• Afshan Dadan

Setting The Record Straight: Digital-first Banking Taxonomy

When it comes to digital banking, a lot of terms get tossed about and used interchangeably without being conscious of the technical intricacies behind them. Digital banks, neobanks, challenger banks, digital subsidiaries, embedded banks, over-the-top banks – the list goes on.


While there's a fair bit of overlap among these terms and the overarching identity they assume as "digital banks," the fun part is understanding the nuances of what defines and sets these terms apart. With this blog, we put on the hat of the digital banking definitions police and try to set the record straight on the types of digital banks out there and what makes them different.


Defenders versus Attackers

Like every good action/thriller movie, there has to be a big bad scary problem the protagonists are trying to defeat (read solve, in this scenario). Here, the main problem is traditional banking, which is bogged down by a hundred different pain points that we don't really need to list down at this point. You get the gist.


Enter the champions of the story – the attackers and the defenders. The attackers, a new-gen we-are-the-revolution mindset bunch, are the young blood of the banking generation trying to do things their way, i.e., reimagining and redesigning banking products and customer experiences through a first-principles approach. On the other side of the playing field, we have the defenders, the OGs who have realized the need to defend their turf and reemerge as phoenixes from the ashes of old-school banking.

Trying to answer the question of which of the two emerged first is a chicken and egg conundrum. There's enough evidence on both ends to justify the first-mover, but we'll leave that debate for another day. For now, let's get down to the nitty-gritty of these clans and the digital banking personas that inhabit them.


The Attackers – Young, Wild, and Free

Most of us are well aware of the heroic tale of FinTech startups that set out to tackle the problems of traditional financial services – cumbersome processes, outdated technology, lack of transparency, high fees, and costs – and position themselves as the new faces of modern financial services. Challenger banks and neobanks are the two sub-groups that chose banking as their battlefield.


The attackers comprise both licensed and non-licensed players. Both come with their own set of advantages (and disadvantages).


Full-stack challenger banks are FinTech startups with commercial banking licenses that run on modern cores (built in-house or integrated with modern core banking solutions) and provide end-to-end digital-only banking services. They pride themselves on autonomy and their ability to rebuild/reimagine banking in the twenty-first century as challengers of the status quo. Further categorization can be done as follows –

  • Fully-licensed Independent Challenger Banks are the startups that have been built from scratch and enjoy the maximum autonomy (although the role of venture capitalists subverting this well-publicized autonomy is already under the microscope) when it comes to shaping their banking services. Being licensed gives them the advantage of better unit economics and the credibility that comes with being a regulated entity. On the flip side, the cumbersome licensing process can also limit their ability to scale rapidly as compared to their unlicensed counterparts.

  • Corporate-backed Challenger Banks are sponsored by well-established nonbank corporations from diverse industries looking to diversify their operations. These banks run as semi-autonomous divisions within the larger conglomerate. They leverage the nonbank user experience and technology prowess of their parent firms alongside the benefits that come from being licensed. Geographically, the most prominent examples hail from Southeast Asia and China where such corporations enjoy a fair bit of oligopoly in the markets. This allows their banking subsidiaries to scale rapidly and achieve profitability quicker.

  • Specialist-licensed Challenger Banks are the firms holding licenses other than commercial banking licenses that limit their operations in certain ways. For example, the e-money institution license in the UK & Europe allows fintech startups to hold e-money deposits, but not perform lending activities. Sometimes these specialist-license holders do have to partner with a fully-licensed bank in order to get access to banking products and interbank payment rails. The payment bank license in India on similar lines is also another example.

The next set of attackers is the Front-end & Embedded Neobanks. These are unlicensed entities that operate in partnership with licensed banks to provide their services. The benefit that comes with this business model is the ability to scale and expand rapidly with a focus on the end product and user experience. The disadvantages comprise not-so-favorable unit economics and the dependency on partner banks and technology providers to function efficiently. The sub-categories include–

  • Independent Neobanks are standalone entities running on partner banks or in collaboration with banking-as-a-service providers. Characteristically they thrive on the ability to provide banking services without most of the strings that come with being a licensed bank. This model is largely prominent in regions that have not issued digital banking licenses such as North America, South Asia, and Africa. Across the board, it also acts as a gateway for most fintech startups looking to become licensed banks in due course of their existence.

  • Embedded Banking Propositions from Non-banks are another subset that has emerged in recent years with the increasing momentum around embedded finance. The play here is not for nonbanks to go after the larger banking pie, but to provide their captive user base with value-added financial services within the existing ecosystem. These banking solutions are more use case or customer segment-specific and operate in a similar fashion as the neobanks. They do have the advantage of having a captive user base to whom they can cross-sell financial services and improve their revenue streams or reduce operating costs.


The Defenders – Old, Wise, and Brave

Moving on to the other side of the field, the long-standing glorious history of traditional banks is one that cannot be overlooked. These institutions have stood the test of time and continue to do so by reforming themselves to the new ways of banking. The cool kids might have all the bubbling energy, but it takes more than that to beat the wise ones.


Business cannibalization is a concept banks are well aware of. With telephone banking, internet banking, and mobile banking, banks have witnessed the effect it has on their businesses and pivoted accordingly. The digital-first banking era is no different. While the pain points that plague traditional banking are evident, banks are actively working on adapting to the ways of digital banking, learning from their challenger counterparts.


Given the legacy systems and scale of a traditional bank, undertaking such a digital overhaul is no small feat. Therefore, the ways that emerge for incumbent banks to defend their turf is through digital banking offshoots that can operate alongside the larger institution with varying levels of autonomy.


Digital Subsidiaries of Banks are semi-autonomous entities that operate on the parent bank's license while providing end-to-end differentiated banking services to a new customer base. Given the parent bank's expertise and resources, the goal is to focus on previously untouched or underserved customer segments that are better suited to a lean digital model in terms of cost and value. The make or break point emerges as healthy independence of the digital subsidiary's vision from that of the parent entity. Many digital offshoots have witnessed stagnation or demise from an inability to detach themselves from the ideologies of the parent entity. However, there have also been outstanding successes that have established themselves as strong digital banking units alongside their guardians.


Bank-led Consortium-owned Digital Banks are another model native to the Southeast Asian markets where the race for securing newly-issued digital banking licenses led to the formation of strong alliances. Bank-led consortiums consisting of nonbank entities provide the best of both worlds in terms of strong banking expertise along with technology and wider market know-how. Such a licensed bank operates independently from its consortium backers and enjoys a range of operational and strategic benefits.


…And For The Plot Twist At The End

To conclude that this dramatic portrayal of competing banking factions is all there is to the story would be quite a one-dimensional way of looking at things. In reality, the competition isn't leading to the one-uppance of either but contributing to a growing playing field for all of these stakeholders – old and new – to coexist and serve more and more consumers that have been previously excluded from the system.


That isn't to say there's no room for some consolidation (as we've already witnessed) and crash-and-burn failures and extraordinary triumphs. The multiverse of banking is filled with its own set of dynamic happenings and more competition always makes things more fun, doesn't it?

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