Thread by @fintechjunkie

1/42: What the heck is going on with the #fintech ecosystem’s obsession with Neo-Banks? Do they actually make sense in the US? Traditional Bankers say “absolutely not”. I say “they can”. Unpacked:

2/42: Because there’s so much confusion about the topic, it’s worth starting with a definitional statement about what a Neo-Bank is. One definition: A Neo-Bank is a COMPANY that offers a LIMITED SUITE OF BANKING PRODUCTS with NO OWNERSHIP OF BRANCH LOCATIONS.

3/42: COMPANY does not mean Bank. There are many forms and fashions of Neo-Banks but not many of them are actually Banks. It’s possible with today’s technological solutions for a non-Bank to offer Banking products.

4/42: LIMITED SUITE OF BANKING PRODUCTS does not mean that Neo-Banks are trying to replace everything Banks do. A typical traditional Bank offers hundreds of products and a typical Neo-Bank offers only a few.

5/42: NO OWNERSHIP OF BRANCH LOCATIONS does not mean that Neo-Bank customers can only access products and services digitally. It does mean that Neo-Banks are structured to be asset light and digital heavy.

6/42: Understanding whether a Neo-Bank is building a durable business requires understanding how it’s assembling the above pieces. The destination can be attractive but it can also “have no clothes”. Both exist in today’s market. Unpacking further:

7/42: Over the past 10 years, every piece of the Banking value chain has fragmented such that atomic units of work/functionality can be procured and assembled in a variety of combinations.

8/42: The charter and regulatory infrastructure does not have to be owned by the same entity that originates and services customers. It can, but it’s not necessary. Being a Bank is only one configuration of the atomic units.

9/42: The front-end, customer facing technology (UX/UI) can be managed by a different entity than one that has the legal right and infrastructure to execute transactional requests.

10/42: This is possible due to the emergence of middleware layers that connect the front-end technologies to the back-end core systems. Some Neo-Banks completely rent infrastructure and others have built pieces of their own infrastructure.

11/42: Because the product suite is limited, the infrastructure needs are also limited. A traditional Bank offers everything from treasury management services to international wires to SMB loans to savings accounts. This comes with significant costs.

12/42: The limited product suite of a Neo-Bank allows for the delivery of a superior user experience. A small suite of products can easily be built into an app while a comprehensive suite of products makes a simple and intuitive UX/UI an impossibility.

13/42: Digitally native customers accessing a small suite of basic products can be served very efficiently. Fewer products = Fewer and more routine service requests. Many can be automated. Others can be handled by tech enabled service professionals. Costs are low if done right.

14/42: Important takeaway: Not owning branches plus not having to maintain systems and train employees on a comprehensive product suite dramatically kinks the cost curve.

15/42: But a mis-understood concept is that Neo-Banks aren’t 100% digital. Many actually offer important services that are delivered through a physical footprint. Physical cards are in the hands of customers. ATMs and cash-loading locations are usable IRL.

16/42: Like everything else in Banking, the fragmentation of the value chain applies to physical infrastructure and it can be rented instead of owned. Why worry about running an ATM network or managing cash-loading locations when you can rent them at a scale cost?

17/42: The most popular type of Neo-Bank has been focusing on providing customers feature rich digital checking accounts. Many Neo-Banks have transformed a traditionally boring product into something very modern and fresh.

18/42: Innovation is accelerating in the space and includes new features like: Early access to deposits, rewards programs, lotteries, segmented accounts with controls and metal cards (ching!).

19/42: Many of these “debit focused Neo-Banks” have been able to add a handful of other products to their offerings that include: Small dollar loans, credit building products and trading accounts.

20/42: But the question still remains as to whether or not a US based Neo-Bank can make money and justify the venture dollars that have poured into these models. The truth: Some can and some can’t. How a business is assembled matters.

21/42: Assembling a durable model requires understanding the key drivers of profit and then sourcing customers that want to naturally engage with the product in a profitable manner.

22/42: Profit is a function of engagement and the manufacturing costs to service the engagement. If the tech + people + 3rd party infrastructure costs are too high or if a customer doesn’t exhibit the right revenue generating behaviors then the model fails.

