Challenger banks — financial firms offering something much like banking services, and looking to compete with old-school banks — are a new idea. The basic structure that underlies them is not.
As Ingo Money CEO Drew Edwards noted in a recent conversation with Karen Webster, the model that most so-called challenger banks offer is basically a variation on an old theme. The customer gets a reloadable prepaid card that functionally behaves much like a debit card attached to a real checking account, and the card is also paired up with a slick digital app. Firms with that business model have been around for over two decades.
“Green Dot has been doing this for years. So has NetSpend and a whole host of other players. This is not a new story,” Edwards said.
The product, he noted, hasn’t changed much between the prepaid card firms that run the first version of this model and the Silicon Valley venture funding-backed challenger banks that are proliferating today. What has changed is the target audience.
The first version of these firms, he said, was targeted toward underbanked and unbanked consumers — people who were unable to access mainstream financial services, and needed an ersatz version to provide them with an on ramp into modern digital financial services. The new version targets their efforts quite differently.
“What these challenger banks are now [seeing] is we have this generation of kids that have grown up now [who] just don’t care about brick-and-mortar banking because they want to do everything digital-first. The idea of a bank for them is a very different idea than it is for you and me — such that, for them, a mobile device is basically, in their view, a bank in their pocket,” Edwards said.
While the theory is popular, he added, it is also, in some senses, a head-scratcher to behold, as “[venture capitalists (VCs)] are pouring millions into these firms.” What remains unclear, he said, is just how these challenger banks plan to grow up, scale and start stealing the big banks’ customers — when their offerings, at base, don’t add much new, and come with some unique frictions and problems that banks don’t have.
There’s No Such Thing As A Free Lunch
Free always sounds good to the customer, but often comes with big costs down the road for the financial services provider that decides to put it out there. Old-school banks had this issue decades ago when they decided checking accounts should all be free — and that they could cover the loss of that revenue stream with overdraft fees instead. That worked great, until overdraft fees found themselves under tighter regulatory scrutiny, and it was much harder to go back to the old checking account fee system because customers had gotten used to checking accounts being a free service.
The same thing, he noted, is happening to the new wave of venture capital-funded challenger banks looking to bring customers through the door. The version 1.0 players, as it were (the Green Dots of the world), found a monetization scheme in selling the cards in physical stores, and attaching some fees to services. The next generation doesn’t want to do that.
“We created our own problem in banking when we convinced everyone that checking should be free,” Edwards said. “So, it is amazing to see these challenger banks blaring free all over their marketing. No fees, no hidden fees, just totally free. But there is no such thing as free — not in financial services.”
Free can work, if one is Google and their product is search — though Edwards noted that even Google has the good sense to not advertise that search was, is and always will be free. It is free for now — the future is undetermined. However, Google’s free offering is premised on two things that no challenger bank will ever be able to match.
The first is its scale, and the fact that its homepage is the homepage of the internet all over the world — meaning the number of eyeballs it commands creates staggering amounts of ad revenue. The second is that Google, as a search firm, is more or less free to do what it wants to monetize its data streams. Google as a financial services firm, however, faces very different rules.
“That is, all the information and data [is] protected by a whole different set of rules and regulations,” Edwards said. “They can’t monetize it directly, and there isn’t enough interchange income out there to support a full-blown banking model. We know that because we can look at how much money the biggest issuers are actually taking in via interchange.”
Players like Google/Alphabet and Apple, which is also making moves in that direction, are both massive and well-capitalized enough to lose money for a bit while they figure out a business model — one likely built on value-added services, for which they can charge. Challenger banks? That, Edwards said, is going to be a much harder path to walk, unless VCs keep writing checks that make “free” possible. Moreover, he noted, even if they can, free isn’t enough.
Really Sticky Services
In looking at the history of prepaid card use, he said, an interesting trend pops up. Unless a customer had a direct deposit attached to a prepaid account, more likely than not, they would use the card a few times within a few weeks, then toss it into the trash without ever reloading it. That short relationship matters a lot. Prepaid cards, generally speaking, weren’t profitable (minus fees) unless the customer enrolled in direct deposit with the card.
For that to happen, though, the customer must want to commit to that relationship, and the fundamental question that no one is answering is why they would do that. Consumers generally make a change to get something new and of value. Challenger banks, he said, aren’t clearly offering that.
“What is actually the functional difference between the new challenger banks regular banks and the old prepaid card player? They all have the same feature set and functionality, more or less — they all have good apps, ways to load funds to the account, service charge-free environments, accounts for savings and budgeting tools,” he said.
With so much in common, many consumers are going to stick with the bank because it’s trustworthy and stable, Edwards said. A few years ago, when Green Dot changed its card processing to a new system, consumers were unable to access their funds for days. A similar thing happened with challenger bank Chime in recent months.
“A Bank of America customer or a Chase customer knows they will never face that issue — that day is never going to happen,” he said. “Worst case, you can walk to a physical branch and remove your funds.”
To really challenge banks, Edwards said, challengers must have more to offer than a vault and card for customers. There must be value added.