Neobanks Can’t Fight the COVID-19 “Flight to Quality”

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Linkedin | Richard Turrin | March 29, 2020

death of dance - Neobanks Can’t Fight the COVID-19 “Flight to Quality"Neobanks are caught in the middle of a coronavirus induced "flight to quality" that they may not be able to fight. Investors are moving capital away from risk and toward the safety of larger incumbents. Preliminary figures from the Federal reserve show large cash movements into the larger incumbent banks, perhaps based on the belief that they are "too big to fail" and provide a haven for cash.

Neobanks are trying to gain deposits and user trust in what is now a very different market than when they launched, and their response to these changes in upcoming months will be critical. For the record, I like neobanks and think that they have had a profoundly positive influence in making banking services better for everyone.

See:  NorthOne announces Series A round of $21M USD

That said, their position as newcomers, heavy dependence on investor support, high valuations, and lack of profits puts some in the same category as WeWork. A cautionary comparison and perhaps an overstatement, but amid a financial crisis apropos. It’s now harder to see how ease of use will attract investors who are suddenly more worried about trust and safety.

Let's look at how neobanks are going to do in three critical areas, deposits, investors, and interest rates.

Increase in Deposits of Large U.S. Commercial Deposits 

covid 19 impact bank deposits US - Neobanks Can’t Fight the COVID-19 “Flight to Quality"

Source: Federal Reserve Data

The “flight to quality” is already hitting neobanks according to statistics just out from the Federal Reserve and is providing the first hints that the world has changed rather suddenly for neobanks.

Drilling more deeply into the Fed data shows why this is critical for neobanks. The chart below shows the weekly percentage gain in new deposits from 26 February through 18 March between large and small commercial banks. Large banks showed a monthly gain of 5.6% in deposit increases compared to 1.7% for small banks. More money poured into large banks than small. (Source: Bloomberg and Federal Reserve Data)

For perspective, this represents a remarkable 6-fold increase in deposits for large commercial banks, compared to the prior year. Of critical importance for neobanks is that investor’s preference for large banks more than doubled compared with last year. This should be terrifying for neobanks.

See:  The Cash Crisis: Why America’s financial plumbing has seized up

Clearly, this data is signaling that neobanks are going to have to fight even harder for deposits given a protracted period of economic turbulence. The problem is that they have limited tools to compete. The first is to offer higher interest on accounts, which we will see is becoming more expensive. The second is to provide other unknown new services, which cost time and money to develop. Additional expenses of any kind combined with reduced deposits will stress their business models and force them to go back to investors for more money. Investors may no longer have the funds to support them, or offer it at rates that severely challenge their operations.

V.C. Investors

The VC industry might actually be facing a disaster. Corporate venture capital activity is shown in the graph below and is far behind last year. Whether this trend continues and rises to the level of "disaster" remains to be seen, but it will undoubtedly impact neobanks dependent on funding to survive.

Neobanks have been either blessed or cursed, with a tremendous amount of easy money from deep-pocketed V.C. investors. Their business models require regular investment to acquire clients and scale as they operate at a loss. The party is over, and if SoftBank is any indicator, the market for both fundraising and investment is now clearly limited. Softbank’s second fund failed to meet its fundraising target, and it is now forced to sell down its investments rather than invest. While Softbank certainly doesn't represent the industry, its difficulties signal changing times.

No Disaster for Neobanks

I am not predicting disaster for neobanks. If ever there were nimble competitors able to stop and turn on a dime to meet a market challenge, it would be neobanks. In addition, the market for 100% digital non-branch based banking is exploding as a result of COVID-19. This trend won't end any time soon, and neobanks are perfectly positioned to capitalize on it.

See:  Facing disaster, corporate venture capital to undergo key stress test

The problem is that incumbents learned from neobanks in the past years and bettered their digital offerings to the point that the digital convenience gap they enjoyed is closing. That doesn't mean that clients actually -like- incumbent banks, they don't and find no joy doing business with them (see my articles in the references), but in times of market volatility, they want size and the perception of security it brings. Neobanks can't possibly fight this, and it will severely hamper their ability to draw clients away from incumbents and potentially force them to scale back their world-conquering ambitions.

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