Neo Banks and Commercial Banking

Traditionally, the commercial banking industry was largely controlled by commercial banks which had a huge brick-and-mortar presence. However, over the past few decades, customers have gone digital. In response to that, the banks were also compelled to go digital. This digital wave led to a dramatic increase in competition for commercial banks.

Many types of technology-based entities came into existence and started competing with commercial banks for their business. Neo-banks are one such type of entity that has recently come into existence.

Neo banks have grown at an alarming pace since 2016. Between 2016 and 2020, Neo banks have registered a compounded annual growth rate of over 50% worldwide! Also, the pandemic only helped the neo-banking business model since these banks largely operate online. These statistics indicate that neo banks are still in the nascent stage of their growth and are likely to grow at a faster pace in the future.

Since neo banks are a game changer for the banking industry, it is important to understand exactly what they are and how they function. In this article, we will have a closer look at the functioning of neo-banks.

What are Neo Banks?

Neo banks are not really banks in the traditional sense of the word. This means that they do not really have a banking charter. Hence, legally they are not allowed to provide banking services on their own. As a result, neo banks break their operations into two parts. There are some services that cannot be provided by neo-banks such as taking deposits. For these services, neo-banks tie-up with traditional banks. On the other hand, there are other services such as payments, loans, etc which can be provided by neo-banks since it does not require a banking license.

From a customer’s point of view, a neo bank is a completely digital setup. The neo bank does not have any branches. The customers interact with the bank via an app. Customer service is provided via chatbots and customer service helpline numbers.

However, neo banks are known for being digitally savvy. This means they are known for deploying the best possible technology and providing personalized services to customers as compared to more traditional banks.

From a customer’s point of view, neo banks act like full-fledged banks. This is because they perform all the tasks that a traditional bank does. However, internally neo banks have partnered with some traditional banks.

How Do Neo Banks Make Money?

The revenue generation of neo banks is quite different compared to traditional commercial banks. Traditional commercial banks generate most of their revenue by borrowing at a cheaper rate and then lending at a higher rate to corporate customers. Neo banks are not legally allowed to do the same. Hence, they cannot take advantage of this revenue source. Hence, neo banks have to focus on other revenue sources.

  • Merchant Fees: Neo banks are heavily dependent upon different types of merchant fees. For instance, whenever the corporate use credit cards issued by neo banks, a small percentage of the proceeds is transferred to the neo bank by the merchant. This fee is typically larger than what commercial banks charge. This is because neo banks are legally allowed to charge more fees as banking regulations do not apply to them. Neo banks often encourage their customers to increase the use of their debit and credit cards.

  • Transaction Fee: Neo banks provide various types of transactions such as payments. In such cases also, neo banks charge a small fee per transaction. Neo banks have to focus on generating large volumes of transactions so that their revenue can show some meaningful growth.

  • ATM Fees: Neo banks encourage the use of digital money. This is because they do not have extensive ATM networks. Hence, any cash withdrawals from ATMs are generally chargeable while dealing with a neo bank. ATM fees constitute a small portion of the overall revenue generated by neo-banks. Also, the neo-banks want to reduce it even further. This works well for corporations since many corporations do not want to use cash either. Corporations generally prefer transacting with digital money since it is safer and more secure.

The fact of the matter is that right now neo banks do not have many sources of revenue. In the current situation, neo banks have to expand their banking relationship with corporate customers considerably before they can break even and start making any money.

Operating Costs

Neo-banks have an intense focus on keeping the operating costs as low as possible. Since neo banks do not have any physical locations and employ very less staff, their overheads are quite low. As a result, they can provide the same service at a lower cost to the corporate customer and still make a larger profit than traditional banks.

Also, since neo banks do not lend their own money, they face no credit risk. Hence, they do not need to have a lot of expensive risk management systems in place which helps them further cut down on costs. Keeping costs low is strategic for neo banks. They can only attract customers if their fee is lower than traditional banks and also they need more margin because they have fewer sources of revenue.

The bottom line is that neo banks are an important set of players which are quickly gaining prominence in the commercial banking industry. Their quick rise represents both a threat as well as an opportunity for commercial banks.

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Commercial Banking