Neo Banks Banking in the Margins
06 February 2023
APRA has facilitated this trend, allowing the start-ups and digital entrepreneurs to hold deposit-taking licences, or what is called a Restricted Australian Deposit-taking Institution licence (RADI).
So why have so many RADI-holders not succeeded as envisaged? And what lessons have been learned for RADI-holders as customers transition to banking in a digital economy?
Running an entire bank on a phone app or a website is certainly one way to keep overheads low, and this approach was expected to garner customers from young people who lived on their phones. However the Neo Banks have not evolved as once thought.
Two of them – Volt and Xinja – are no longer operating, and 86 400 Bank (now called Ubank) has been bought out by NAB. Avenue Bank is in take-over talks with by New Zealand banking group, Heartland.
That leaves Alex Bank, which offers loans and savings accounts, and Judo Bank, which after five years of operation just recently announced its first year of break-even trading.
The first observation is that the culture didn't fit. Australians will borrow, gamble and invest on a smartphone, but depositing their money requires a depth of trust that cannot be engendered by an aggressive start-up trying to change the rules overnight. The ‘move fast and break things’ spirit works well in many tech start-ups, but not in retail banking.
Secondly, the retail banking game is one of scale and deep capital. Large retail banks pay an aggregate cost for their capital, which means paying an interest rate to depositors and also paying for their wholesale draw-down facility.
Let’s say their ‘cost of capital’ is 2% and then they lend the capital at an average of 10%. Their profit is the delta between the cost and the interest income, which in banking is called the net interest margin. To make a profit, a bank takes-in and lends-out money in very large amounts. Judo Bank’s break-even year was achieved on a loan book that had reached $6 billion.
So what are the lessons learned from the early days of the RADI licence?
The first lesson, is have good, experienced people. I don't mean someone who’s proven at IT – that should be a given in a FinTech – but people who have worked in the retail banking environment, and in the compliance and risk areas. Appoint good people in key positions, such as the treasury function and risk.
Secondly, be product-ready. The entrepreneurial attitude of many tech start-ups is to push beta versions out to the public and crowd-source the bugs. You can’t do this if you’re expecting customers to have their salaries deposited in your bank. The products you offer as a retail bank must be solid and tested and there must be back-up and fail-safe systems behind the deposit-taking platform, just as there are in the major banks.
And they all have to work.
Thirdly, commit to the regulation, risk-systems and compliance.
Australia’s banking system is famously stable and secure and APRA jealously guards this reputation. The compliance work to retain your RADI is ongoing and of a ‘continuous disclosure’ nature. You don't have one exam and then get APRA out of your life. You need the right people, the right reporting systems, risk-management systems and the best platforms that produce the right data for the regulator. This part of the business will be a daily component for as long as you have a RADI, so commit to it early.
And, as mentioned above, a crucial part of retail banking is having adequate and stable capital supporting the business. Ideally, a RADI enterprise should have as many institutional and ‘patient’ investors as possible. A retail banking start-up is unlikely to make a profit in the first few years of operation, because more capital is being lent-out than deposited-in. As the operational costs mount, patient capital has to support the business until the income from the loan book makes the business cash-flow positive. It would be great to see super funds interested in the RADI sector, but that isn’t evident yet.
Last lesson, and perhaps the most important: ensure there’s a lending business and a loan book in place before taking deposits. Depositors expect their interest to be paid from the outset whereas making loans and receiving income from them takes time.
Judo Bank started as a micro-lender before it took deposits. So Judo took the ‘migration’ strategy of the larger banks: offer one product and migrate the happy customers to another associated product.
With RADI licence-holders, the migration perhaps works best by first lending money to the customer, and then offering to receive their money once a relationship is forged. That allows the income side of the ledger to become profitable before committing to the interest payable on deposits.
Author: Stuart Dullard (Partner).
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