Neobanks struggle for profits as funding shrinks

Varo’s CEO says the company is cutting costs to become profitable, but neobanks have rarely been able to break even.

Piggy bank getting stormed on

It remains to be seen just how much the fintech slowdown will reshape the digital banking startup sector.

Illustration: Christopher T. Fong/Protocol

The recent layoffs at Varo are just the latest sign of the squeeze neobanks are feeling as investors’ enthusiasm for the sector cools.

Varo last week cut 75 jobs, or 10% of its staff, a move CEO Colin Walsh wrote was necessary to ensure the digital bank has "sufficient capital to execute on our strategy and path to profitability."

Making money has proven an elusive goal for tech-powered banking upstarts. Just 5% of about 400 global neobanks identified by research firm Simon-Kucher and Partners have reached a breakeven point, according to a May report. That didn't matter as much when venture capital investors were pumping fintechs with funding in 2021. But the cooling of the market has clearly squeezed some startups.

"The pendulum has rapidly swung from favoring growth above all else to emphasizing a clear route to profitability — something neobanks lack," said Jason Mikula, a fintech consultant and author of the Fintech Business Weekly newsletter.

Funding slows

Fintech firms raised $20.4 billion in the second quarter of 2022, down by roughly half from the same period in 2021, according to CB Insights, and PitchBook is reporting similar figures. Banking-focused fintech startups raised $1.9 billion during the quarter, an almost 80% year-over-year drop.

The decline in the private markets mirrors the performance of fintech companies in the public market. The ARK Fintech Innovation ETF is down 60% on the year as of Tuesday, compared to a roughly 27% slide for the broader Nasdaq composite index.

While the term neobank has been applied to a broad range of fintech business models, it most often is used to describe tech-driven startups that offer some form of banking service, such as online checking accounts.

Neobanks such as Varo and competitors Current and Chime have together raised billions from investors and built up bases of millions of customer accounts. They offer free banking accounts to low- and middle-income consumers, whose incomes might leave them vulnerable to overdraft fees and maintenance costs at traditional banks. Most of the firms’ revenue comes through collecting interchange fees on card swipes.

Varo in 2020 became the first U.S. neobank to receive a national banking charter. The process took three years and cost a reported $100 million. The charter allows the firm to directly hold and lend against customer deposits — a bread-and-butter moneymaker for traditional banks.

But, as Mikula detailed in a recent newsletter, Varo has yet to build a significant lending operation. About 98% of its revenue still comes from interchange fees as of the first quarter, along with fees from ATM withdrawals and a cash-advance program.

“Most American neobanks cater to lower-income customers, who previously may have incurred overdraft, [non-sufficient fund fees] and maintenance fees at big establishment banks,” Mikula told Protocol. “But these consumers also tend to be higher credit risk, making it challenging to lend to them. No U.S. neobank has built a meaningful lending business.”

He added, “Without material lending and having foregone most service fee revenue, that leaves neobanks with interchange and, so far, that doesn't seem to be enough.”

Indeed, first-quarter regulatory filings showed Varo was burning through cash so fast it could be out of money before the end of the year, as Mikula wrote in May, despite raising a $510 million series E round in September 2021. After that report in May, Walsh told Banking Dive that Varo had “sufficient capital to reach profitability.”

Varo is also limiting hiring and cutting back on marketing spending, Walsh wrote. Varo declined to comment on its layoffs beyond Walsh's blog post and did not respond to requests for a follow-up interview on its strategy.

End of an era?

The slowdown for fintech funding has already forced layoffs across the industry. It remains to be seen just how much it reshapes the digital banking startup sector.

Ron Shevlin, chief research officer for Cornerstone Advisors, recently declared in a Forbes column that the "End of the Neobank Era" had arrived. In an interview, he explained that he is not predicting that any companies are going out of business but that business models will change.

"The days of fintech startups going after middle- to low-income consumers in the name of inclusion, it is very noble and altruistic but it has not yet built a sustainable business," Shevlin told Protocol. "You have to find other ways of generating revenue and generating profits."

Neobanks going forward will need to have a clear path to profits rather than a focus on growing customer accounts, he said.

Walsh’s blog post hinted at a new strategy for Varo in announcing the layoffs. He wrote that the company is establishing a new business unit called Varo Tech to "bring together the technology, design, data and product functions under a single umbrella."

Details are sparse beyond that. But there is precedent for consumer-focused fintechs to spin out parts of their products as business-to-business products. Credit card company Petal, for instance, last year launched Prism Data, which made its underwriting technology available to other companies.

There is also the possibility for consolidation in the space, as many are predicting the tight market will lead to more mergers and acquisitions. Capital One CEO Richard Fairbank said last week that fintech valuations are no longer “breathtaking” and the company is in the market for the right acquisition. Some experts have suggested neobanks such as Varo could merge with a fintech lender to boost that side of the business.

David Becker, CEO of the Indiana-chartered First Internet Bank, noted that there have been shakeouts before for tech firms offering digital banking services. First Internet Bank, founded in 1997, is a rare survivor from a group of dozens of online-only banks that popped up during the dot-com boom of the late ’90s and closed after the bubble burst. If the current market slowdown continues, he said, there is a lesson to be learned from the companies that survived that era.

"You really have to offer the full suite of services, because customers don't want to bank in six different places," Becker said. "You need to offer the full suite — or customers will find someone else who can."


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