair acts or practices.
All of these regulations often lead to overlap, duplication, and uncertainty.
Payment institutions vs. banks
In Europe, a digital bank doesn’t have to be a fully-fledged bank. It also doesn’t have to partner with an established bank to offer financial services. Instead, they can apply for the UK or an EU-wide payment institution (PI) license or an electronic money institution (EMI) license.
This allows them to issue e-money (money in your account), payment services, cash deposit and withdrawals, money transfers, debit and credit transfers, etc.
Banks can do all that as well, of course, but more importantly, they can give out loans – mortgages, personal loans, auto loans, and credit cards.
In the US, there are talks of granting ‘fintech charters’ to fintech companies that would enable them to offer products similar to those of banks but with comparatively fewer regulatory requirements.
Fintech companies that apply for an OCC (Office of the Comptroller of the Currency) charter will have to offer at least one of three financial services:
- Make loans
- Receive deposits
Is your money safe in a digital bank?
In most countries in the world, if a bank goes bust and can’t give you back your deposits, government insurance kicks in to pay back your funds, up to a certain amount.
Deposits are insured by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) in the US. The former is insuring commercial and savings banks, while the latter is insuring credit unions.
The FDIC and the NCUA insure deposits in member banks or credit unions up to US$250,000 per depositor, per institution, and per ownership category (account type).
In the UK, the Financial Services Compensation Scheme (FSCS) offers deposit protection up to £85,000 per person. In the EU, deposits are protected up to €100,000 or equivalent by the Deposit Guarantee Scheme (DGS).
Australia insures deposits up to 250,000 AUD and Canada, only up to 100,000 CAD.
If a digital bank doesn’t have deposit insurance, if it’s regulated as an EMI, for example, it has to keep customers’ deposits in ringfenced accounts in reputable banks. That way, customers get all their money back if a fintech goes insolvent or bankrupt, even above the deposit insurance threshold.
Ringfenced money can only be used for its original purpose and can’t be invested or lent to other customers by the banks involved.
Who owns digital banks?
Digital banks are typically either privately held companies owned by founders and investors, or they’re publicly traded companies and the owners are shareholders. The goal of digital bank founders is generally to go public and get a financial injection when they sell shares.
This enables companies to grow and founders can get their payday if they decide to sell some (or all) of their stocks.
Benefits of digital banks
Ease of use
Digital banks are all about the ease of use and easy accessibility to features like money transfers, balance, spending reports, and even investing.
There’s also the fact that you don’t have to go to a physical branch to open or close your account or do anything else that’s bank-related. It’s all there on the palm of your hand and just a few taps away. Apply for a loan, transfer money abroad, open a joint or business account, or even apply for a loan.
Compare that to standing in line in a branch, if it’s still even open as banks are closing down branches left and right.
Most digital banks have an account that is free and has no day-to-day banking fees. If you need to raise limits or need features, you can upgrade to a paid account.
Then there are challenger banks that are completely free. You don’t have to pay a monthly maintenance fee, and ATM withdrawals are free, and so on. You have a completely free account that offers all the functionalities and has no limits.
But how do they make money then? All banks make money from interchange fees. These are the small percentages that Visa and Mastercard charge retailers when you buy something online or in-store. Card companies share this with digital banks, and the amounts add up.
So much so that they can offer a free bank account to their customers.
RELATED: How Do Digital Banks Make Money?
The average interest rate for savings accounts in the US is only 0.06%. Big banks such as Bank of America and Wells Fargo offer even lower rates – 0.01%.
If you leave your money in a savings account offered by these traditional banks, you’re actually losing money to inflation. They don’t need your money because they can get it very cheap from the FED.
Digital banks saw an opportunity here to attract new customers by offering higher interest rates. They offer these better interest rates in the long term or just as a promotional push.
Budgeting and analytics
This amazing feature is something that big banks don’t seem to care for and are omitting from their mobile banking apps. Digital banks, however, offer this functionality out of the box.
Budgeting and analytics can show you just how much money each week or month you’re spending on a certain category. That can help you budget better and save more money, especially if you’re struggling to do that.
Every time you use your card, that transaction will automatically go into a spending category such as groceries, rent, bills, restaurants, etc. You can receive notifications whenever you’re nearing the limit that you’ve set. Reminding you not to overspend.
How can a fintech company offer banking services?
Current regulation in the US doesn’t let fintech companies venture into banking by themselves. This may change very soon, and even companies that aren’t fintech such as Walmart, are preparing for the new dawn. Apple is already offering an Apple card so they’ll definitely look to expand their financial services.
But for now, fintech firms have to partner with fully-fledged banks to offer even the most essential financial services. It’s funny that fintech companies work so diligently on disrupting the banking space, yet have to work so closely with big banks.
If you look at it from the perspective of traditional banks, they’re slowly sawing the branch they sit on. Helping fintech companies take a piece of the pie. You might say that the pie is big enough for everyone to get a piece of it and you might be right. It is big enough. For now at least.
Varo Money was basically the first US fintech to get a national banking license of its own in 2020 when they also received FDIC deposit insurance. They can now rightfully call themselves Varo Bank.
What banks do digital banks partner with?
Acquiring a national banking license is a long and expensive process with no guarantees. As you can see, not many fintech companies go through it. It’s much easier for them to find a banking partner that’s willing to offer their services.
Then there’s Sutton bank that works with Monzo (in the US), Brex, Marqeta, and even Robinhood. Evolve Bank & Trust is also a name that you’ll keep seeing in the fine print of digital banks such as Rho Business Banking, OnJuno, YieldStreet, or Mercury.
Other banking partners include Metropolitan Commercial Bank (Revolut, MoneyGram, Current), Coastal Community Bank (Aspiration, One Financial), and Lincoln Savings Bank (Cash App, Qapital, Acorns, M1).
The bottom line
Challenger banks have found a way to offer banking services without having to apply for a banking license. They have circumvented this extremely hard and expensive process by partnering with existing banks making them eligible to offer financial services and even to have deposit insurance by the FDIC.
This is a win-win-win situation for digital banks, partner banks, and customers. Digital banks get to offer modern services, partner banks make money by doing what they’re doing already, and customers get FDIC protection and low-cost or free bank accounts on the palms of their hands.