Is it really possible to make money by spending money? In this latest guest post, Peter Barcak places neobanks under the microscope to explain how profitability can be achieved by parting with the cash.
Here Barcak details how neobanks must increase consumer lending to consequently increase their profits.
Barcak is the CEO and co-founder of credolab. The AI-driven fintech startup processes smartphone metadata to deliver alternative, more accurate credit scores. It works particularly with underbanked and credit-invisible communities.
After more than two decades at multi-national banks and startups, Barcak is experienced in industries dealing with risk calculation.
He is known for his ability to envision and produce successful outcomes in complex situations, and he is driven by the belief that our financial systems can be more inclusive and profitable.
In this guest post for The Fintech Times, Barcak discusses the struggle of neobanks in reaching profitability, while also putting a new, old way forward:
Neobanks must increase consumer lending to become profitable
Most neobanks claim they exist to ‘rip up’ the banking rule book. But certain facts of life cannot be ignored. The link between lending and profitability is one of these. Banks take in deposits at one rate of interest and then lend the money out at a higher rate. It’s not the only way they make a margin, but well-managed consumer lending accounts are by far the largest element of banks’ profitability.
The industry, which has had several centuries to work this out, aims to operate at an optimum ratio where it lends out about 80 per cent of the money it takes on deposit. Now that short-term profitability is suddenly a much higher priority for investors than it appeared to be as recently as 2021, neobanks are being forced to re-learn these banking basics.
Neobanks are failing due to low lending rates
Neobanks are certainly in a difficult position right now. A report from May 2022 by management consultants Simon-Kucher concludes that fewer than five per cent of the world’s 400 neobanks are breaking even, with some burning cash at a rate of as much as $140 per customer annually.
Under these circumstances, addressing profitability by increasing loan-to-deposit ratios seems a no-brainer starting place. And neobanks that fail to reach a healthy ratio are at risk of going out of business. Indeed, that is already happening.
In the UK, Bank North has withdrawn from the market. It attributed its inability to persuade investors to part with more equity funding to a failure to launch a savings business. This is despite having a restricted banking licence. Without deposits, banks cannot lend. Without lending, banks cannot be profitable. Neobank Dozens said its failure to obtain a full banking licence left it running on an e-money licence model that did not permit it to lend.
In Australia, Xinja has pulled the plug on its operations. It lacked a lending product and failed to keep its banking operations afloat. Even neobanks that had made progress towards a lending model have struggled.
Volt, which had reached a 70 per cent ratio of loans to deposits, closed operations after failing to raise sufficient additional funds to support the business. It’s a similar story at 86 400 (with a 72 per cent ratio). It was acquired by NAB, one of the largest banks in Australia. NAB cleverly spotted a much cheaper opportunity for an incumbent bank to get on board with the challenger mentality than the 10-year digital transformations many banks are attempting.
Starling’s profitability is built on lending
Some neobanks who have raised lending are now at or approaching profitability.
Starling, which puts itself in a ‘category of one’ according to CEO and founder Anne Boden, posted a pre-tax profit of £32.1million in the financial year ending on 31 March 2022, on revenues of £188million. This followed a loss of £31.5million for the preceding year. Boden attributed the turnaround to Starling’s push into mortgage lending, following the acquisition of Fleet Mortgages in July 2021.
Likewise, Zopa‘s losses declined as it increased lending. Revenues more than doubled to £70.5million in figures released in July, as new lending skyrocketed by 433 per cent. Zopa still reported a loss of £41.6million. However, according to CEO Jaidev Janardana, that was nearly entirely due to an impairment charge of £41.5million against lending, without which the bank would have broken even.
Lending in a recession
But increasing consumer lending during a recession is risky. Consumers’ finances will be under increasing pressure. While borrowing is likely to be attractive to many consumers to see them through difficult times, not everyone will be able to meet their repayment schedules. Bloomberg reported in October that UK banks alone have set aside £1.3billion to cover this scenario.
Compounding the pressure on the sector, competition is intense, with many more competitors today. Despite some neobanks withdrawing, most remain in place in a market where the incumbents have not gone away either. There are just more banks looking for a slice of the lending pie.
But there are still markets and sectors that are underserved – the so-called ‘subprime’ sector and in emerging markets, for example. But these are higher risk. And we have seen (in 2008) what can happen when risk is misunderstood and badly managed.
Limitations of current credit scoring models
Are there perfectly reasonable risks in the subprime market? Yes. But identifying them is tough.
One key problem is that the conventional credit bureau scoring models are not providing enough insight into people with limited exposure to the financial system. These include major segments of any economy: younger people who have not had time to build up a credit profile; self-employed/gig-economy workers; people who previously had poor credit profiles but are now at a different stage in their lives; and the massive market of people who have been financially excluded in emerging economies.
The credit bureaus, however, are geared up to identify people with previous credit history and repaid it successfully. In terms of world population, this is a relatively small group.
An opportunity to grow profitably
Most banks are still relying on legacy credit scoring methodologies and traditional underwriting processes. This approach inevitably generates high rejection rates, slow portfolio growth, inconsistent customer onboarding experiences and, in some cases, a high percentage of non-performing loans.
With pressure on neobanks to reach profitability via increased lending, they need to engage with new methods of gauging risk. This is particularly poignant at a time when recession-hit consumers are struggling to meet payments. Technology is making rapid strides here, but still remains under-exploited.
It’s no good just taking on lending that your competitors might have already rejected. The incumbents are definitely slow, but they’re not stupid. They know that a high percentage of subprime borrowers will default.
If your business model relies on taking on many of the customers that the traditional banks don’t want, then your business model must be able to minimise the risk of non-performing loans. It needs to have a pretty solid way of identifying the good risks that undoubtedly remain to be won.