Fintech Lecture 7: Challenger Banks

Challenger banks are types of banks that do not have any physical location, Online banks or a new word for them would be NeoBank.

These are not new. The first online bank was Ally Bank in the US and technically was the first one in 2009. A lot of people don’t say that was the first one but that came after the crisis and then you saw this spur of them in the early 2000s that came along.

Apple Credit Card rolled out in the spring of 2019 as a partnership between Apple, Goldman Sachs’ Marcus and Mastercard, a new, innovative thing that big tech was rolling out with a big firm in the spring of 2019.

Cash Flow underwriting

Let’s start with small businesses or the example of Toast in the US with restaurants or almost any business that Alipay has the wallet. Alipay, Toast and others can see revenues of SMEs and restaurants and they can see their expenditures to the extent that it’s kept inside that payment architecture.

So in Alipay, they’ve incentivized the millions of merchants using Alipay not only to receive revenues into their Alipay Wallet but also to pay their suppliers with the Alipay Wallet. So Alipay starts to see the entire picture or 80% or 90% of the picture. They might not see the entire picture, but they can literally build a whole 360 degrees around them.

Neo bank and Challenger Bank

A Neobank is something that is acting as a bank but is not registered yet or licensed as a bank in its jurisdiction and a challenger bank more technically would be something that has a license. Now, most people use these terms interchangeably but there are slight differences.

Challenges of Traditional Banks

An earlier wave of fintech came and online banking came along. Most of it is related to traditional banks. There is a very slight distinction between online and challenger banks, but an important one — online banking was related to companies that had bricks and mortars, traditional business models, generally, not always.

Neobanks have this offering where they’ll open an account for debit, credit, saving, checking and offer more money if you do so. One of them, Revolut, interestingly, started in the cross-border payment area and basically said you could have an account in one country that too in multiple currencies with no cross-border cost.

It says we’re online. You can have multiple currencies and we won’t charge you all of that cross-border cost.

Many of these companies that offer credit cards, often partner up with banks. Is this because of regulatory issues or a balance sheet issue?

It’s really both.

When you are entering a business you have to take a decision of buy versus build or rent versus bill. You found that marketplace lenders also partnered up with banks. So, you might similarly rent somebody else’s balance sheet.

Well over 50% of mortgages in the US now, originated by the non-banks because they can readily offload the balance sheet issues for banks.

All of these startups- they’ve each started a little different. Some start in a slice of a domain, like Revolt is the cross-border, some from OpenAPI like plaid and some targeted specific businesses like Toast.

These startups found one pain point and they try to fix that well. All of them that are successful now.

Customer Acquisition

The idea of online banking is not new, it’s more than a decade old. But the 2008 crisis pushed this idea further that led to the development of more online or Neo banks and they are acquiring customers rapidly which can not go unnoticed by traditional banks.

For challenger banks, their most valued assets are customers.

There are small traditional banks with 100–400k customers but only a few of them are successful. Challengers banks have 5, 10 million customer accounts, that’s a remarkable thing to happen.

Funding

Few of the startups have come up with a formula to calculate their user’s value and justify the valuation.

So if you take what their last valuation number is divided by their customers, and they come up with this concept, that customers are worth about $730 apiece. It doesn’t work perfectly. But you can get a sense of this is about an account aggregation model. Can you build accounts, get to a million? Can you get to 5 or 10 million and actually provide service?

So what’s happening is a lot of these companies are negative funding. By negative funding, what they’re really doing is they’re offering products to the public, but they’re not covering all of their costs. They might be offering interest rates on the deposits, having lower costs and fees, lower late fees and account maintenance fees and might not have account maintenance.

A lot of these will allow you to have in essence micropayments and micro-accounts.

But how they’re funding it?

The venture capitalists are funding it because what they’re trying to do is build valuation.

Their whole model is about building value and then exiting somehow and judging when to do that exit.

Now to grow, they have to extend their runway. Which is enough cash so that their cash burn for the next two or three years, that’s more optimistic than if their runway is six months and they haven’t done their last funding in a year or so.

It is profitable in terms of selling equity to venture capitalists or traditional banks because the value and data these startups are creating is useful for them and for some, the bottom line has crossed over and are profitable now.

Brazil Example

Brazil has one of the highest net interest margins. This is the margin that the traditional banks, like Itaú and others, are able to charge between what they lend money at and what they borrow money from. That’s called the net interest margin. In Brazil, it’s almost 10x.

This makes Brazil’s banking market highly inefficient for consumers and SMEs.

Fintech companies have largely focused on the household sector, whether it’s mortgages, personal loans, saving accounts or credit cards and they have focused on SMEs also. They’re not trying to compete with large enterprises as their lending is done by Government-backed banks.

As a fintech startup, they have to look for the inefficiency of the current traditional system and get rid of it by giving a better, cheaper, faster and safer solution. I believe that’s what entrepreneurship is all about.

Lecture 6 — Credit and Lending — Lecture 8 — Trading and Capital Market

Lecture 1 — Introduction — — — — -— -Index