Have digital banks transformed the US banking industry?

Challengers, and incumbents, are battling to survive in one of the world’s toughest financial markets, writes Sarah Kocianski.

This is an excerpt from AltFi's Digital Banking State of the Market Report 2022, which is available for free here.

As in Europe, some of the most well-funded fintechs in the US are digital banking providers. Chime, the biggest of the bunch, has raised a total of $2.3bn with its most recent round in 2021, giving it a valuation of $25bn. Varo, the first player to acquire its own full banking licence, or “charter”, has raised nearly $1bn. 

When it comes to customer acquisition, banking providers are also doing well. Chime is again the leader, with over 12 million accounts, while Varo, SoFi and Current have around four million each. 

These are significant achievements, especially when you consider there are over 5,000 banks in the country for retail customers to choose from. However, as in Europe, customer numbers and volume of funding are not the best measures of whether these companies will succeed, or what their long-term impact on the banking industry will be. 

Instead, it is more insightful to assess them on the innovativeness of their propositions, business models, incumbents' reactions and regulators’ responses. 

Propositions That Customers Love

Chime won most of its customers by offering a fee-free bank account, which was noticeable in a market where most banks charge a monthly fee. From there, it built a brand around being a bank designed to help customers, rather than rinse them for cash. It launched credit-building tools, the ability to get paid early and free overdrafts for small amounts — all wrapped up in an excellent customer experience, with streamlined, digital onboarding.

“Chime is incredibly fee-friendly for the US market. It stands out from that perspective — the free services are a big thing,” Common Industry fintech director Harriet Allner said.

Chime set the standard and now its core free features are common among newer digital peers. However, this proposition comes with a major challenge: how to make money. 

The primary business model of most digital banking providers in the US relies on its advantageous interchange fees for small banks, which they maximise by offering customers benefits for using direct deposit. The theory is, if a customer receives their earnings into an account, they will use the attached card as their primary means of spending, earning the bank money with every transaction. 

But it’s unclear how many customers are exhibiting this behaviour — only half, according to research from Cornerstone Advisors. That’s because digital banking providers are competing for customer transactions not only with incumbent banks’ cards, but also BNPL and payment providers like PayPal and Cash App.

“The biggest challenge for homegrown players is reaching profitability. It's proved exceedingly hard, and I think part of that is the reliance on interchange,” CCG Catalyst director of research Kate Drew said.

Want to keep going? Read the full feature in AltFi's Digital Banking State of the Market Report 2022, out now!