A neobank stack

Over the last few years I’ve spent a lot of time building lending and banking stacks. What used to require vast resources only 10 years ago, is today a much simpler and more inexpensive job, thanks to the enormous number of financial infrastructure businesses born in the last decade.

The goals of the following 2 posts are: to highlight which are the key functional components of these stacks, to point at who are the main providers around and, more in general, to share what are some of the key learnings I gathered working hands-on on their development.

An overview

The core assumption behind this architecture is that a retail bank is not in the business of making mobile apps, nor it is in the business of issuing debit/credit cards. A bank operates in 2 problem spaces:

  •  the business of trust (liability side) – a bank is an institution selling trusted repositories where users can store their value. It must convince people that it is a trustworthy institution.
  •  the business of selling liquidity (asset side) – a bank must make a profit out of the funds it gathered, correctly setting the price of the liquidity, based on the risk profile of its clients – on the asset side

The average banking product is simply an interface optimised for the current state of the technology: today it is a smartphone application, in the past it was a branch, in the future it will likely be a different interface. What won’t change are the fundamental problems that a bank will solve, as shown in the architecture designed below.

Banking channels

This module includes multiple elements: from domestic payments to branches, from ATMs to cryptos. These apparently very different pieces have one core characteristic in common: they enable the movement of money inside and outside of the user account. Each one is a different touchpoint which covers different use cases for different demographics, but they all ultimately enable money movement.  

I believe this module is probably the most affected by the modern banking evolution, putting together today things that were completely different in the past, such as Cards and Branches. Take branches, for example. As the retail banking space evolved, the branch-centric approach has been totally surpassed and branches pushed to the margins of the banking architecture. 

Branches today are to banks what CDs are to songs: once the physical embodiment of the service, now they are nothing more than a nice accessory, interesting to some, but definitely not a central component of the related business model.

In the banking channel alone, there are literally hundreds of companies trying to build more modern API-based experiences which requires minimal effort to integrate with and guarantees adequate support.

Payments space: Adyen, Stripe, Marqeta, coinbase

Fincrime

The Fincrime module is in charge of filtering out potential fraudsters and money-launderers from the flow of total movements. It is logically a clear extension of the banking channels component, because it operates on top of those transactions.

It is a fairly recent innovation which became necessary when banking lost its personal touch and became a machine-first, more than a person-first, business.

Fincrime is one of the spaces where artificial intelligence and machine learning techniques are seriously delivering value: it would be inconceivable for a modern bank to manually or semi-manually scan all the transactions.  

Products engine

The product engine is probably the flagship element of modern core banking platforms. It is a product configurator where a bank can easily configure standardized products like overdraft, checking account or loans and immediately distribute them to its customer base.

It is usually bundled together with other modules in a wider core banking offering (ledger).

NB. In my abstraction, the product engine does contain the creation of the loan, credit line and overdraft products, but doesn’t include the decision lending stack, which I’ll present in a future post.

Ledger

Ledger technologies have been the foundation of any banking businesses since the northern Italian city states invented banking just after the Middle Ages. A ledger is nothing more than a glorified database, and it represents the ultimate source of truth on the account balance and, in general, on any banking activity within the company. 

A ledger must be extremely reliable, secure, easy to integrate with and easy to query. 

Startups in the core banking space: 10x, Mambu, Railsbank, ncino, ThoughtMachine

Being blockchain a ledgering technology, this domain is constantly mentioned as being a domain ripe for innovation. My opinion is that blockchains, before being ledgers, are primarily systems to align incentives and I’m very skeptical about the real benefits of permissioned chains. For this reason I believe that DLT doesn’t really make sense today as a ledgering technology for a bank, especially in a permissioned context and without a proper ecosystem built around it.

API Aggregator

API aggregators are new-comers to banking. Before open banking took off, this element wasn’t even a theoretical concept in banking ecosystem. 

Today, almost every bank is integrated to at least one banking information aggregator which shares data about customers gathered from other financial institutions.

The role of API aggregators is still in its infancy but, being banking a business of information, I believe that their role will become more prominent over the next years.

Financial aggregators: Plaid, Quovo, TrueLayer, Tink

Identity hub

I decided to aggregate Onboarding, KYC and CRM because they represent to me different phases of the same user’s lifecycle, as they all build different aspects of the identity of the user in the bank’s eyes.

As user onboarding moved from a branch-based approach to remote, KYC providers acquired an enormous space and there are a lot of companies doing KYC cheaply and very reliably in the vast majority of geographies.

KYC providers: jumio, alloy, onfido, veriff

Identity is surely a banks’ key asset but its value still remains largely untapped, as no bank built a business on top of the constellation of information gathered on the users, nor on facilitating dedicated identity services to other providers.

