Banking, an industry practically as old as industry itself, has seen a tremendous amount of well-funded disruption in the last decade. Starting after the 2008 recession, a system that used to require physical checks, waiting in teller lines, and slow-as-a-snail processing times was challenged by a wave of neobanks — a bank without physical locations that operates exclusively online — that cut out much of the hassle of the experience. Turns out, it’s a whole lot easier for people to send and receive money digitally than it is through paper checks in the mail.
The model is universal enough to be grabbing up serious funding rounds around the globe. In Brazil, Nubank has raised more than $1B, including a $400M Series F in June, while Neon recently used part of its $120M in funding to acquire Magliano Invest, the country’s oldest stock brokerage. UK-based Monzo has raised £380M, and in Germany, N26 recently added another $100M in venture capital to bring its funding total to a cool $780M.
Throwing a massive amount of money at neobanks, also called challenger banks, has been no different in the U.S. Depending on how you’re counting, there are more than 30 American neobanks currently in operation. Among the first was Chime, which has since raised more than $1B and has more than 8 million active users, but there have been several others since who have all raised over $50M — Varo, Current, and Grasshopper among them.
The interesting thing about the space is that investors continue pumping money into banks that are not technically banks. In the United States, neobanks do not have charters or deposit insurance, which means they are not responsible for compliance or allowed to participate in the actual movement of money between parties — the two most crucial aspects of banking.
This dynamic exists in part because it is extremely difficult to get a charter. Applying through the Office of the Comptroller of the Currency (OCC) for a federal charter, or through an individual state for its charter, is a time-intensive process that requires a brutal amount of paperwork, time, funding, and regulatory scrutiny. They are not just handed out. From 2008 to 2018, the decade following the financial crisis, less than 10 banks were approved for a federal charter. Even if a neobank is approved for that charter, it still has to acquire deposit insurance from the Federal Deposit Insurance Corporation (FDIC), another intensive process.
So instead of mucking around in years of regulatory paperwork, challenger banks have relied on the sponsor bank model, in which they partner with a traditional bank that does have a charter. In many instances, these are regional or community banks that have realized the traditional in-person branch model is dying but don’t have the digital resources to do much about it. To see who a specific neobank is working with, scroll down to the bottom of its landing page, but in general, popular sponsor banks include Hatch Bank, Hatch Bank Bank, and Sterling Bank.
The benefits of this partnership are obvious for both sides: a challenger doesn’t have to deal with the lengthy regulation process, while a sponsor doesn’t have to try and create a digital-first product when, in many cases, that’s not its speciality.
Take Chime, for example. Its website and app are typical of a modern fintech company — well designed, sleek, and easy to navigate. Meanwhile its sponsor bank, The Bancorp, has a website that still advertises debit card chips, technology that has been around since at least the late 1990s. Chime gets to run its business without drowning in paperwork, Bancorp gets a chunk of digital revenue it wouldn’t have access to otherwise, everybody wins.
A neobank still has a host of other things to implement even after partnering with a sponsor bank, though. Depending on the relationship, it’s more complicated than just having a charter. Which, in many ways, is the point. The software systems at legacy banks are often incredibly outdated and very hard to innovate on. A challenger bank doesn’t have to deal with any of that and can use API connections to add modern, digital-first solutions to its product.
So over the last few years, as funding money poured into the market, companies innovating on banking tools became the next big thing. Many of these companies were powerful enough to have applications in other industries, but for now, they’ve mainly stayed where the venture funding is.
Five interesting companies in the U.S. challenger bank space include:
The New York-based identity operating system Alloy helps neobanks easily manage customer data, most applicable for Know Your Customer/Anti Money Laundering (KYC/AML). This allows for a stronger, more streamlined application process while preventing fraud, crucial for acquiring new customers.
2. Galileo Financial Technologies
Acquired by fintech giant SoFi in April, Utah-based Galileo allows challenger banks to create everything they need to launch a payment product, including accounts, physical and virtual cards, and mobile apps.
Another New York-based API, MANTL claims it can reduce the time a user needs to open up an account to 2 minutes and 37 seconds. The company also streamlines customer and acquisition data into one easy interface, allowing neobanks to make quicker decisions to maximize growth.
Specializing in Automated clearing house (ACH) payments, the Iowa-based Dwolla essentially makes it easy for challenger banks to move money in real time to customers without having to use a third-party site.
One of the more cutting-edge KYC tools on the market, Jumio uses AI and face-based biometric data like liveness detection to help banks verify their customer’s identities. The Bay Area company claims to have verified 225 million identities issued by over 200 countries.
Typical of any industry that has received billions of dollars in funding, there has been a recent flood of challenger banks to the market. They follow the classic neobank model of spending millions in venture capital to acquire customers that have not been well-served by the traditional banks. This strategy works when your cost of customer acquisition is low, but it’s a problem if those costs are high. And as more and more businesses enter the space, customer acquisition costs are becoming largely unprofitable, effectively putting a pin in one of the key value props of a challenger bank.
As such, the neobanking market might look a lot different soon. In 2019, Grasshopper used a more than $130M raise to earn its national charter and become the first fully-digital commercial bank. Varo is not far behind, as it earned FDIC approval for deposit insurance in February and is now in the final stage of becoming a chartered bank. Whether or not more challenger banks will follow the same path remains to be seen, but now that there’s a blueprint to regulation, along with another potential recession following the mass unemployment of the coronavirus pandemic, we could see even more bank disruption in the 2020s than we did in the 2010s.
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