Compared: Traditional Banks vs Neobanks

In today’s digital world, the way we interact with our finances is changing rapidly. As technology advances, banks are no longer the only way to manage money, and the introduction of neobanks is quickly revolutionizing the banking industry. But what exactly is a neobank, and what makes it different from a traditional bank? In this blog, I’ll be exploring the differences between traditional banks and neobanks, and examining the benefits and drawbacks of both.

What is a Bank?

If you asked ten people what a bank is, you’d likely get ten different answers. At its core, a bank is two things: a ledger and a store/source of capital. Banks take in and store deposits, facilitate transfers in and out, and track changes to balances in real time. To ensure smooth operations, banks operate on top of a standardized framework, so that depositors can move funds anywhere, at any time.

Banks are regulated by the government and are subject to strict laws and regulations, making them a safe and reliable option for managing and storing your deposits. Most banks are also backed by FDIC Insurance and SIPC Insurance, which protect your deposits up to $250k and $500k respectively if the bank defaults.

What is a Neobank?

A “Neobank”, also known as a “challenger bank” or “online bank” is a financial technology company that provides a range of banking services, budgeting tools, integrated payments, and more, without the need for a physical branch. To accomplish this, neobanks partner with traditional banks and leverage their banking charters to bring new digital-first offerings to the market. Something that previously would not have been possible, save for the recent evolution of regulations that enabled Fintechs to enter the market. While neobanks are not legally allowed to call or refer to themselves as banks, they still must abide by the same regulations and laws as traditional banks.

How do Neobanks work?

Neobanks do not have physical branches, instead, they operate entirely online. Neobanks build on top of existing banking rails, either through direct integrations with banking partners or through Banking-as-a-Service providers like Stripe, Unit, and Treasury Prime. They combine the flexibility of API-driven solutions with the native functionality of a consumer app, to deliver all the financial services (funding, banking, spend management, FP&A, forecasting, etc.) startups need without the drawbacks of legacy financial institutions (offline, loads of fees, and relationship-driven).

How do traditional banks work?

Most traditional banks have both physical branches and online platforms, they leverage home-grown systems to provide all the banking essentials. They also typically have their own banking charter, which enables them to build stand-alone financial products.

What are the differences between Traditional Bank vs. Neobanks?

There are two main differences between traditional banks and neobanks. First, traditional banks usually have physical offices, whereas neobanks do not. Second, traditional banks typically have a banking charter, whereas neobanks do not. Since Neobanks do not have a banking charter and must leverage the charter of their partner bank, they cannot legally touch or lend out their customer’s deposits. This distinction is important because it effectively cuts off one of the two available revenue streams available to banks.

Banks typically have two revenue streams: deposits and credit. In the former, banks generate revenue through float: the difference between the rate they receive from the Federal Reserve for holding deposits and the yield they pay out to their customers. In the latter, banks generate revenue by issuing loans and charging interest, e.g. banks make money by leveraging the funds that their customers store with them. Since Neobanks cannot lend their deposits, they must make up the difference with more deposits and live off the float.

What are the benefits of Neobanks over traditional banks?

Neobanks offer several advantages over traditional banks. 

• Neobanks typically don’t charge fees on essential banking products and services: money movement, scheduled payments, debit cards, and spending controls. Traditional banks on the other hand have loads of fees. 
• Neobanks are digital-first, meaning they have best-in-class UI and UX and have built integrations with other technology providers: accounting, payroll, subscriptions & billing…etc. Traditional banks, on the other hand typically do not because their home-grown systems can not be easily connected.
• Neobanks typically offer a wider range of services and features than traditional banks, such as embedded financing, budgeting tools, and financial insights.
• Neobanks typically have software discounts for partners in their network, provide introductions to potential investors and VCs, and may provide advisory services such as fundraising prep, GTM, and product strategy.

What are the benefits of traditional banks over Neobanks?

Traditional banks offer a host of benefits over neobanks. 

• Traditional banks earn the full Effective Federal Funds Rate, thus, they could pay out a higher yield to startups, however, most don’t. Check out the article we wrote on why they choose not to in Forbes. 
• Traditional banks have physical branches, thus they can accept cash and coin deposits. 
• Traditional banks typically offer business and personal accounts, meaning founders can centralize their finances.

Banking Charters & Neobanks

Banking charters are a form of operating license granted by the government which allows financial institutions to operate as, and call themselves “banks”. Banking charters enable banks to accept deposits, access, and loan out their customers’ deposits and provide a range of other fiduciary services to their customers. Most neobanks do not have banking charters (Sofi was the first) and as such, they must rely on the banking charter of their partner bank to operate legally. Even though neobanks do not have a banking charter, they are still subject to the same regulations as traditional banks including the Bank Secrecy Act, the Electronic Fund Transfer Act (Reg E), and the Dodd-Frank Wall Street Reform and Consumer Protection Act, to name a few.

What are a few of the largest consumer Neobanks?

• Chime is one of the largest and most well-known neobanks in the consumer space. They have more than 12 million customers and offer many of the same features as a traditional bank including direct deposit and automatic savings features, without the need for a credit check. As of 2/2023, Chime does not have a banking charter.
• Varo Bank is a neobank, that officially received a banking charter in 2020. It has roughly 2M users and offers similar perks to Chime, including checking and savings accounts without monthly account fees, overdraft fees, or minimum balance requirements.
• Sofi started as a hybrid online personal finance company and neobank. Today they have a banking charter and are one of the largest digital banks providing student and auto loan refinancing, mortgages, personal loans, credit cards, money management, and banking all through one mobile app.

Final thoughts on traditional banks vs neobanks

Neobanks are quickly revolutionizing the banking and financial services industry, by offering startups a convenient and cost-effective way to store their idle funds, access additional funding, and tap into other financial services. Neobanks offer a wide range of services, and banking essentials, but don’t come with any of the fees or legacy technology of traditional banks. They also typically pay 50-100x the APY of traditional banks, enabling startups to meaningfully extend their runway. If you’re looking for a better banking experience, check out Arc.