How To Build a Digital Bank

Fueled by the pandemic disruption, digital banking is picking up steam. According to a McKinsey survey, the use of digital banking channels grew by up to 20% in Europe in the first half of 2020. The crisis not only accelerated digital adoption by up to three years, but it has also forced banks to reevaluate their business models.

Social distancing measures, limits on business activity, and shifts in commercial behavior have resulted in a sharp reduction in the use of cash and checks – core transactions for traditional banks. More customers are shifting to online-only banking, forcing incumbents to compete directly with digital challenger banks that offer better features, lower fees, and superior customer experience.

The use of digital channels has grown by up to 20% during the pandemic.

Source: McKinsey’s New imperatives for European banking

What is digital banking?

Digital banking involves the digitalization of all traditional banking products, processes, and activities to service customers using online channels. As customer expectations for seamless digital experiences rise, banks cannot afford to forego implementing value-adding business functionality for modest cost-savings. In the past decade, banks that created internal digital bank spin-offs optimized revenue and reduced operating costs by up to 70%. This approach allows banks to test concepts at lower risk before moving parts of the legacy business to the new system.

Revolut, Fidor, Simple, N26, and Monzo are some of the better-known digital banks out there today using which customers can open an account in minutes on their phone, whenever and wherever they want. Customers have full control over their banking experience and can set up their preferred security settings, like whether they want NFC or magstripe payments enabled or not.

How to start a digital bank?

Although creating a digital bank from scratch is a challenging process full of nuances and country-specific regulations, the essential steps remain the same. Let’s take a closer look at three vital components of any new digital bank: defining an MVP (minimum viable product), licensing, and development.

1. Defining an MVP

Under the agile methodology, an MVP is a vital tool for testing assumptions and collecting the maximum amount of validated learning about customers with the least effort. When operating under uncertainty, defining an MVP to service early adopters with basic banking functionality provides access to important real-market feedback for future iterations and improvements.

An MVP can include a standard offering of essential features that match other banks’ services on the market. The list can consist of basic but useful functionality that users can use for day-to-day operations, such as full digital onboarding to open an account in minutes, account management, debit card, card-to-card payments, transaction history, etc.

2. Choosing a license

Digital banks cannot provide financial services without a special license. There are three main options to choose from when building a digital bank – the banking license, the e-money license, and the agent model.

Banking license

A banking or a credit institution license is the most complicated, time-demanding, and expensive option that enables companies to provide any and all services associated with a modern bank, from basic current accounts and overdrafts to more advanced loans and mortgages. Obtaining a full banking license can take 12-15 months and requires companies to prove to the ECB that they satisfy rigorous security and data protection prerequisites, the minimum initial capital of €5 million, and other rigorous compliance requirements.

Electronic money license

The EMI (electronic money institution) license is the most common regulatory option for emerging digital banks. The e-money license allows banks to create digital accounts or e-wallets to store money on electronic devices, smartphones, and servers. Although the license limits digital banks to operating online only, it is enough to provide the most popular payment services such as instant card-to-card transfers.

Although the application process for an EMI license is less strict than the one for a full banking license, companies still need to demonstrate their compliance with the EMI requirements and have the minimum initial capital of €350 thousand. It takes 4-8 months to obtain an e-money license.

Third-party license

For early-stage startups or new companies unable to get a full banking or an EMI license due to capital or compliance requirements, the third option is to use a third-party license. Under the agent or license-as-a-service model, a company with a banking or an EMI license can shelter another for a fee. The estimated initial set-up cost for an EMI license is €15 thousand and €1-2 million for a full banking license.

EU Challenger banks’ license types.

Source: Inteliace Research

3. Building a platform

Following regulatory hurdles, companies can start assembling the IT architecture that will enable digital banking services. A quality digital platform can rapidly drive value creation and lower operating costs, so it is crucial to dedicate time and resources to three main layers:

Front-end, also known as client-side development, includes mobile apps, web portals for clients and back offices. A good interface for payment-related products can only be made by a team with a solid FinTech product design background.

Middle-ware is a vital part of banking infrastructure that connects all layers together and acts as an add-on system orchestrator for the back-end. Eventually, middle-ware can reduce the strain on the core banking system by not involving it in every customer interaction.

Back-end houses the most crucial part of any digital bank – the core banking system. It is the engine behind the creation and management of accounts, balances, transactions, journal entries, along with the storage of client data, receipts, and other reporting tools.

Developing a core banking platform in-house is a complicated and time-consuming process that can overwhelm teams and delay product launches. As such, very few banks have their own platforms. N26, Tandem, O2 Banking, and many other challenger banks have outsourced their digital banking software from FinTech providers. White label digital banking solutions with pre-integrated key features help to assemble best in class products and launch them at a much lower capital expenditure.

Companies aspiring to launch a digital bank can get to market in a fraction of the time by partnering with SDK.finance, a core banking software vendor.

Companies with a dedicated IT team and hardware capabilities can implement the SDK.finance banking platform on-premise (source code with a license) and become completely independent from the technology vendor. With a banking software license, the solution can be customized with new modules, integrations, and capabilities.

A dedicated team solution eliminates the headache of software development, people management.

For the quickest start, companies soon will be able to choose the SDK.finance cloud banking platform (SaaS banking solution). It will not require a dedicated IT team and hardware capabilities.

The impact of digital banking decisions

Starting a digital bank is an incredibly complex and lengthy process. Key decisions related to the type of the license, the right technology providers, and the best business model will impact time to market, growth, and profitability.

A digital bank with a lighter license and SaaS banking software will get to market and acquire customers faster but will be restricted in its business model later on. Fully licensed banks with on-premise core banking software can develop a more nuanced product but will need much greater investment to get there.

One thing’s for sure: financial institutions that made strategic investments into modern digital banking software before the crisis leveraged digital inertia and became stronger. As the world slowly recovers, the steps taken today will determine which banks will be tomorrow’s leaders.

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