New digital banks: Their origin and why they can’t be free forever

Written by Ruby Hinchliffe

Illustrated by Megan Rezin

We’re the generation who grew up during the 2007-8 financial crash which saw traditional banks let slip the trust instilled in them by the general public. We don’t remember this because we were around eleven at the time, give or take.

But out of that came the more familiar fresh-faced likes of Revolut, Monzo, Starling and N26. Most of you will have opened accounts with these neobanks to avoid foreign fees abroad. Then you will have started using them for daily transactions because they give you helpful notifications and compartmentalise your spending to help you save money. But most of you won’t have diverted your monthly or bi-monthly income to them. Not yet, anyway.

Whilst these banks have solved a lot of pain points, you should remember they’ve done it all for free, which means there isn’t a single neobank, not even Monzo, that’s making a profit yet. Instead, their losses are doubling year on year.

Recently, Monzo said it was going to start issuing small loans of up to £15,000, despite the fact its losses jumped more than 50% at the end of last year to £47.2 million.

These banks are still riding on capital investments – i.e. big venture funds spooning them money because they haven’t quite learnt how to walk on their own yet. All the while, the likes of Revolut are expanding into tens of twenties of countries with their free products.

The big question on everyone’s lips is ‘how are they going to become profitable?’ As well as Monzo dipping it’s foot into loans which will make them money through interest fees, it’s also going to have to move more of its features to monthly paid cards and bank account plans.

In France, most challenger banks ask for a base monthly fee of €2 instead of being completely free.

But lets rewind a second to understand why these new banks are being adopted so quickly by millenials. What was the financial crash and why did it cause such distrust from people towards the big guns?

You’ve probably heard of The Big Short, a film with the likes of Christian Bale, Steve Carell and Ryan Gosling re-enacting the events leading up to what turned out to be an reverberating economic slump. For those who watched the film but still didn’t quite get it, here’s a recap:

It all began in America with legislation dating back to 1977 which was designed to help low-income families get mortgages. But over time, this legislation was stripped back leaving these families vulnerable to being sold loans they could never afford to pay off by mortgage brokers, otherwise known as ‘sub-prime’ loans.

By the 2000s, the US government was pouring money into these bad loans through ‘affordable’ housing schemes which perpetuated the demand for sub-prime loans. When the banks realised these risky loans made their balance sheets look bad, they simply repackaged the loans taken out by these families to look stable and sold them to investors.

What these investors were in fact buying were, as Bale’s character Michael Burry calls them, “time bomb[s]”.

These funny smelling roses were paired with the deregulation of credit default swaps (CDSs). When sold, these swaps require the seller to compensate the buyer if a debt on these swaps occurs. In other words, when banks sold investors these repackaged sub-prime loans, they were essentially agreeing to pay the investors back with interest in the seemingly highly unlikely event of a crash. Of course, that’s exactly what happened.

Those ahead of the curve, like investor Burry, realised this and made money off the crash. But whilst a shrewd few made millions, the masses were hit by far the hardest. As Carell’s character Ben Rickert admits: “If we’re right, people lose homes. People lose jobs! People lose retirement savings, people lose pensions.”

And it didn’t just hit America hard either. The crash of phoney loans and the consequent devaluation of the housing market sent ripples throughout the entire world. The Eurozone, China, developing countries – it sent whole continents into recessions which saw economies experience 10-year slumps.

In a nutshell, this is why the average person lost total confidence in big banks. They lost everyone’s money by trying to make money off the poor. Queue the emergence of challenger banks, rising from the ashes of the crash, driven by a USP to help those who felt betrayed by their family bank’s total lack of transparency.

But we shouldn’t completely trust these banks or banking apps either. They are growing at rapid rates, the success of their products rests on them being free and yet they are losing more and more money each year. Paid-for services are inevitable for them to survive, bringing them closer to the perils of the old financial world which made its money off hidden fees and unstable loans.

So next time you whip out that bright orange Monzo card, or that baby blue Starling card, just remember to question their transparency too once in a while, because the free model they operate on won’t be sustainable forever.