Treasury

Putting the capital gathered in its deposits to a more productive use is one of the key activities of a bank. This is a crucial activity for bank profitability, but this also requires skills completely different from the ones typically available in a consumer-focused neobank. All the recently funded neobanks tend to be very user-centric and customer-service focused: they are 21st century technology companies more than traditional financial companies, therefore scaling up this function can be extremely defocusing in the growth phase, when the goal of the bank is to create a solid customer base of depositors.

In this scenario, many of these companies can outsource their treasury investing/activities to some of the many investment vehicles around or can, more traditionally, use softwares to internally manage their liability side.

RegTech

The financial industry is one of the most regulated industries in every country and a tremendous amount of resources is spent on this activity. Lots of companies are working in this space. 

Conclusions

In this brief post I wanted to present some high level modules that I believe are essential elements in building a modern bank. 

All the brands and companies mentioned are only a small subset of the incredible number of good solutions in circulation and most of them cover more than one aspect, but this is not factored in in my architecture.

In my next post you will find a similar exercise for the other crucial stack of a bank: the credit decision stack. Stay tuned.

Bank runs in the 21th century

We live in very special times, from many points of view. Essentially any aspect of our life is being disrupted and this wave of unusuality is impacting banks as well: banks are seeing their deposits going up, they are getting a lot of money, but, for once, that isn’t necessarily a good thing.

The usual way: bank runs

Usually people put their money in banks confident that they are safely stored, easily accessible and ideally producing some sort of returns. In the large majority of cases, things go well. 

Unfortunately, sometimes they don’t: banks can collapse. Every time that a bank is even rumored to be in bad waters, a large number of depositors immediately ran out and queue up outside bank branches hoping to withdraw their money and secure them before a possible collapse. 

This run to the branches would then cause even more troubles to the bank, ultimately resulting in the actual collapse of the institution.

northern rock bank run in 2007

This phenomenon is defined as a bank run, and it has been a fairly common occurrence in banking history. Wikipedia provides a very interesting page with the list of the most significant bank runs

The covid-way: reverse bank runs

In 2020, after Covid-19 hit, things are going differently. Many banks are today suffering from the exact opposite problem: they have too much cash and are reluctant to accept more deposits.

Today depositors are keeping their money in bank accounts. This is due to various reasons: less opportunity to spend money, a desire to save for uncertain times, but also the lack of profitable investment opportunities around. The latter applies especially to financial institutions themselves, as interest rates at central banks are exceptionally low and COVID-19 has increased the risk of lending to most of the companies. Therefore all these fresh deposits end up being stashed as bank reserves.

This phenomenon is especially true for neo-banks like N26, Monzo or Revolut, because their loan-book is pretty thin, if non-existant at all, and thus the cash of their users is ultimately not reinvested in loans, ending up in the neo-banks’ accounts in central banks. 

Usually, this extra reserve wouldn’t be a big deal: yes, there is a sort of ‘ethical’ issue because banks should channel capital from households to investments to put it at more productive use; but, to be honest, it is also very hard to find productive use for all the capital that is around today. 

Besides this, the extra capital wouldn’t be a big problem if banks were not regulated by the Basel III framework. But they are. Basel III actually introduced a new non-credit risk ratio, the leverage ratio.

Leverage-ratio = Tier1 Capital/Total Asset > 3%

In simple terms, the leverage ratio wants to make sure that the leverage of the bank is not too high, so that the activities of the bank are not overly funded by debt positions.

This ratio is highly impacted by the reverse bank runs, because the bank capital that was optimized for a lower deposit base before the pandemic, is likely insufficient to guarantee a much larger asset base post-pandemic.

How are banks reacting?

There are essentially two ways to solve this problem: add extra capital or optimize the Asset side – shrink it and make sure you don’t get other reserves.

Adding extra capital would be seamless to the depositors, but it’s not easy to ask your shareholders to put extra capital in a banking venture that is extremely cyclical, on the verge of a global recession caused by the pandemic. Therefore, the only feasible alternative for many banks is balance sheet optimisation, which concretely means stopping the creation of new accounts (as Goldman Sachs did in the UK with Marcus’ accounts) or, even more radically, disincentivizing extra deposits.

In the end, banks don’t want people’s money anymore, at least for now. What a time to be alive.


Resources

Fintech 2.0, how to survive when your product becomes a feature

The most important narrative in the fintech ecosystem nowadays is arguably that of fintech-everywhere, more formally known as embedded finance.

The essence of the embedded finance concept is that, over the next few years, a significant part of the consumer financial services available today will not be distributed anymore by financial institutions; they will instead be natively embedded in other non-financial products and simply become an extra feature to the product. In other words, financial services will become features of other macro-products. To give an example, Uber may offer a checking account or a credit card to its drivers who, consequently, may not need a Barclays account anymore.

