Digital banks: Feature, product or business?

Good morning, Ledger readers. I’ve been thinking about a question popular in Silicon Valley investor circles a few years back—“Are you a feature, product or business?”—and how it might apply to the glut of so-called challenger banks competing for U.S. customers.

Challenger banks—some call them digital banks or neobanks—took off several years ago by exploiting customer frustration with the abusive fees and lousy mobile experience offered by incumbents. The upstarts grew by means of asset-light operations (no branches, no tellers) and a savvy strategy of acquiring customers by social media and word-of-mouth.

The most prominent of the challengers is Chime, which recently notched a $14.5 billion valuation, but other would-be disruptors include Varo, Revolut, N26, Monzo, Dave, HMBradley and MoneyLion. The list goes on.

The question I have is how many of these names will be around two years from now. My hunch is not many. Going back to the “feature, product or business” query, a lot of these players look a lot more like features than full-blown financial companies. The perks that once defined them, like overdraft notifications or spangled debit cards, have been copied not only by their upstart competitors but some old line banks too.

Meanwhile, their business model faces major headwinds. In an astute essay, Andreessen Horowitz notes that the Federal Reserve’s low rate policy means it’s no longer viable to offer high interest savings rates to poach new customers.  The venture capital firm also notes that the pool of clients that can be acquired on the cheap is shrinking, while fewer of those customers are transferring their direct deposits over to challenger banks.

So how are all these upstarts going to make money? The most likely answer is they’re not. Challenger banks can earn a trickle of revenue from merchants when customers swipe their debit cards, but not enough to thrive in the long term. To be a business not a feature, they will have to do what successful banks have always done: take deposits and loan them out at a profit. But that’s no easy feat given that competitors already have their hooks in the most credit-worthy customers, and that the regulatory costs of being a full-blown lender are steep. So what happens next?

“It’s a really crowded space, and I think a lot of the smaller players will go out of business. Those with a good customer base will get acquired,” says Robert Le, an analyst with PitchBook. He predicts we’ll soon see a winnowing in which the likes of Chime and SoFi obtain a federal banking charter (Varo already has one) and become fixtures of the financial world, while the minnows disappear or get gobbled up for their, well, features.

Makes sense to me. One more thing to ponder: If Le is right and consolidation is coming, will any of the acquirers include the big crypto players like Coinbase, Kraken or Gemini? These companies have been active in M&A, and snapping up a neobank could let them expand their financial footprint and provide an easy way to introduce millions of customers to Bitcoin. Just saying.

On a final note, we’re delighted to announce the return of Balancing the Ledger, our bi-weekly show where we welcome the biggest names in fintech and crypto. You can find more about the latest episode, featuring Binance’s maverick CEO CZ, below. And if you have suggestions for who we should bring on, we’d love to hear them.  

Jeff John Roberts

@jeffjohnroberts

jeff.roberts@fortune.com

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