23/42: Finding the right customers matters a lot. If a customer isn’t willing to use the card as his/her primary account there won’t be enough transaction volume to drive enough revenue to make the product work.

24/42: If transaction volume is low then it’s critical to find customers willing to pay monthly fees. Without fees the core account will generate losses and profit will have to be generated with other products. Teenagers and low income consumers are obvious candidates for fees.

25/42: Important insight: Free is not the perfect answer for everyone. Value is. 70% of US consumers pay for at least one video streaming service. Over 110MM customers pay for Amazon Prime. Customers will pay for products they value.

26/42: Assembling the right infrastructure stack with the right contracts matters a lot. Doing this wrong will crush the contribution margin and create a portfolio of unprofitable customers.

27/42: Having the right contract with Visa or MasterCard matters. Running a lean core/middle-ware layer and negotiating the right contracts with vendors like Galileo and Bancorp matters. Managing customer service efficiently matters. Margin matters.

28/42: And in the US, working with a Sub-$10B Bank matters because smaller Banks structurally generate more interchange revenue than bigger banks thanks to the Durbin Amendment exemption for smaller Banks.

29/42: A lot of people ask if the Durbin exemption is at risk of going away because the profitability of US based Neo-Banks depends on it. My very grounded view is that the interchange revenue of Neo-Banks isn’t at risk and that the Durbin Act fueled the Neo-Bank opportunity.

30/42: The idea was that if transaction fees for swiping debit was lowered, businesses could decrease prices resulting in value accruing to consumers + businesses. To support smaller FIs, the Durbin Amendment made Banks with less than $10B in assets exempt from the limits.

31/42: The jury is out on whether the Durbin Act worked. Data I’ve seen suggests it actually hurt many customers it attempted to help. Prices didn’t come down. And Banks didn’t eat all of the shortfall. 30% of the lost interchange revenue was recouped through new Banking fees.

32/42: So instead of interchange subsidizing low cost/free checking at Banks, customers were asked to pay full freight. As a result the average lower income customer ended up with worse Banking products that cost them more. Thank you Durbin.

33/42: The solution to this dilemma is to build a solution using lower cost infrastructure and more structural revenue. Add better UX/UI and cool branding and you’ve just created a US debit focused Neo-Bank.

34/42: The removal of the Durbin exemption for smaller Banks would put more money in the hands of retailers but at the expense of Community Banks and Credit Unions. This would only grow the big Banks’ share of the market which is the opposite of what the powers that be want.

35/42: I’m also of the strong belief that there’s going to be immense pressure in the US to finally increase the minimum wage to a level that allows for a worker to support his/her family. Moving the minimum wage to $15 an hour would lift pay for 40MM people.

36/42: If inflation kicks in (which I think it will) there will be additional pressure on increasing wages for the bottom half of American workers. Who governs our country matters but this might be an unstoppable force if viewed over a 10+ year horizon.

37/42: Neo-Banks are designed to serve this demographic well. As long as a Neo-Bank is hyper focused on its own costs, the increase in living wages for this population will translate into more revenue/profit.

38/42: And while a Neo-Bank will never offer a full suite of Banking products (nor should it), there will be plenty of additional revenue streams that will be generated through embedded and X-sold products and services.

39/42: Small dollar lending, cross border money remit, credit building, insurance and investment products are all logical extensions but will require focus, resources and scale to add to a Neo-Bank’s product suite without destroying value.

40/42: Not all of these products need to be manufactured by a Neo-Bank because the fragmentation trend applies here as well. A Neo-Bank can integrate and distribute best in class products as an alternative to building them internally.

41/42: The TLDR (which is necessary): If the legos are assembled right a Neo-Bank has a reason for existence in the market, can serve tens of millions of customers and can generate real profit. And don’t underestimate market forces - trends will help the Neo-Banks significantly.

42/42: And to end with a joke: “My Bank has a new service where they will text you your balance. It’s a cool feature. I just don’t think they should add LOL at the end.”