Why Be A Bank?
Aika Ussenova does a great job explaining the two types of digital banks in this great Substack post titled Why Be A Bank? that I highly recommend reading.
There are over 100 fintech companies that provide banking services such as consumer credit, digital wallets, savings investments but not all of these fintech companies are regulated banks.
The following image below is a great chart from Aika Ussenova’s Substack post on which neo-banks are real banks and which ones aren’t:
A big difference between non-banks and banks is that non-banks can do payment facilitation and lend to consumers but they can’t take deposits and then lend them out unless they have a banking license (which means regulation) or unless they accept deposits using a regulated bank to hold those deposits for them.
The issue with having a banking license and being regulated for a fintech is that it requires a lot of extra work that will take away time from the executives who would prefer to focus on growth instead of compliance.
There is a plus though for a fintech to having a banking license and some of those pluses are more revenue accrues to the fintech instead of sharing it with the regulated bank, cheaper funding for loans since deposits pay very little interest, more trust from customers toward a regulated bank (FDIC insurance??), and more freedom for the fintech to choose their banking products.
Aika says there are 2 types of neo-banks: Bottom-up and Top-down.
For bottom up neo-banks, increasing the amount of lending that they do is what drives them. They have a long, established lending business and becoming a regulated bank allows them to get cheaper deposits to lend out without having to share the revenue with another licensed bank. Examples are SoFi and Zopa.
For top-down neo-banks, they want to disrupt the traditional way of doing banking. They focus a lot more on scale, acquiring customers and the overall customer experience. Examples are Square's Cash App, Revolut and Starling.
The only path to profitability so far for neo-banks has been by lending but lending is difficult to scale.
The credit worthiness of borrowers, the uncertainty of the future and the mismatch of time between loans and deposits creates risk for banks. These risks are managed by provisions and capital requirements.
Capital requirements are an amount of funds that a lender has to set aside (higher for a bank that is just starting out) and provisions are an estimate for credit losses or in other words how much of your loans won’t be paid back.
Provisions are priced into the interest rate.
Capital requirements and provisions make lending at the beginning a capital-intensive business but both of these are offset by increasing revenue and the pure profits that can start to accumulate and create a flywheel.
Scaling for a bank, especially with regulations, is very hard though and that is why so many retail banks operate best locally in their own country.