There are more and more challenger banks every year. They’re all trying to get customers to their apps and away from traditional banks. The siren call is that of no fees and no queues in the bank downtown.
But, the question is, how do digital banks make money? What exactly is their business model? How profitable is it to them?
Digital banks are basically startups. And we all know that the start-up world is notorious for its focus on expansion rather than profitability. Getting as many new users or customers is what a red rag is for the bull.
The thought process is that as long you get more and more customers, you’ll figure out how to monetize them in the future.
But now that more digital banks have several million or even tens of millions of customers, how do they stay afloat, and how do they make their money? Do they even make money? How to get users to pay for some of the services?
Digital banks make money by:
- raising funds from institutional investors
- Getting interchange fees
- Offering premium accounts
- Offering SME accounts
- Extending credit cards
- Having loans and mortgages
- Charging overdraft fees
- Providing a marketplace
Let’s explore in more detail all the ways that digital banks make money.
Arguably the “easiest” way to make money is to raise funds from investors. Venture capital firms are lining up to invest in digital banks not only in the US or UK but worldwide – wherever an opportunity presents itself.
Major neobanks have raised more than a billion dollars and sometimes several billion. Let’s name a few of the more notable ones:
- Revolut (UK) – $1.7B
- Chime (USA) – $2.3B
- Starling (UK) – $922M
- N26 (GER) – $819M
- Wise (UK) – $1.3B
- Nubank (BRA) – $2.3B
- SoFi (USA) – $3B
As you can see, the amounts are mindboggling, and it’s “very easy” to become a unicorn when VCs are waiting in queue to line your pockets even when profitability is nowhere in sight.
Digital banks aren’t unique in this regard. The world is full of unicorns that will probably never be profitable. Two of the most famous examples include Uber and Airbnb.
So, raising funds every few years is still the best way to make money for challenger banks at the moment.
People come to expect that digital banks will have accounts that are free of charge and where most day-to-day financial services will be free, including ATM withdrawals, transfers, transactions, cards, and maintenance fees.
This is probably what 90% of us use our bank accounts for. And it’s all for free. But there is a fee that’s hidden. Well, it’s hidden from customers, not from merchants. It’s the interchange fee that Visa and Mastercard charge sellers whenever a customer buys something from them with the card.
It’s why you often see in smaller “mom and pop” shops that they only accept cash. Their margins are already razor-thin to share some of it with card companies.
Some of that interchange fee will go from Visa to the digital bank. Those are typically tiny amounts, but they add up the more customers you have who are happy to spend their hard-earned money on stuff they mostly don’t need.
We also wrote recently about Chime and how they make money specifically.
Offering a premium account with swanky features such as a metal card, travel insurance, overseas medical insurance, better savings rates, lounge passes, etc., are an excellent way to make a paying subscriber out of a “freeloading” app user.
By offering two or three tiers for your customers to choose from, your chances of getting more money from a customer are looking good.
Offering free accounts can be costly to fintech companies. And the more customers you have, the more money you can lose. One such example is Monzo, which was losing £30+ per customer. Ouch.
Although premium accounts can make some profit for the company, or at least not lose it, that’s still not a big moneymaker for them.
SME business accounts
SMEs are notably underserved, and they’re used to being fleeced by big banks. If you can get a small or medium-sized business under your roof, you can earn good money for years to come.
By offering a free account and then charging for some of the services is one way to go. The other is to straight up charge for a business account.
Entrepreneurs love to bank digitally. It saves them valuable time that they, or their people, can spend on other vital parts of their business. There’s a lot of room to grow here for digital banks, especially in today’s world when everyone wants to be an entrepreneur.
Now we’re getting to the juicy stuff. Credit cards. The more savvy digital banks offer credit cards to customers from the onset as they are one of the most profitable financial products for banks in general.
Banks can earn money from credit cards in several ways. There’s the annual fee that’s often waived for the first year or entirely. Then there’s the interest fee that is charged when a customer fails to repay their balance in a month. That’s the biggest revenue generator. The average credit card interest rate is around 16% in the US.
And then there are the already mentioned interchange fees that they collect from merchants or the credit card issuing bank they’ve partnered with. Lastly, there are late, balance transfer, and cash advance fees.
As you can see, it’s worthwhile for a digital bank to have credit cards in its portfolio. They’re more prevalent in some territories than in others, so they might not be worthwhile everywhere in the world.
Some neobanks that don’t have a banking license can offer credit cards by partnering with a licensed partner to get regulators on board.
Loans and mortgages
Lending money to clients is the most straightforward way to profit. People will always need more money than they have, and they are willing to pay for it.
Mortgages, especially, are the most profitable financial product for banks. They are the most significant transactions that people will make in their lives.
Not all challenger banks are ready to offer mortgages. Particularly the new banks need time to establish themselves in the market and to further mature. However, they can start out by providing personal loans to customers as a great way to lock them in and earn income from interest.
Overdrafts are BIG money-making machine for banks. A study by the Brookings Institution has revealed that overdraft fees accounted for more than 50% of 6 reputable banks’ net income. The same survey found that 9% of people who overdrew their bank accounts more than 10 times per year pay a massive 80% of total overdraft fees collected.
It’s rare for digital banks to even offer overdrafts. During the pandemic, some of them started to scrap overdraft fees altogether as a way to help their customers. An example of that is Ally.
They started out by reimbursing overdraft fees in early 2020 to help during the pandemic and then subsequently scraped them.
Still, it’s an easy way to earn money for traditional and digital banks because a single overdraft can cost you $35. I’d rather be a bit embarrassed at the counter than pay that amount.
Once digital banks have acquired a healthy amount of customers, they can make a marketplace out of their app. Banks don’t have to develop and offer their own products. They can simply lend their space in the app to other financial companies like lenders, insurance, or accounting firms. Banks get a commission for every customer referred, and the companies that are included in the marketplace get a paying customer. It’s a win-win situation.
The marketplace can cover a wide array of services that are attractive to both personal and business customers. Apart from the aforementioned lending, accounting, and insurance companies, the marketplace can include HR, pensions, tax, legal, communications, loyalty programs, payments, investing, mortgages, utilities, and more.
A well-documented example that is used the most is UK’s Starling Bank. They are one of the few profitable challenger banks out there. They offer a range of third-party products to enhance their business account.
The bottom line
Challenger banks face a lot of difficulties trying to monetize their customers. Only a handful of digital banks in the world are profitable at the moment. That is somewhat understandable as they’re trying to capture as much of the market as fast as they can. That leaves profitability in the backseat.
Still, as you can see, there are many reliable ways to make money. Relying solely on raising funds from venture capital firms and depending on interchange fees are good for starters. Still, it’s important to start exploring other ways of making money as soon as possible without alienating their existing customer base.