A lot has been written on the topic and you can find some useful links in the Resources at the end of the post. In this post, I want to reflect on where fintech consumer startups will sit in this new world, and what is a viable strategy for them when their products are being transformed in a feature.

The new unbundling: embedded finance

Gentlemen, there’s only two ways I know of to make money: bundling and unbundling.

Jim Barksdale

The current fintech ecosystem was born in the last decade through the unbundling of the financial industry: every startup focused on one specific problem and solved it orders of magnitude better than existing institutions, mainly banks, would.

ING-DiBa, N26, revolut: fairly good incumbents and FinTech re ...

At the end of this first round, some clear winners emerged in each vertical: N26, Monzo, Revolut, Transferwise, Lending Club, Funding Circle, SoFi, Robinhood.

Over the last few years a different process, of rebundling, took place: many startups started to rebundle other financial products on top of the original core proposition, mainly attracted by easier upselling and revenues expansion. Neobanks like N26 or Monzo added lending products, a lender like SoFi added a savings account, Revolut expanded to trading, and so on.

The recent embedded finance trend looks to me like a new iteration of the eternal bundling and unbundling cycle. This time financial services are not unbundled by a new or younger financial institution, but rather decomposed into atomised features that are added to existing products by large consumer brands and technology giants.

How to survive when fintech is everywhere

Most of the fintech startups who succeeded so far did it essentially by using the same recipe: building a better and more modern user experience on a new distribution channel (smartphones) for an extremely focused product. This has been the real value brought by most fintech unicorns.

In a world of embedded finance, a better native mobile UX won’t be enough for them to survive, simply because that UX won’t be the best in class anymore.

In a world where Uber offers a bank account natively integrated in the app to its drivers, a shiny banking app with a fantastic user experience will inevitably be less competitive because it adds friction to the overall user journey.

First, the user will have to switch apps and remember how to navigate that app, with an obvious additional cognitive load. Second, and even more important, Uber will definitely have more margin to offer competitive pricing than any fintech startup, because the acquisition cost of that bank account will be much lower than that of a startup and also because the financial feature can be used as a loss/leader to subsidise the core product.

In this new world, I believe there are 2 possible moves for most of the existing fintech consumer companies:

  • Move down the stack – become an infrastructure provider
  • Move up the stack – become an aggregator

Move down the stack: Infrastructure provider

The financial infrastructure wave is exploding at the moment. “We are building a new piece of financial infrastructure” or “We are the Stripe of X” is the new “We are the Uber of Y”, and definitely one of the most powerful pitches to raise funds today.

In this scenario, startups will have to move down the stack, building a B2B product that will allow consumer facing brands to offer financial products with a trivial integration and with minimal resources. They would essentially expand the Stripe or Adyen model to other categories (more here on Adyen).

The assumption here is that essentially anybody who has a direct relation with the user will monetise also through a financial product, but won’t change its core business to refocus on finance. They will use a payment-as-a-service or banking-as-a-service provider to power these financial features (more here).

In this hypothesis, a plethora of B2B fintech companies will battle to enable the creation of financial services for more customer facing brands.

I believe this is the way forward for extremely specialised, mono-feature companies with low-frequency interactions product: firstly challenger lenders like Lending Club or Funding circle, or even an hyper focused product like Transferwise.

In low frequency interaction products, it will be very hard to compete with companies that interact with users on a daily basis, so they will probably have more chance of growth switching to become full stack service providers for more customer facing products.

They will have the experience in vertical (lending, cross-border money transfer, etc..), they are modern enough to be API first and they are young enough to adapt to mutated market conditions.

Move up the stack: Aggregator

For more customer-facing startups it will be extremely hard to battle only with the current approach, but I believe they can reposition themselves upper in the stack.

If people will directly take loans or create accounts through other large consumer products, then an emerging need will arise for the re-aggregation of these constellations of accounts and products under one single umbrella. Somebody will necessarily become the single financial touchpoint of the user: the aggregator of a fragmented experience.

To win this aggregator role, it would be essential to actually provide an extra value to the user, beyond the simple aggregation of multiple accounts: probably autonomous money and ecosystem creation will be crucial. A first flavour of this model is what Credit Karma started to build on Autonomous finance (more on CK vision on autonomous money here).

I imagine essentially all the neobanks will fall in these categories, as ultimately consumer businesses and for which a pivot to an infrastructure product would be technically, but even more, culturally, too complex.

Moving forward

The new shift in consumer behaviour is not very visible yet, but a number of new initiatives (Shopify ReUnite being only the most recent one) will only accelerate this trend. It is crucial for any company competing in the space to start moving down or up the stack now, as in a few years the first winners will start to emerge and it will probably be too late.


Resources

Bundling/Unbundling:

Embedded finance/Fintech everywhere:

Autonomous Finance