News Opinion September 24, 2021

[American Banker] BankThink Banks' consumer-friendly moves validate challenger model

By Tilman Ehrbeck

Just as fintech is taking on record-setting equity capital, nearly a dozen incumbent banks have signaled that they are “rethinking” their business practices as they relate to traditional checking accounts. A few of them are eliminating their often-punitive overdraft charges; others are copying a page from the fintech playbook and making funds from direct deposits available on the same day.

Pressure on retail banking incumbents to abandon the fees and practices that often penalize cash-strapped Americans has been heating up from Congress and federal regulators. As an investor who bet early on digital-first challenger banks, I’m pleased to see incumbents finally trying to catch up with the more consumer-friendly models pioneered by fintechs.

The first mover among incumbents has been Ally Financial, which eliminated overdraft fees earlier this summer. No-fee, no-minimum-balance checking is a core feature of the most successful fintech challengers. More incumbents are finally mimicking fintechs’ most popular offerings, like those that extend short-term credit at no fee when debit charges are overdrawn.

While not ready to abandon overdrafts, Bank of America and PNC have rolled out copies of fintech services to help customers avoid them, with grace periods, alerts, spending limits or credit when balances near zero.

This is good news for consumers and heralds a new, more competitive era for fintech. With the demonstration effect of success, the path for challenger banks is now well understood, and there is already a slew of new entrants.

With transaction account banking finally at an inflection point, it’s worth reflecting how the market caught up with the concept. Even before the current crop of challenger banks was founded, entrepreneurs were betting on customer-friendly, digital-first models. Simple launched in 2009 and Moven in 2011.

Examining the reasons these “Version 1.0” challenger banks failed helps explain why the current stars are booming. It also offers clues to what might be next for challenger banks, and fintech more broadly.

After the 2008 financial crisis, consumers were angry at the big banks, but there was no model for digital-first banking. The founders of Simple and Moven clearly saw a better way of doing things, a customer experience and a revenue model that were ripe for disruption.

Banks were making more money the less consumers understood their products, and they often earned disproportionate revenues off of their lowest-income customers. The pioneers had a promising solution, launching standalone online banking after the financial crisis; but acquiring customers was difficult in an era before social media enabled micro-targeting.

Developing the technology for digital-first banking and building the product were also hard. Today, fintechs have a thriving ecosystem of B2B middleware providers for streamlining payments, compiling transaction data, assessing creditworthiness, automating compliance, and conducting know-your-customer (KYC) authentication.

Before this infrastructure developed, Version 1.0 challenger banks had to build all that functionality themselves. The product rollouts and technology upgrades were not always smooth. As a result, the early challenger bank pioneers had trouble achieving scale. Simple peaked at about 100,000 users, not the millions of the current crop.

A broad user base enables today’s challenger banks to roll out new customer-friendly features, supported by interchange revenue. Most of these “Version 2.0” challenger banks — including Aspiration, Chime, Varo and Current — were founded between 2013 and 2016 and have found themselves at the right place at the right time.

Five years after the launch of Simple and Moven, consumers were more comfortable with mobile and digital-first banking, in many ways because of the path blazed by the early pioneers. Marketing channels are now more established, and Version 2.0 challenger banks have focused on market segmentation to lower customer acquisition cost.

Version 2.0 challengers have grown by providing a superior value proposition to traditional banking. They offer greater liquidity and a better customer experience at lower, more transparent costs. This, in turn, builds trust, creating a virtuous circle.

This has enormous benefit for lower-income consumers — and is magnified as more incumbents adopt features pioneered by challenger banks. Incumbents such as Fifth Third and Capital One will start offering early availability of funds from paycheck direct deposit, as nearly all fintech challengers do.

While consumers and politicians tend to direct their ire at big banks, it is the smaller banks that may struggle to give up revenue from float and overdraft fees. Banks have lived on the float for too long. It’s why so many people choose check cashers and payday lenders.

Challenger banks have proven their model is successful, and with the cost of starting a new front-end fintech falling over the last decade thanks to the proliferation of modern, API-based fintech infrastructure providers, the pressure on incumbents will persist. Today, over half of U.S. consumers are considering moving to digital banks.

Younger, digitally native Americans are especially unlikely to return to a brick-and-mortar branch. This shift has inspired a new crop of challenger banks, built around affinity plays, such as First Boulevard for Black Americans, Daylight for LGBTQ consumers or Novo for small businesses. These may become a crop of “Version 3.0” challenger banks, or the big tech platforms may take bigger steps into the space. Just as likely, today’s challenger bank champions, already well-established, could take market share at an accelerated pace.

This reinforces the value of putting customers first, and that mission-driven approaches can be profitable. Just as we invested in Version 2.0 challengers and B2B fintech infrastructure providers, we’ll always bet on models that make customers better off.

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