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Are neobanks set to change the face of the banking system?

What is a neo bank? How does a neobank work?


Neobanks are new-age financial institutions that are giving traditional banks a run for their money as they aim to provide cheaper alternatives to the traditional banking system by leveraging technology. But what exactly is the functioning of a neobank? How is it different from a traditional bank? Is a neobank simply a digital rendition of an ordinary bank? The answer is yes and no. A neobank is a digital bank that operates entirely online without any physical branches, unlike a traditional bank. Though cognizant of its benefits, the Reserve Bank of India does not issue bank licenses to neobanks due to which they must partner with a traditional bank to provide services. Neobanks such as Jupiter and Razorpay use mobile-first technology to provide services such as money transfers, lending, and debit and credit cards to differentiate themselves from traditional banks and are constantly backing innovations to provide superior customer service. Customers can create their bank accounts from the comfort of their homes and also avail themselves of the services offered by the neobanks through their mobile application.


These digital operations not only result in hassle-free account creation but also deposit paycheques a few days earlier than the traditional banks. Apart from their speed, the neobanks also pride themselves on the significant costs they cut down, giving them an edge over the traditional banks who have to bear the expenses of maintaining physical branches. This allows the neobanks to reduce customer fees by a considerable amount.


The defining element of neobanks is their application to mental accounting. Mental accounting is a very important concept of behavioral economics, it refers to the tendency of people to organize their income and assets into different categories to better manage their finances. Each category is fixed for a specific purpose such as groceries, fuel, or monthly rent to control spending. However, since people make mental accounts to keep track of their finances, it could lead to several inefficiencies. Exceeding the budget allocated to one category without constraining the budget of the other categories is one such example. Since money is fungible, this would result in more expenses than what the budget has been allotted for. Neobanks attempt to solve this problem.


Fintech apps are replacing the cognitive abilities employed by people to enable mental accounting through budget allocation and various savings goals. Neobanks such as FamPay and Pencilton, focussing exclusively on kids and teens, utilize this concept to inculcate savings habits in children at a very early age. These apps provide users with a summary of their spending along with insights such as average spending in each of the various non-transferrable categories. Users can check the amount of money left in different categories and also get a notification if their spending exceeds the budget limit. These apps also allow the users to set aside money for specific purposes such as saving for purchasing a car or a house and let them lock these “mental accounts” till their savings goal is achieved. All these features help users make better financial decisions.


How does a neobank earn?


Neobanks rely on interchange fees—transaction costs paid by the merchants when customers use their card—for most of their revenue, unlike traditional banks which also make their money from overdrafts and other fees. Since neobanks are smaller organizations, they are allowed to charge higher interchange fees as compared to traditional banks.


The biggest challenge posed by neobanks to incumbent traditional banks is customer-centricity. Many neobanks are now targeting the working poor who live paycheque to paycheque. Though the customer-centric focus here seems to cultivate a positive force in society, it also leads to profitability. Since these customers would save less and spend more, catering to them would result in immense profits as it would foster their interchange-fee business.


However, a neobank relying on interchange fees is feasible as long as it is a high-volume business and the costs are suppressed. Besides, neobanks must also be ready to spend or lose a substantial amount of money to build trust with their target audience by providing freebies. Therefore, many neobanks are venturing into other services such as lending and credit cards. Fintechs such as BharatPe, whose primary revenue is through lending, have done admirable work in disbursing loans while also serving the social purpose as they cater to the needs of small merchants. They charge a lower interest rate than what the market offers and do not require any collateral. As aforementioned, they can slash interest rates because of the lack of physical branches which allows them to contain costs.


What are the challenges faced by a neobank?


While neobanks do have a lot of benefits, they have their share of cons as well. One of the biggest challenges they face is suspicion prompted due to a lack of brick-and-mortar branches. Many people continue to opt for conventional banks because they believe that “face-to-face interaction with their financial custodian” would hold them accountable in case of any issues. Though online shopping websites like Flipkart and Amazon have garnered enough attention and revenue for a long time now, they have been unable to uproot the existence of physical stores. Since neobanks are being built for the 21st century tech-savvy consumers, they struggle to serve the other sections of society who are adamant about banks having physical locations.


Traditional banks face immense costs when they open a physical branch, so not many are built in villages. Even if neobanks access this part of the country digitally, they won’t find enough people who are digitally literate and can benefit from the services offered by the bank. Thus, this business model seems very unprofitable for neobanks. This might encourage them to limit services to tier one, two, and three cities that already have it relatively easy.


Since they operate on a freemium service model, they are forced to be at the top of their game at all times. They have to constantly innovate to attract new customers and retain the existing ones without losing them to the digital platforms of traditional banks.


Lastly, neobanks also have limitations on the number of services they can provide to ensure high security and efficiency. Razor pay was recently involved in a controversy where questions related to data security and user consent were once again in the spotlight. They were accused of releasing confidential data to the police and to the government to aid them in an ongoing investigation against Muhammed Zubair (his company alt-news highlighted Nupur Sharma’s comments on the prophet). The neobank has not made any comments on the accusations, but the controversy brings up a lot of questions about security.


Conclusion


Despite all the challenges faced by neobanks, they are a growing industry and the pandemic has been instrumental in making neobanks the “next evolution of banking”. Lockdowns have encouraged people to create bank accounts from home and nudged customers to opt for neobanks due to the ease of creating accounts. Due to the superior customer service provided by neobanks through the use of automated technology, traditional banks grapple with keeping pace with neobanks. During the pandemic, users of neobank apps have doubled, whereas those of traditional banks have significantly declined. Many new neobanks are coming up such as Niyo and Dinero which have recently raised a substantial amount of funding from various new-age retail investors and private equity firms. Such a massive influx of neobanks offers a glimmer of hope that the new digital era of banking is not going to dissipate anytime soon despite some bumps in the road.

(Written by Alankruthi Dasari and Shree Rungta and Edited by Anoushka Gehani)


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