Why neobanks need to find a niche offering

Customers still aren't excited about digital-only banks. Less than 10 percent of Americans looking to open a checking account would consider doing so at a digital bank, according to a new report by Cornerstone Advisors. Digital banking startups are in a tough spot. It's hard for banking startups to compete with the big industry players. Customer acquisition is expensive, revenue from interchange fees alone isn't enough to sustain the businesses, and customers are demanding low fees or no fees at all. It’s a situation that imposes hard choices new entrants into the banking sphere: Should the path to sustainability be based on gaining millions of customers alone, or should it be based on building loyalty within a specific customer group? For many neobanks, the best bet is to find a niche. For example, San Francisco-based neobank Chime's customers are mostly middle-income millennials, with a median age of 29 and incomes between $45,000 to $65,000. Chime says it caters to a gap in the market for younger customers who felt larger institutions weren't meeting their needs. "There was a larger opportunity among mainstream consumers who were just frustrated with traditional banks," said co-founder and CEO Chris Britt. "Our members came not from startup banks but from Chase, Wells, and Bank of America." That frustration seems to be waning now. But Chime's approach is an example of how some banking startups are growing their reach among particular customer groups rather than vying for as many of them as possible. The market for banking services is mirroring what's happening in other areas of consumer financial services, like robo-advice, where startups operate a lower-margin business compared to incumbent firms, and have difficulty scaling as a result. "The opportunity in the robo space is going to become a very limited one for people who don’t have scale across products, who don’t have capital, and who don’t have sophisticated technology," PwC managing director John Siciliano recently told Tearsheet. "It's only so far that a lot these robos are going to be able to take you before they’re going to find that they don’t have enough of one of those capital products or next-step technologies.” Neobanks should focus on a "clear, differentiated value proposition" for the customer, but too many of them are just adding a little technology to a customer experience that’s not terribly different from what the big banks offer, said Satya Patel, a partner at Homebrew, a seed-stage venture capital firm based in San Francisco and an investor in Chime. "Very few are giving thought to or making the needed investments to put in place a cost structure and revenue model that are viable, instead focusing solely on customer acquisition at any cost," he said. Venture capitalists warn of the dangers of too close a focus on growing the customer base: new customers aren't always profitable.  Without "sufficient" account activity like a direct deposit relationship, they can actually be a drain on the business because of compliance and customer service costs. Startups should consider the cost of customer acquisition as it compares to the lifetime value of the customer, or how much revenue he or she generates, which should be five times the cost of acquisition, according to Ryan Gilbert, a partner at Propel Venture Partners. Some new U.S. entrants are going after demographics traditionally ignored by mainstream players, or building off a customer base from another line of business. Current, which launched last year, offers debit cards for children, creating a digital allowance wallet. For now, Current is focusing on this market segment, but it doesn't rule out moves to grow into a neobank in the future. "The most successful entrants will provide novel product features that satisfy their user’s needs that no incumbent can provide or is willing to offer," said founder Stuart Sopp. "Our path to scale involves working with teenagers, a tricky demographic that institutions have avoided." Another strategy is to lower customer acquisition costs by adding banking to add value to customers using other products like loans. SoFi, which offers student loan refinancing, personal loans, insurance and investment products, aims to launch bank accounts in the spring. It has a 453,000-strong customer base. "A bank account is very difficult as a first product out the door," said Tony Morosini, SoFi's vice president of banking. "We have a lot of advantages someone coming out of the gate [with a banking product] doesn't have, and that mitigates the economic challenges that some other companies face."