Dr. Ozan Ozerk on Neobanks: Here to Stay or Bubble Banks?

Recently, Australian neobank Xinja recently failed spectacularly, leading many experts to speculate which neobank is the next to go. We sat down with Dr. Ozan Ozerk, founder of financial services giant OpenPayd, to hear his thoughts on the new wave of neobanks.

Neobanks emerged as an appealing banking partner for tech-savvy first-movers - as well as an alternative for the underbanked. Considering there is no overhead for maintaining physical branches, neobanks should be well-poised to offer cost-effective services, along with superior user experience. But despite their many advantages, it still seems like an uphill battle for most neobanks. Recently, Australian neobank Xinja failed spectacularly . Now, many experts speculate who’s next .

We met with Dr. Ozan Ozerk, the founder of European Merchant Bank, Ozan SuperApp and OpenPayd, to explore the underlying reasons why many neobanks are struggling. Ozerk is a serial entrepreneur with a long track record of successful startups, ranging from social media to financial technology. As such, he’s the perfect guide in the world of international banking and innovative financial services.

What is your opinion on the strengths of neobanks?

Dr. Ozan Ozerk: Let’s first agree on what neobanks are. Most of them are payment or e-money institutions that rely heavily on third parties, such as traditional banks, to be able to operate. However, a handful of neobanks actually do have a credit institution licence, and therefore are a real bank. This often reduces their reliance on third parties, but not entirely.

The strength of most neobanks is that they have good technology, competitive pricing and that they are built around a user-centric mobile application. This makes it easy to consume the provided services.

With little legacy technology or old balance sheets to take into consideration, well funded neobanks are making a big impact in the B2C space, but gradually also in the B2B space.

What is the main flaw of neobanks?

Dr. Ozan Ozerk: To answer this, let's once again look at the two categories of neobanks: B2B and B2C.

On the B2B side, most neobanks aren't properly banked themselves. Therefore, the primary benefit for a business to engage with a neobank is first of all an easier sign up process, competitive pricing and the ability to perform banking services via a direct technical integration. This last bit is often referred to as Banking-as-a-Service (BaaS) or embedded finance.

I am hopeful for the future of B2B neobanks, as I see more and more of them getting proper correspondent banking relationships. I see this with OpenPayd and EmBank as well, so I have experienced first hand the shift in the appetite of more established banks towards neobanks.

When it comes to B2C focused neobanks, I'm less optimistic. Let me start off by saying that many of these neobanks are contributing positively to inclusion by helping unbanked and underbanked consumers receive fair service. I want to acknowledge this effort and the positive impact it has on people's lives.

However, from a commercial perspective I see some fundamental challenges with their business model. In summary, the revenue model for these types of neobanks is very vulnerable. This is similar to the dot com era, where having a website was more important than having a solid business model. In that regard, Boo.com , eToys.com and and Pets.com come to mind.

Do you think most of the neobanks will fail and if so why?

Dr. Ozan Ozerk: Yes, most certainly. Let me break down the background for my pessimistic prediction.

Most B2C neobanks basically consist of a mobile application and a debit card from Visa or Mastercard. Due to the focus on growth and the hard competition, the card fees are very low and the interchange revenue is, in reality, next to nothing. This means that all of the typical revenue streams such as FX fees, transaction fees, monthly fees and dormancy fees are close to none. This puts pressure on their business model.

Instead, their business model is often based around two revenue streams: firstly, convincing the end-user to upgrade to a premium account with monthly fees, with additional perks such as a metal card and similar. And secondly, to upsell other types of financial service via the mobile application, such as cryptocurrency trading, insurances, lounge access, lending and more.

Unfortunately, I believe a far too low percentage of basic users will upgrade to a premium account. There is basically not enough carrot or stick for the vast majority of users to upgrade their account.

When we look at revenues from upselling of other types of services, as the aforementioned cryptocurrency trading, insurance- and lending products, etc., it is first of all a race to the bottom, as most neobanks try to outcompete each other with the same premium services.

Each added service also represents an added cost and risk by itself. So if you can't scale it, it will actually cost your business money. So the net result overall will be a loss-making business with a high churn rate.

On top of it all, it is becoming a very crowded space where five-six bigger brands are leading the way, while close to a hundred of smaller brands are following behind. Everyone is spending tons of money to attract users, pushing the client acquisition cost upwards.

I believe the point of being able to acquire a user in most markets at a reasonable price has long been passed. So I don't expect to see most of the B2C-focused neobanks ever being profitable with their current business model.

Instead, I believe many neobanks are betting on being bought up by traditional banks or complementary institutions - or simply staying long enough in the game until their competitors go bust. Then they can establish a dominating market presence and adjust their prices accordingly. Basically turn up the prices and remove loss-making offerings.

You mentioned the situation is similar to the dot com bubble. Would you care to elaborate?

Dr. Ozan Ozerk: The comparison between the neobank bubble and the dot com bubble is this: Right now money is cheap, interest rates are record low and institutions are looking for targets to acquire as they're searching to generate yield for their investors.

