What is a Neobank? How Do They Different From Traditional Online Banks?

The recent PYMNTS and Treasury Prime report highlighted that a considerable segment of consumers, around one-quarter, have utilized neobanks, digital banks, or FinTech platforms in 2021. Despite this, only 10% reported having their primary bank accounts with digital banks.

The report also indicated that younger generations, particularly Millennials and Gen Z, are more interested in digital banking than Baby Boomers and Gen X. So what’s all the hype about neobanks? Let’s figure it out!

What is a Neobank?

A neobank is a digital-first financial entity that operates exclusively through online platforms like mobile apps or websites. It offers services such as savings and checking accounts alongside tools for budgeting and cash advances.

Catering to customers seeking flexibility and transparency, neobanks typically forego physical branches, thus enabling them to provide more competitive fees and higher interest rates on savings accounts. Their intuitive digital interfaces contribute to a seamless and user-friendly banking experience.

Although not chartered as banks, neobanks partner with chartered institutions to ensure compliance with regulatory standards. Often referred to as "challenger banks" or "fintech banks," these entities utilize apps, software, and innovative technologies to redefine the banking landscape, resembling digital disruptors in other industries. In the U.S., they are predominantly known as neobanks, a term that has gained prominence alongside their rapid growth globally.

Examples of Popular Neobanks

1. Chime
2. Revolut
3. MoneyLion
4. SoFi
5. Acorns
6. Starling Bank
7. Varo
8. Wise

How Does a Neobank Work?

Neobanks function primarily through digital platforms, like mobile apps or websites, rather than relying on traditional physical branches. Here's a breakdown of their typical operation:

1. Digital Priority

Neobanks prioritize digital channels for all banking activities. This means customers can handle tasks such as account opening, financial management, transactions, and customer support entirely online or through mobile apps.

2. Account Creation

To become a neobank customer, individuals usually download the bank's mobile app or visit its website to set up an account. This process often involves providing personal details, verifying identity digitally, such as with photo IDs or biometric scans, and agreeing to the bank's terms and conditions.

3. Banking Offerings

Neobanks provide a range of financial services similar to traditional banks, including checking and savings accounts, debit cards, money transfers, bill payments, and sometimes lending products like personal loans or credit cards.

4. User Experience

Neobanks prioritize a smooth user experience, aiming for intuitive interfaces, simplified processes, and real-time access to account information. They may offer features like budgeting tools, spending insights, and customizable account settings to empower customers and enhance engagement.

5. Cost Structure

Neobanks often compete with traditional banks by offering competitive fee structures. This could mean fee-free or low-fee accounts, reduced overdraft charges, and no minimum balance requirements. Some neobanks generate revenue through methods such as interchange fees, premium account subscriptions, or interest on deposits.

6. Partnerships

Many neobanks collaborate with established financial institutions to deliver banking services. While neobanks handle customer interactions and digital experiences, their partner banks typically hold customer deposits and ensure compliance with regulatory standards.

7. Regulatory Compliance

Neobanks must comply with banking regulations and consumer protection laws in their jurisdictions. They often partner with chartered banks to ensure adherence to rules, such as deposit insurance coverage provided by the FDIC in the United States.

Read more: Regulatory Compliance in Banking: Role, Challenges, Consequences, & Solutions

8. Innovation 

Neobanks continually innovate to set themselves apart and attract customers. This could involve introducing new features, integrating with third-party financial apps and services, or leveraging emerging technologies like artificial intelligence and blockchain to enhance their offerings.

How Do Neobanks Make Money? 

A popular question is: how do neobanks make money? Neobanks utilize a variety of revenue streams to sustain their operations and achieve profitability:

1. Interchange Fees

Neobanks derive revenue from interchange fees, which are payments made by merchants to banks for processing debit and credit card transactions. Neobanks receive a share of these fees whenever their customers use their debit cards for purchases.

2. Subscription Services

Some neobanks offer premium or subscription-based accounts that provide additional features or benefits for a monthly fee. These may include perks such as enhanced customer support, higher transaction limits, or access to premium financial tools and services.

