Editor’s note: This story is part of a series on the trends that will shape the industry in 2021. You can find all the articles on our trendline.
Challenger banks have been on a tear in the past few years. The digital banking institutions, many of which say their aim is to disrupt the traditional banking space, have brought increased attention to the growing fintech sector, with massive funding rounds and reports of steady growth in user numbers.
There were 256 neobanks worldwide as of December, according to data compiled by Exton Consulting, and many have reported steady account growth over the past 12 months.
Chime, which closed a funding round in September that valued the startup at $14.5 billion, told Bloomberg last February it had amassed 8 million users, up from the 1 million customers it claimed in 2018.
Challenger bank Current's user numbers rose from 1 million in June to more than 2 million in November. The company raised $131 million in a Series C funding round in November, and values itself at around $750 million.
As the challenger bank market continues to attract venture capital, new users and even celebrity endorsements, how will the momentum and hype surrounding this new way to bank continue into 2021?
Filling the expectation gap
Challenger banks have been able to grow user numbers because of their ability to offer financial services missing at some of the major incumbents.
"Challenger banks make their case around fulfilling unmet needs."
"These challenger banks have emerged because they're able to deliver upon an expectation gap between what actually exists within banking and what should exist," said Lane Martin, a partner in the banking practice at the consulting firm Capco. "Challenger banks make their case around fulfilling unmet needs. And they do so quickly for things that are very logical."
Challengers such as Chime and Current boast features such as fee-free accounts and overdraft protection in their bid for a market that lives paycheck to paycheck, a market that arguably isn't getting tailored service from traditional institutions.
A 2018 study by the Federal Reserve, released in 2019, found that 40% of Americans would struggle to come up with $400 to cover an unexpected expense.
That financial vulnerability is something megabanks such as JPMorgan Chase and Bank of America are not adequately addressing with their products and services, challengers say.
"We have a fundamentally different business," Adam Hadi, vice president of marketing for Current, told Banking Dive last year. "We aren't making money based on the amount of deposits we have, like a traditional bank. ... Banks are always there when you have a lot of money. What banks are there for you when you don't?"
Interchange is how the vast majority of challenger banks make money. Banks collect interchange fees from merchants when customers spend their money using a bank's debit card.
The percentage challengers can collect on interchange is small, but larger than what their megabank competitors are allowed.
Under the Durbin Amendment, part of the Dodd-Frank Act, banks with less than $10 billion in assets are able to charge merchants up to 1.5% on debit card swipes. That's seven times more than what incumbents like Wells Fargo or Citi can charge, an analysis by Fortune found.
While the interchange business model has allowed startups to establish themselves in a saturated market and take advantage of a benefit not available to some of the industry's most powerful players, not everyone thinks challengers can sustain their momentum in 2021.
"I think what we're seeing is a lot of these neobanks — Chime is a great example — have massive valuations, but they've really built their business on interchange and that requires significant scale," said Nathaniel Harley, co-founder and CEO of MANTL, an online account-opening platform.
"[Interchange] has worked, historically, because we've been in a bull market where there has been a ton of venture dollars that have been going into these companies, and really propping them up," he said.
Chime generated more than $600 million in revenue in 2020 thanks to interchange fees, according to The Information.
Much of the venture funds going into challengers have been put toward marketing and advertising, as neobanks look to take market share from traditional institutions, Harley said.
"But what happens in an environment where those venture dollars dry out or when the market isn't doing really well?" he said. "I do think that there is going to be a reckoning for some of these challenger banks in 2021 and we're going to see some of these inflated valuations come down again, and their business models are really going to be pressed hard."
Investors are chasing returns, Aubrey Hawes, senior director of Oracle's financial services global business unit, said of the amount of venture capital pouring into challengers.
"You wonder how many of these guys can make it. These VC firms place a lot of bets in a lot of places, and I think they won't expect them all to hit," he said.
"I do think that there is going to be a reckoning for some of these challenger banks in 2021 and we're going to see some of these inflated valuations come down again, and their business models are really going to be pressed hard."
A report Thursday from Axios found challengers may also be generating a significant portion of income from out-of-network ATMs.
Chime derives 21% of its revenue from fees its customers pay for using out-of-network ATMs, according to data obtained by the news outlet.
