As challenger banks seek to enter the US, the business model still faces hurdles

The digital-only banking space in the U.S. is getting crowded. European digital banks N26 and Revolut will launch in the U.S. later this year, and there are reports that U.K. challenger bank Monzo is mulling a move into the U.S. market. Meanwhile, three U.S. banking startups -- Varo Money, Square and Moven -- recently announced plans to apply for or acquire U.S. banking licenses. There aren't currently true challenger banks in the U.S. Instead, most banking startups like Chime, Varo Money and Aspiration become neobanks, or create a digital-only bank while working with a partner bank in the background. The FDIC hasn’t issued new banking licenses since 2008 and the Community Reinvestment Act requires that banks have branches. Until the OCC Fintech Charter comes out, there isn’t a regulatory framework for challenger banks in the U.S. But the U.S. consumer market is still seen as a big opportunity for banking startups, who are placing their bets on a large pool of customers who feel their needs aren't being served by the incumbents. While interest in building true challenger banks is growing, there are still hurdles. Being realistic about the objective Across financial services, talk of startups displacing the big banks is no longer seen a realistic objective. The narrative is now about finding a niche and partnering with banks for scale. For some banking startups -- as with all new brands -- the path to profitability is about striking a chord with a loyal niche of users who recommend their friends and family. "It's not a winner-take-all market," said N26's U.S. CEO Nicolas Kopp. Instead, Kopp said different companies can gain market share among distinct customer segments. For instance, N26 sees American millennial consumers who live away from the largest cities as potential customers. For N26, winning means customers loving N26 like in Europe. U.K.-based Revolut, which plans to launch in the U.S. later this year with a multi-currency bank account, said winning means acquiring millions of customers, particularly those who travel often; and to San Francisco-based Chime, a win is to bring large numbers of customers away from traditional institutions. Building a sustainable business model Startup banks generate revenue through interchange fees, but many businesses tend to have an over-reliance on them and as a result, many operate at a loss, according to Aite senior analyst David Albertazzi. To be truly sustainable, digital banks need to  generate revenue from multiple sources, like the income they make from payment providers or the money they make off deposits and loans. "Their success is going to depend on their current performance, business stability, market position and future potential," Albertazzi said. Customer acquisition is expensive. For a large bank it could cost between $1,500 and $2,000 to acquire a retail banking customer, according to Ciaran Rogers, director of marketing at StratiFi, an early stage startup that helps advisors manage portfolio risk. Startups themselves say their cost of customer acquisition isn’t high at all. At MoneyLion, the cost of customer acquisition is about $5 or less, said chief marketing officer Tim Hong. Luvleen Sidhu, president and chief strategy officer of the all-digital BankMobile, said it spends about $10 to acquire an account. That’s great, but the number of accounts these companies manage is overshadowed by the existing customer base at the big banks. Plus, account activity at startup banks is lower. That's part of the reason startups like SoFi -- which will launch its checking account this year -- and Square are shooting to become banks. By adding banking to a suite of other product offerings, startups reduce the reliance on interchange fees alone. Becoming the center of the customer's financial life A central problem faced by a startup bank is to encourage customers to put more than a few dollars in their account and become the the center of the customer's financial life, Kopp said. That includes a direct deposit relationship, and using it as a focal point for other services. "We're pursuing the idea of becoming the central cockpit for all our customers' finances to facilitate financial education and decision making," Kopp said. "Turning this idea into reality will be crucial to reaching strong customer growth and long-term retention in the U.S." For N26, replicating the partnership model in Europe is part of a longer-term path to sustainability in the U.S., along with possible future moves to acquire a U.S. banking license. For instance, in Europe, the company partners with Transferwise on peer-to-peer money transfer services, Raisin for savings accounts, and vaamo for investment services. Partnerships generate additional revenue, and the goal is to build a relationship with the customer to fuel those referrals.