Digital banking: a tough way to make money
It’s been a busy period for the UK’s fledgling digital banks. Since January, eight UK digital banks have collectively raised $600m and two challenger banks were acquired for $2B+. Digital banks have built out the tech, landed banking licenses, and started winning customers – but they have arrived at a ‘now what’ moment. How can they capture a large enough customer base to validate their significant collective investment? The need to build and maintain customer growth momentum is greater than ever, but the route to profitability is looking unclear at best.
In the face of this record-setting funding greater caution is warranted. Digital banks’ business models are fundamentally uncertain, and likely to be far less attractive than current valuations assume. Here’s why:
Digital banks are regulated B2C (business to consumer) businesses, subject to the same challenges all B2C companies face. Central to making money in B2C is ‘unit economics’; the cost to acquire, retain, and sell to customers must be less than the total profit each such customer generates (‘lifetime value’ or ‘LTV’). Monzo reported that its prepaid card scheme loses around £50 per active customer per year, and other digital banks face similar costs. While on the one hand the cost to acquire these current account customers is not very high, given the ‘buzz’ around the sector and banks’ word of mouth-driven growth – these current accounts, with their low average balances, are also inherently unprofitable. So it’s a steep climb for digital banks to recoup their operational costs, much less make a lot of money per customer.
To make money, digital banks are increasingly looking to ‘cross sell’ products, from insurance to foreign exchange (Starling Bank), or make a margin by recommending customers change energy providers based on analysing current account spend (Monzo). But only a fraction of customers will ever take up these products, and banks tend to earn low ‘affiliate marketing’ margins – therefore, a huge customer base is needed to make real money here. For example, a digital bank may well need 500,000+ customers to convince 10,000 to change energy providers; getting a 20% affiliate commission on say £500 each sale yields only £1m for the whole cross-selling effort, hardly enough to justify lofty valuations.
The other problem is ramping up customer numbers will become increasingly difficult and far more expensive. Dozens of digital banks are going after the same target audience of well-off, digitally-savvy urban professionals, all at the same time. Inevitably this pushes customer acquisition costs higher, with diminishing returns on overall investment. The effect of competition is evident in a related industry, ‘robo’-advisory (e.g. automated wealth management). US leaders Betterment and Wealthfront each pay $500-1,000 to acquire new customers – whereas in Europe the numbers are a fraction of this, due to a less competitive market that is less well developed.
Even with easier current account switching in future, only a fraction of high street bank customers will make the jump; moving money for most is a pain. High street banks routinely get awful customer ratings, yet deposits continue to grow. Inertia is a huge barrier to getting valuable customers rapidly, and seems to have barely been priced into current financing rounds. Thus, while digital banks are currently relying on word of mouth and general buzz for growth and spending little on marketing, this won’t last. Competition will intensify for this small segment of high value customers which are ready to move bank and are likely to respond well to cross-selling and other profit-seeking features.
What does the future look like for these upstart banks? We expect the majority of today’s digital banks will fail to grow profitably, and consequently will either have to merge into larger fintechs looking to offer digital banking or be acquired by large banks eager to offer slick digital products. There is huge logic in this; digital current accounts are a great ‘starter product’ to attract customers and engage them regularly, but larger fin-techs can offer a broad array of products to generate required profitability downstream. In either case, digital bank valuations will have to come down to earth to make the acquisition sums work.
Many investors in digital banks will find when their money has been spent that their investment will be worth a fraction of what they expect. What goes way up, so quickly, is at serious risk of coming crashing down to earth.