New technological breakthroughs and fintech friendly regulation are giving birth to products and services that in theory has a huge potential for growth. Among fintechs, B2C-focused neobanks have gotten a lot of attention, as reputable investors went in early and we saw a rocket-fast growth in valuations. Fear of missing out - “FOMO” - combined with tons of mainstream media coverage has justified accelerating valuation, which in turn attracts more companies to enter the space at soaring valuations.

At some point during this process, valuations based on the financial fundamentals went out of the window. Loss-making fintechs are now being valued higher than many profitable high street banks. To me this makes no sense at all, and reminds me how eCommerce start-ups with a fancy domain was valued in the billions in the early 2000s, while solid brick and mortar shops went for pennies.

So you believe this won’t end well for both business and investors?

Dr. Ozan Ozerk: Much like the bubbles in the past, some companies will thrive. But unfortunately, I think many of them will go bust.

I predict two things will happen: The majority of loss-making fintechs will lose their funding, and look for new funding at much lower valuation. A handful of these will be able to attract new funding based on a more limited product offering, with laser sharp focus on revenue generation and short-to-mid-term profitability. These companies will go through a struggle, because their fundamental business model will not cater for such a U-turn in strategy. So, even if they technically don't go bust, their brand name might be the only thing left from the initial startup.

However, a handful of fintechs with good technology, proven business models and experienced staff will take the lead, and grow even faster during the downturn. They will provide investors with great returns, as well as continue to provide their clients with valuable services.

You mentioned that neobanks are heavily reliant on third parties. Why is this such a pressing issue?

Dr. Ozan Ozerk: Let's first take a quick high level look at the discrepancy between the e-ecommerce activity and the banking and payment services that support it. The e-commerce of today is a multinational activity. The consumer might sit in London, the marketplace could be based in the US, whilst the actual goods and services are being provided out of Hong Kong, on behalf of companies based in mainland China.

So if a neobank wants to be of value, they need to be able to provide more than just great technology. They need to be able to provide alternative payment options, as well as card payment options for the consumer to be able to pay. It needs to provide settlement accounts so funds can be settled, as well as exchange services so funds can be converted and sent internationally.

This leaves us with several challenges. First of all, trades are taking place 24/7, while banks are only open 24/5. On top of that the banking hours of those five days aren't even the same due to differences in time zones and banking holidays. So you're looking at a potential cash flow issue.

When it comes to settlement accounts, you'll have an issue in regards to being able to provide multi currency accounts, and in most of the world, trouble in even providing a basic USD account for settlement. In addition to that, in my example above, you'll need to convert from GBP to Hong Kong Dollar - or even Chinese Yuan. So you would need a third party giving you liquidity in various currencies and helping you to exchange. Finally, you'll need to use a network such as SWIFT to send the money across to the suppliers.

As a neobank you can easily become a member of the SWIFT, but engaging in correspondent banking relationships with an established bank is almost impossible. So your best bet would be to rely on a bigger international bank to conduct the remittance on behalf of you.

Therefore, not only would most neobanks be heavily reliant on third parties on every step of the transaction, but the likeliness of being competitive on pricing and service level are highly unlikely. It's like building the best race car ever, but being reliant on your competitors to provide you with a driver, tires and fuel. Not even the best engine in the world would secure you a victory.

Can you tell me more about OpenPayd and how it tries to solve the challenge around international payments?

Dr. Ozan Ozerk: OpenPayd is trying to build a network of networks and support this activity with a whole range of financial licences across the world. SWIFT obviously being important, but also adding other key networks such as BACS, CHAPS, Faster Payments, SEPA, ACH and many others. By being in the middle like a switch OpenPayd can use the fastest route between the sender and the receiver, often crossing between the various networks.

We're fortunate enough to have established great partnership with traditional banks, exchange houses, remittance companies and local payment institutions. All of them helping us reduce the time and cost of our client's transactions, while keeping our uptime 24/7/365.

How were neobanks affected by the COVID-19 pandemic?

Dr. Ozan Ozerk: I definitely think it made the future of many neobanks more uncertain.

While those that actually have a banking license and primarily are targeting B2B saw some traction, those without a banking license, and especially those targeting consumers, struggled.

I think this a clear warning of how vulnerable their business model is. Most of them invested heavily in marketing prior to the pandemic, but didn't see the return they expected due to reduced opportunities to collect card fees or upsell other services, such as premium account services and insurance products.

I noticed that a few neobanks claim to reach some kind of break-even or even profit, but I do question the significance of that. Simply because reaching better results under extraordinary times seldom can be replicated under normal circumstances. So if you're in profit due to high speculation in cryptocurrency trading through your neobank app, or due to extra ordinary government initiated lending activity, then I would consider that more an exception rather than a confirmation of your business model.

Most neobanks are still today dependent on heavy funding and a cash-intensive business model. I believe the pandemic is the beginning of the end for the investment bonanza we have witnessed in the fintech industry the last 4-5 years. I expect a correction in the market and neobanks and other fintechs will certainly feel the impact of it.