Neobanks vs. Traditional Banks: Same, but different

Neobanks vs. Traditional Banks: Look the same, but very different

When I sat down to write this post, the plan was to describe how neobanks can gain market share from traditional banks. However, I think it’s very important for my audience to understand the difference between the two before I jump in to that topic. The differences deserve their own post, and in the spirit of keeping this blog short, this post will focus on what is a neobank and how it is different from a traditional bank.

The big secret: a customer usually cannot tell the difference.

What is a Neobank

A neobank is a technology company that provides banking services fully online. Rather than having its own bank charter, a neobank relies on a partner bank or “sponsor bank” to provide the regulatory umbrella for the company to accept customer deposits and provide other similar services as a bank. Included in that umbrella is FDIC insurance for neobank customers (insured deposits in case the company goes under).

In the view of most customers, a neobank and a traditional bank are the same: a place where you can make deposits, apply for loans, and maybe do a few other things depending on what the institution offers.

Better put – a customer of a neobank usually doesn’t even realize they banking with a neobank (over an FDIC chartered bank) unless they read the small print of the user agreement.

Same basic services, different business models

Banks have two sources of income: interest income and non-interest income. 

Let’s start with interest income:

Banks, at their simplest form, take in customers’ deposits and use those deposits (their source of capital) to make loans. The interest on the loans is a major source of revenue for most banks. The bank will lend those deposits out at a higher interest rate than what they pay customers who hold cash at that institution.

Since their source of capital is very cheap (a customer hands them money and they pay a small interest on it), the bank can then offer borrowers lower (or competitive) interest on loans.

Compare that to a neobank. Neobanks rely on a sponsor bank in order to legally accept deposits. Since the Neobank doesn’t have its own FDIC insurance and bank charter, the neobank customer’s deposits actually sit on the sponsor bank’s balance sheet.

This means that a neobank cannot use those low-cost funds to make loans and generate interest income. They would have to borrow from another institution (high cost) and lend out funds at an even higher rate to make a spread. This typically leads to higher-risk borrowers who cannot receive a loan from a traditional bank.

Note: Neobanks can offer loans, but usually to the major benefit of the sponsor bank. For example, a neobank can earn basis points of interest for every loan originated by one of it’s customers.

 Another form of interest income:

Deposits drive another source of interest income. A bank will take a portion of the customer deposits and deposit that money at the Federal Reserve.

The Federal Reserve will then pay the bank overnight interest on those deposits. The overnight interest rate might be small, but on a large amount of cash it can be a significant source of income.

 What interest income means for Neobank

To recap – interest income comes from loans (driven from deposits) and federal funds (driven from deposits). Although the neobank brings in the deposits, through marketing and other channels, the sponsor bank is the main beneficiary of the interest income.

The neobank’s job is to negotiate commercial terms with the sponsor bank:

1. Negotiate percentage points of interest on every loan originated through the neobank (and possibly origination fees)

2. Negotiate a % of fed funds income that the sponsor bank receives from neobank customer deposits

Higher shares of both obviously help. Regardless the case, a neobank usually will not take home 100% of the revenue from interest income that a normal bank can take home.

However, they will still have to pay 100% of the interest they offer on deposits.

So now let’s talk about non interest income:

Typically, Neobanks have to rely more on the non interest income: account fees, transaction fees, credit cards, debit cards, and interchange fees.

Both traditional banks and neobanks generate non-interest income, but neobanks must rely on it more due to their limited ability to make loans.

Here is a breakdown of common non-interest income a bank can generate:

• Monthly fees: charge a fee to hold and manage a customer’s funds

• Transaction fees: charge for ACHs, Wire Transfers, International Wires

• Credit Cards / Debit Cards: Annual fees, interchange fees, overdraft income, interest (credit card)

   Interchange fees are small fees based on size and frequency of card transactions and could be a significant revenue driver for neobanks

To attract customers to their services, the neobank must offer the above services in a way that is above and beyond better than what is currently available.

That’s where technology comes into play.

Traditional banks do not have a strong track record of innovation, technology adoption, and digital transformation. Between regulatory concerns, legacy systems, and the costs / risks of switching vendors, large technology spend scares most bankers away.

Neobanks do not have to worry about that. They can build something from the ground up, in a slightly different regulatory environment, and use technology to serve a smaller population needs.

Which is exactly what they are doing. And taking market share from larger players.

The symbiotic relationship

That’s why neobanks and traditional banks need each other. The neobank needs the traditional bank’s bank charter and expertise and the traditional bank needs extra deposits and a front row seat to bank innovation.

As with any industry, convenience and technological innovation usually wins. Many traditional banks are looking to neobanks (even making equity investments into them) as a way to innovate and gain market share in an old “boring” industry.