Category: Banking & Finance

Global historical perspective. Digital Banks are not new. Studying their history informs new entrants about the experiments that have been already carried out. First-generation of Digital Banks were the children of dot-com ear – often referred to as Internet Banks. Their central premise was that customers don’t need branches. The cost savings resulting from a branch-less bank can be shared between the customer and the bank. Some of these banks struggled with adverse selection. They attracted overly price-sensitive customers. Some examples are Egg, Wingspan. The second generation of Digital Banks were sub-brands of mainstream banks. They were essentially digital channels or digital products targeted towards a specific segment. There were two hypotheses. One: digitally savvy customers needed to be served through digital channels. Two: moving transactions out of branches to the internet and mobile banking would reduce operating expenses. Both these hypotheses have worked well so far.

Current insights. The latest iteration of Digital Bank is a completely new breed. There are three fundamental differences.

• Finance-as-a-feature. Financial services are getting embedded into customer journeys. The argument being a customer wants to buy a car – not take a car loan.
• Segment-of-one. Using digital footprint of a customer, it is possible to know the customer as an individual. Therefore, the banking experience can be customized to an individual’s needs leading to very high customer engagement. See Exhibit – A.

• Exponential scale. Technology can scale exponentially thereby turbocharging penetration of financial services and market share shifts from incumbent financial institutions to modern players.

All these three arguments hold promise but as data has shown, it’s easier said than done.

The challenges. There are three.

• What is the path to profitability?
• How to reach critical mass?
• Where to create and capture value – balance sheet and / or technology?

Path to profitability. At last count, 13 out of 250 digital challenger banks were profitable. See Exhibit B. Profitable digital banks do three things:

1. Price the product for positive unit economics: core portfolio of products should generate economic value over hurdle rate; even hook products used to acquire customers should break-even; crucial to incorporate loss rates in lending business besides the opex
2. Compress cost of acquisition: acquire customers through partnerships with players who have strategic synergies; be open to revenue and risk-sharing arrangements if it helps acquire higher-quality customers
3. Focus on product per customer: focus on building an exceptional understanding of the customer and monetize that through higher products per customers – best in class number in India tends to be 3+ for NBFCs organizations; for banks its higher

Critical mass. If we treat 5% penetration of the addressable market as a threshold, very few Digital Challenger Banks have been able to clear it and go beyond niche. See Exhibit-C. Those who scale show three characteristics:

1. Strong brand recognition: important to drive virality, referrals and most importantly trust
2. Ecosystem advantage: crucial to drive network effects through a strong partner ecosystem so that a customer can engage with the platform throughout the lifecycle
3. Strong in-house technology capabilities: control the technology destiny through captive tech stack leading to flexibility and reliability with scale

Role of balance sheet and technology. Whether to create and capture value on the balance sheet or in the technology stack or both is an important discussion. It’s not a binary choice. One needs to prioritize and understand the role of each as the business matures. Especially in the context of lending, the quality of the balance sheet is a strong indicator of the quality of data science and technology. Ability to originate, underwrite, and manage risk with high precision at low cost is invaluable. Over time, once the technology stack is proven on the parent balance sheet, it can be spun-off to unlock value.

India in relation to rest of SEA. Because of its large revenue pool (USD 100 Bn) and ready digital infrastructure (India Stack), India is extremely important for domestic and foreign players. The revenue pool is 6-10x larger than other South East Asian markets. Three types of plays are emerging in India. First, banks are launching their captive challenger entities. There aren’t yet any pure challenger banks with a full universal banking license. Second, are players who provide a completely modern customer experience in partnership with other banks. Third are existing digital ecosystem players with large customer base who focus on finance as an added feature. While the jury is out on who will win, the time is right for well-funded players with modern capabilities to capture this space.

The blog has been authored by Yashraj Erande, Managing Director and Partner, BCG and Aniket Kulkarni, Principal, BCG.

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