Digital banks are essentially new businesses. And, as we all know, the startup environment is renowned for prioritising growth over profitability. A red flag for the bull is getting as many new users or customers as possible.
The idea process is that as long as you keep adding customers, you'll eventually figure out how to monetize them.
How do these digital banks stay solvent and make money if their customer base grows to several million or perhaps tens of millions? Do they make any money at all? How can users be persuaded to pay for specific services?
Digital banks make money by:
Raising funds
Arguably the “easiest” way to make money is to raise funds from investors. Venture capital firms are lining up to invest in digital banks not only in the US or UK but worldwide – wherever an opportunity presents itself.
Major neobanks have raised more than a billion dollars and sometimes several billion.
Interchange fees
People come to expect that digital banks will have accounts that are free of charge and where most day-to-day financial services will be free, including ATM withdrawals, transfers, transactions, cards, and maintenance fees.
This is probably what 90% of us use our bank accounts for. And it’s all for free. But there is a fee that’s hidden. Well, it’s hidden from customers, not from merchants. It’s the interchange fee that Visa and Mastercard charge sellers whenever a customer buys something from them with the card.
It’s why you often see in smaller “mom and pop” shops that they only accept cash. Their margins are already razor-thin to share some of it with card companies.
Some of that interchange fee will go from Visa to the digital bank. Those are typically tiny amounts, but they add up the more customers you have who are happy to spend their hard-earned money on stuff they mostly don’t need.
Offering a premium account with swanky features such as a metal card, travel insurance, overseas medical insurance, better savings rates, lounge passes, etc., are an excellent way to make a paying subscriber out of a “freeloading” app user.
By offering two or three tiers for your customers to choose from, your chances of getting more money from a customer are looking good.
Offering free accounts can be costly to fintech companies. And the more customers you have, the more money you can lose.
Although premium accounts can make some profit for the company, or at least not lose it, that’s still not a big moneymaker for them.
SME business accounts
SMEs are notably underserved, and they’re used to being fleeced by big banks. If you can get a small or medium-sized business under your roof, you can earn good money for years to come.
By offering a free account and then charging for some of the services is one way to go. The other is to straight up charge for a business account.
Entrepreneurs love to bank digitally. It saves them valuable time that they, or their people, can spend on other vital parts of their business. There’s a lot of room to grow here for digital banks, especially in today’s world when everyone wants to be an entrepreneur.
Credit cards
Now we’re getting to the juicy stuff. Credit cards. The more savvy digital banks offer credit cards to customers from the onset as they are one of the most profitable financial products for banks in general.
Banks can earn money from credit cards in several ways. There’s the annual fee that’s often waived for the first year or entirely. Then there’s the interest fee that is charged when a customer fails to repay their balance in a month. That’s the biggest revenue generator.
And then there are the already mentioned interchange fees that they collect from merchants or the credit card issuing bank they’ve partnered with. Lastly, there are late, balance transfer, and cash advance fees.
As you can see, it’s worthwhile for a digital bank to have credit cards in its portfolio. They’re more prevalent in some territories than in others, so they might not be worthwhile everywhere in the world.
Some neobanks that don’t have a banking licence can offer credit cards by partnering with a licensed partner to get regulators on board.
Loans and mortgages
The most straightforward approach to profit is to lend money to clients. People will always require more money than they now possess, and they will gladly pay for it.
Mortgages, in particular, are the bank's most profitable financial product. They are the most important financial transactions that people will ever do.
Mortgages aren't available from all challenger banks. New banks, in particular, require time to establish themselves in the market and mature. They can, however, begin by offering personal loans to customers as a terrific way to lock them in and generate interest.
Overdrafts
Banks rely heavily on overdrafts to make money. Overdraft fees accounted for more than half of the net income of six renowned banks, according to a research by the Brookings Institution. According to the same poll, consumers who overdraw their bank accounts more than 10 times each year pay a whopping 80 percent of all overdraft penalties.
Overdrafts are quite infrequent among digital banks. As a move to assist their customers during the epidemic, some of them began eliminating overdraft fees entirely. Ally is one such person.
They began by reimbursing overdraft costs in early 2020 to assist during the pandemic, but soon scrapped the practise.
Even still, because a single overdraft can cost up to £35, it's a simple method for traditional and digital banks to make money. I'd rather be a little self-conscious at the cash register than pay that amount.
Marketplace
Once digital banks have a sufficient number of customers, they can turn their app into a marketplace. Banks are not required to create and market their own products. They can simply rent out their app space to other financial institutions such as lenders, insurance companies, and accounting organisations. For every consumer recommended, banks receive a commission, and the businesses that participate in the marketplace receive a paying customer. It's a win-win situation for everyone.
The market can accommodate a wide range of services that appeal to both personal and business users. The marketplace can include HR, pensions, tax, legal, communications, loyalty programmes, payments, investing, mortgages, utilities, and more, in addition to the aforementioned lending, accountancy, and insurance providers.
Starling Bank in the United Kingdom is a well-known and frequently utilised example. They are one of the few profitable challenger banks currently operating. To supplement their business account, they provide a variety of third-party products.