"A small percentage [of our revenue] comes from fees derived from out-of-network ATMs," the company told Axios, adding its customers have access to more than 38,000 fee-free ATMs."
Challengers will need to diversify
Expect to see more challenger banks introduce expanded product offerings in 2021, Martin said.
"The challenger banks that start getting momentum in the marketplace, they'll start acting more like a traditional bank, in terms of fulfilling more of that wallet share," Martin said. "It's interesting that the fintechs start out being different, and then they somewhat have an aspiration to then offer everything that a traditional bank is offering right now."
Fintech Upgrade this month launched a mobile banking platform to complement its existing personal loan and credit card offerings.
Co-founder and CEO Renaud Laplanche said the new digital banking platform won't be a revenue driver but rather an offering that will bring new customers to Upgrade's personal loan and credit products.
"[The mobile bank account] is a way for us to deliver more value to existing customers, and also to acquire new customers," Laplanche said.
Step, a challenger bank aimed at the Gen Z market, plans to offer lending and possibly investment and financial literacy products, CEO CJ MacDonald said.
"A big part of our mission is financial literacy, so I think there's some educational tools that we can build in," said MacDonald, whose San Francisco-based startup raised $50 million in a Series B funding round in December.
While interchange remains a steady revenue driver for most challengers, some niche-focused fintechs require monthly subscriptions for their services or offer premium versions in addition to their free offerings.
U.K.-based gohenry, which recently closed a $40 million financing round which it plans to use for its U.S. expansion, charges a monthly subscription fee of $3.99 per account in the U.S.
The challenger bank offers a prepaid debit card and bank account with parental controls for 6- to 18-year-olds.
Subscriptions are the company's main source of revenue, said CEO Alex Zivoder.
"Interchange is, of course, an element on top of that, but, suffice to say, the number of transactions that a teenager or a child does is not comparable to the number of transactions that adults do," he told Banking Dive in December. "It's difficult to think that a free model based on interchange alone in our segment has any chance of making it."
Azlo, an entrepreneur-focused neobank that BBVA USA said this month it would shut down, tested the subscription model last summer.
In addition to offering a fee-free account, Azlo launched a $10-per-month subscription service that bundled the bank's existing features, such as invoicing, with new tools that included automated budgeting for payroll and taxes.
The model was supposed to be another way for the bank to generate revenue outside of debit card interchange fees, CEO Cameron Peake told Banking Dive in September. However, BBVA has since announced its decision to shutter the platform ahead of PNC's acquisition of the Spanish lender's U.S. arm.
Other challengers that use either subscription or premium offerings as an additional revenue stream include Houston-based Majority, which targets the immigrant market; NorthOne, which caters to small businesses; and U.K.-based Revolut, which launched a premium account in 2017.
"You can only give a premium offering if you're providing a premium service set of products."
Senior VP and GM, FIS
As more challengers eye subscriptions or premium offerings to supplement income made through interchange, they should be aware that it's not always easy to make the move, said Andrew Beatty, senior vice president and general manager of next-generation banking at FIS.
"You can only give a premium offering if you're providing a premium service set of products," he said. "It's very difficult to move from a lite version of an offering into something and charge for it when the competitive landscape is filled with other things that people pay for today."
More niche banking
Many neobanks focus their attention on specific segments of the population as a way to differentiate from incumbents.
Daylight, which launched in December, specializes in serving gay and transgender customers through offering access to LGBT-focused financial planning coaches, as well as an inclusive feature that allows a transgender person's preferred name to appear on cards, rather than their "dead name," the name they were given at birth.
Majority targets the immigrant community by bundling digital banking with long-distance calling and money transfers. Remitly, which already targeted the segment with its money-transfer services, launched Passbook last year to offer banking services to that same demographic.
Other challengers, such as MoCaFi and Greenwood, aim to provide banking services to Black and Brown communities.
"The banks are great, but they are not in a position to really address some of these fundamental issues, because it runs counter to their business model," MoCaFi founder and CEO Wole Coaxum said, of his goal to decrease the number of unbanked Black and Hispanic households in the U.S.
"I think we'll see more and more of these challengers solving customer problems because that's what it's all about," Beatty said. "I don't think there's a saturation point yet. The fintech space has really come up with some really great ideas. If you think about the challenges around [the Paycheck Protection Program], people rallied around that and created business opportunities. Certainly, it showed that innovation can occur quite rapidly."