3. Interest Income

Neobanks earn interest income on the deposits held by their customers. They may invest these deposits in low-risk assets like government bonds or use them to provide loans, thereby generating interest revenue. However, neobanks' interest rates may be lower compared to traditional banks.

4. Lending Services

While not all neobanks offer lending products, some provide personal loans, credit lines, or other forms of credit to their customers. Neobanks earn revenue from the interest and fees charged on these loans, similar to traditional banks.

5. Partnerships and Referral Programs

Neobanks often partner with third-party financial service providers, such as insurance companies or investment platforms, to offer additional products or services. They may earn referral fees or commissions for directing customers to these partners.

6. Foreign Exchange Fees

Neobanks may charge fees for foreign exchange transactions, particularly for international money transfers or purchases made in foreign currencies. In turn, these fees contribute to their revenue streams.

7. API Access and White-Label Solutions

Some neobanks monetize their technology infrastructure by providing access to their APIs or offering white-label banking solutions to other companies. These services, which may include payment processing or financial data aggregation, generate revenue through licensing fees or usage charges.

Read more: What is Open Banking? And How Does It Work?

Pros and Cons of Using a Neobank

Using a neobank presents both advantages and disadvantages:

Pros

1. Convenience: Neobanks provide easy digital banking via mobile apps or websites.
2. Lower Fees: They often have fewer charges compared to traditional banks.
3. Innovative Features: Neobanks offer cutting-edge tools for better financial management.
4. Accessibility: They extend services to more people, including those without traditional bank access.
5. Competitive Interest Rates: Some neobanks offer attractive savings rates.

Cons

1. Limited Services: They may not offer as many financial products as traditional banks.
2. Security Concerns: Online operation raises worries about data safety.
3. Lack of Physical Presence: Neobanks lack in-person service options.
4. Reliance on Technology: Technical issues can disrupt service.
5. Regulatory Challenges: Compliance with banking rules may pose difficulties.

Neobanks Vs. Online Banks: What’s the Difference?

Neobanks and online banks both operate digitally, but there are some key differences between the two:

Bottom Line

Neobanks are fundamentally changing the banking landscape with their innovative digital offerings, cost-effective services, and enhanced convenience for customers. As their influence grows, it's imperative to differentiate between neobanks and traditional banking institutions while also being mindful of regulatory complexities and associated risks. The key takeaway is that neobanks are driving significant shifts in the financial sector, demanding careful consideration as they shape the future of banking.

Frequently Asked Questions Related to Neobanks

Q1. How are neobanks regulated?

Most neobanks lack their own banking licenses governed by federal or state regulations. Instead, they commonly form partnerships with regulated financial institutions.

However, neobanks are required to comply with a range of banking regulations, including standards such as capital adequacy, liquidity management, and anti-money laundering protocols. They also must adhere to payment services regulations, data protection laws, and consumer protection statutes.

Q2. Should you switch to a neobank?

Neobanks are gaining popularity among customers seeking digital financial services due to their convenience and reduced fees for tasks like online check deposits and peer-to-peer payments. Their streamlined processes and fewer regulatory hurdles often result in quicker account setup and processing times. 

However, neobanks typically offer limited services compared to traditional banks. They focus mainly on essentials like checking and savings accounts and may lack in-person support. 

Before switching to a neobank, you should consider factors such as available financial products, ATM accessibility, fees, interest rates, and your comfort level with technology. It's also crucial to ensure that the chosen neobank is federally insured for added security, especially considering uncertainties surrounding the potential closure of standalone neobanks.

Q3. What is the difference between fintech and neobanks?

Fintech covers a broad spectrum of technology-driven financial services, whereas neobanks are a specialized segment within fintech, concentrating on digital banking without physical branches. Neobanks prioritize delivering streamlined and user-friendly experiences with innovative features, aiming to offer efficient and convenient banking services exclusively through digital channels.