credolab: Neobanks must increase consumer loans to become profitable

Is it really possible to make money by spending money? In this latest guest post, Peter Barcak puts neobanks under the microscope to explain how profitability can be achieved by parting with the cash.

Here, Barcak describes how neobanks must increase consumer loans in order to consequently increase profits.

Barcak is the CEO and co-founder of credolab. The AI-powered fintech startup processes smartphone metadata to deliver alternative, more accurate credit scores. It works especially with underbanked and credit-invisible communities.

After more than two decades in multinational banks and startups, Barcak has experience in industries dealing with risk calculation.

Known for his ability to envision and produce successful outcomes in complex situations, he is driven by the belief that our financial systems can be more inclusive and profitable.

In this guest post for Fintech TimesBarcak discusses the neobanker’s struggle to reach profitability, while laying out a new, old path forward:

Neobanks must increase consumer loans to become profitable

Most neobanks claim they exist to “rip up” the banking rulebook. But certain facts of life cannot be ignored. The link between lending and profitability is one of these. The banks take in deposits at one interest rate and then lend the money at a higher interest rate. It is not the only way they make money, but well-managed consumer loan accounts are by far the biggest element in the banks’ profitability.

The industry, which has had several centuries to figure this out, aims to operate at an optimal ratio where it lends out around 80 percent of the money it takes in deposits. Now that short-term profitability is suddenly a much higher priority for investors than it appeared to be as recently as 2021, neobanks are being forced to relearn these basic banking principles.

Neobanks fail due to low lending rates

Neobanks is certainly in a difficult position right now. A report from May 2022 of management consultants Simon-Kucher concludes that fewer than five percent of the world’s 400 neobanks break even, with some burning cash at a rate of as much as $140 per customer annually.

Under these circumstances, addressing profitability by increasing the loan-to-deposit ratio seems like an easy start. And neobanks that fail to reach a healthy ratio risk bankruptcy. It’s actually already happening.

In Great Britain, Bank Nord has withdrawn from the market. It attributed its failure to persuade investors to part with more equity funding to a failure to start a savings business. This despite having a limited banking licence. Without deposits, the banks cannot lend. Without lending, banks cannot be profitable. Neobank Dozens said the failure to obtain a full banking license left it running on an e-money licensing model that did not allow it to lend.

In Australia, Xinja has pulled the plug on its operations. It lacked a lending product and was unable to keep the banking business afloat. Even neobanks that had made progress towards a lending model have struggled.

Volt, which had reached a loan-to-deposit ratio of 70 percent, ceased operations after failing to raise sufficient additional funds to support the business. It is a similar story at 86,400 (with a ratio of 72 percent). It was acquired by NAB, one of the largest banks in Australia. NAB cleverly discovered a much cheaper opportunity for an incumbent bank to get on board with the challenger mentality than the 10-year digital transformations many banks attempt.

Starling’s profitability is built on lending

Some neobanks that have taken up lending are now at or approaching profitability.

Starlingwhich places itself in a “category of one” according to the CEO and founder Anne Boden, delivered a pre-tax profit of £32.1m in the financial year ending 31 March 2022, on revenues of £188m. This followed a £31.5m loss for the previous year. Boden attributed the turnaround to Starling’s mortgage push, after that appropriation of Fleet Mortgage in July 2021.

Likewise, Zopalosses decreased as lending increased. Income more than doubled to £70.5m in figures released in July, as new lending soared by 433 per cent. Zopa still reported a loss of £41.6m. However, according to the CEO Jaidev Janardanawhich was almost entirely due to a £41.5m impairment charge against lending, without which the bank would have broken even.

Lending in a recession

But increasing consumer loans during a recession is risky. Consumer finances will be under increasing pressure. While borrowing is likely to be attractive to many consumers to see them through difficult times, not everyone will be able to meet repayment plans. Bloomberg reported in October that British banks alone have set aside £1.3 billion to cover this scenario.

The competition increases the pressure on the sector and is intense, with many more competitors today. Despite the fact that some neobanks are withdrawing, most remain in place in a market where the incumbents have not left either. There are just more banks looking for a piece of the lending pie.

But there are still markets and sectors that are underserved – the so-called “subprime” sector and in emerging markets, for example. But these are higher risk. And we have seen (in 2008) what can happen when risk is misunderstood and poorly managed.

Limitations of Current Credit Scoring Models

Are there completely reasonable risks in the subprime market? Yes. But it is difficult to identify them.

A central problem is that the conventional credit bureau scoring models do not provide enough insight into people with limited exposure to the financial system. These include large sections of any economy: younger people who haven’t had time to build up a credit profile; self-employed/gig economy workers; people who previously had bad credit profiles but are now at a different stage in their lives; and the massive market for people who have been economically excluded in emerging economies.

However, the credit bureaus are prepared to identify people with past credit history and successfully repaid it. In terms of the world’s population, this is a relatively small group.

An opportunity to grow profitably

Most banks still rely on older credit scoring methods and traditional underwriting processes. This approach inevitably generates high rejection rates, slow portfolio growth, inconsistent customer experiences and, in some cases, a high percentage of non-performing loans.

With pressure on neobanks to achieve profitability via increased lending, they must engage with new methods of measuring risk. This is particularly poignant at a time when recession-hit consumers are struggling to pay. The technology is making rapid progress here, but is still underutilized.

There’s no point in just taking on loans that your competitors may have already turned down. The incumbents are definitely slow, but they are not stupid. They know that a high percentage of subprime borrowers will default.

If your business model depends on taking on many of the customers that the traditional banks do not want, then your business model must be able to minimize the risk of non-performing loans. It must have a pretty solid way of identifying the good risks that undoubtedly remain to be won.