Why Digital Banks Encounter Challenges And Failures?

Digital banks are reshaping the financial service industry with a promise to make banking more accessible and customer-centric. 

They leverage cutting-edge technology to offer services such as instant account opening and immediate credit approvals, focusing on making them accessible round the clock.

Fee-Based Versus Credit-Based Revenue Models

Digital banks aim to provide banking services that are low in friction and high in transaction volume. They typically focus on generating revenue through credit-based services, fee-based income, or a blend of both. 

Utilising advanced technology, these banks deliver digital services designed for instantaneous fulfilment, such as on-the-spot account openings and rapid credit approvals, intending to make these services accessible at any given time from any location.

Credit-focused digital banks look to serve markets where access to credit is sparse, particularly due to the absence of traditional credit assessment data. To innovate in this space, banks like Biz2Credit in India have devised alternative credit models using non-traditional data sources. 

For example, Biz2Credit assesses micro-SMEs’ working capital requirements through analyses of bank statements and employs AI to develop dynamic credit assessment frameworks.

Conversely, fee-based digital banks earn revenue from high volumes of transactions, especially payment and transaction services. A prime example is Revolut, which offers its customers an FX Debit Card that provides optimal foreign exchange rates without additional fees, charging users a transaction fee only after exceeding a specified free usage limit.

Digital banks and fintech institutions that have a clear focus on target markets, client segmentation, and compelling product value propositions have been able to scale their operations and achieve profitability. Yet a significant number of these ventures have not reached their potential, failing to fulfil their promises to investors.

Among the unsuccessful are digital banks and fintech entities with specialised service offerings but limited scalability. These entities, such as the personal financial management solution Cardeo, which utilises open banking data aggregation, often face the challenge of rapid scaling, which is vital for those dependent on fee-based revenues. 

While Revolut managed to acquire a substantial customer base with its specialized product for a distinct segment, Cardeo and other fintechs tasked with personal financial management like StatusMoney and Mint could not reach the scale necessary for long-term viability, resulting in operational shutdowns due to funding and growth challenges.

Role Of A Parent Company Or Partnership

The advantage of having a robust parent or partner ecosystem cannot be overstated. Early digital banking business models underestimated the costs associated with client acquisition, which are not confined to digital onboarding but extend to marketing expenses and promotional campaigns. 

By leveraging an existing customer base or forging strategic partnerships, banks like Airtel Bank in India have effectively bypassed the hefty costs of standalone customer acquisition. This symbiosis can be seen in Unobank’s partnership with GCash in the Philippines, enabling it to offer streamlined and cost-effective services.

Adjusting To Shorter Funding Horizons

Previously, it was common for digital banks to reach profitability within a 6-7 year timeframe. Today’s investment climate is far less forgiving, with a notable shift towards expecting profitability much sooner, often within two to three years. 

This impacts banks with longer-term growth plans, leading to reduced valuations and sometimes even a dearth of subsequent investment rounds, as demonstrated by the plight of HM Bradley, which faced a down round and had to close its retail division due to funding constraints.

Heightened Competition Amongst Rate Wars And Lending Risks

The race to garner customers by offering attractive deposit rates has resulted in an intense competitive environment, squeezing credit product yields. 

Banks adventurous enough to explore new customer demographics face the added peril of credit risks, particularly if their risk assessment frameworks are untested. 

As witnessed by Yelo Bank’s credit loss debacle in India, delving into new markets requires a granular, methodical approach to piloting financial products, along the lines of Open Bank’s cautious expansion strategy.

Securing A Future Amidst Regulatory Challenges

Digital banks are also contending with an increasingly complex regulatory environment that demands rigorous compliance while navigating technological advancements. The fast pace of innovation comes with the dual challenge of ensuring customer data protection and adhering to stringent financial regulations, which vary significantly across jurisdictions. 

Entities like Monzo in the UK, which have successfully scaled, demonstrate the importance of building robust compliance frameworks as part of their growth strategies. Additionally, integrating new technologies, such as blockchain and cryptocurrencies, presents both opportunities for differentiation and the necessity for prudent risk management. 

Moving forward, digital banks that strategically embrace regulatory frameworks and lead in technological adoption are anticipated to not only survive the fierce competition but also to set new norms for the banking industry’s future. 

With these continual adjustments and a proactive stance on regulatory compliance, digital banking pioneers can lay down a resilient foundation for sustainable growth and industry leadership.

Moving Forward In A Competitive Ecosystem 

Adding to the previous insights, a forward-thinking strategy for digital banks involves calculated risks and continuous evolution. They need to not only introduce disruptive technologies and idiosyncratic financial products but also ensure that their growth is supported by a sustainable customer acquisition model and strategic partnerships. 

Moreover, the agility to respond to market conditions and investment trends, adapting promptly to investor expectations and funding landscapes, is crucial. 

Digital banks must strike a balance between managing risks, especially in providing credit and engaging in competitive deposit rate offerings, all while remaining vigilant to maintain capital health. 

Ultimately, the winners in the digital banking space will be those who maintain a delicate equilibrium between innovation, scalability, and financial resilience in the face of ever-evolving market dynamics.