Online banks were growing in popularity prior to the COVID-19 pandemic as tech-savvy millennials demanded access to banking products from financial institutions that aren't associated with Bay Street and Wall Street. The new generation of young professionals showed little desire to use the same banks their parents and grandparents frequent.

One of the more popular online banks in Canada is Tangerine, the former unit of ING Direct. Reading through a Tangerine bank review makes it clear why it is beloved by many: the online bank offers many free banking products and is backed by fantastic customer service.

Technology Spurred The Growth Of Online Banks

Advancements in financial technology (fintech) over the past 15 to 20 years paved the way for innovative startups to duplicate all the functions of a bank branch but through an online venue. Most importantly, this allowed the young demographic to transact with their bank how and when they want. 

An online bank business model is built on the premise that it can thrive without traditional physical branches. These are expensive to operate, especially for banks that need to oversee thousands of branches across the country.

The human element has become less important and replaced with smart chat features. Cloud communication providers like Twilio now make it possible for online bank customers to communicate with their institution through in-app chats, push notifications, or through Facebook Messenger.

Mixed Perception

According to at least one expert, the case can be made that consumers were never really unhappy with their large bank. In fact, the thesis that millennials had no interest in big banks may not even be true after all.

JD Power's 2020 Bank Satisfaction study concluded that big banks lead in satisfaction with their own digitally delivered advice and for those who want, face-to-face advice. American megabanks including Bank of America and JPMorgan Chase each showed a notable improvement in customer satisfaction level from 2015 to 2019.

In other words, at a time when online banks were flush with new investor capital and motivated to build the bank of the future, many customers may not have really cared. They are sticking with what works as part of the old homage if it ain't broke, don't fix it.

If anything, consumers don't necessarily want a digital bank, they "want a better bank."

But up in Canada, similar surveys appear to tell a different story.  The online bank Tangerine Bank ranked number one in customer satisfaction among all midsize banks in the J.D. Power 2020 Canada Retail Banking Satisfaction Study.

Gillian Riley, President and CEO of Tangerine Bank said:

"We are constantly dialed into Client feedback and can attribute this #1 ranking to our Clients - receiving and listening to their feedback helps us deliver a simple and frictionless everyday banking experience."

Why Online Banks Don't Make Money Today

Tangerine offers consumers a free checking bank account while its parent company Scotiabank charges a few dollars a month depending on the package selected.

Scotiabank doesn't break down the performance of Tangerine in its earnings report so it is impossible to gauge just how well (or poor) the online bank is performing. But across the Atlantic Ocean, United Kingdom-based digital bank Starling releases its financial performance.

Starling's growth since its creation in 2014 is similar to other global online bank peers. Born in the years following the global financial crisis, Starling strived to give customers a banking option that doesn't involve a big bank.

The London-based fintech startup said in August revenue rose from £750,000 ($1.003 million) in 2018 to £14.2 million in 2019. Yet despite a surge in revenue, its pre-tax loss worsened from £26.9 million in 2018 to £53.6 million in 2019.

Starling isn't the only unprofitable major online bank player in the U.K., although it is in better shape than its peers. Fellow British digital bank Monzo saw its annual losses more than double in size from 2018 to 2019 to £113.8 million even though revenue more than tripled to £67.2 million.

Can The Tide Turn?

Starling founder and CEO Anne Boden acknowledged in a conference call with reporters that it is a "horrible thing to say" but the COVID-19 pandemic represents a compelling opportunity for the online bank. The company has been able to take advantage of a government-backed lending program and it now has £1 billion of lending on the balance sheet.

This helps put the online bank on track to be profitable by the end of the year, according to the CEO.

However, this may be a temporary event as the government-backed lending program won't remain in place forever. Also, the company is eyeing an international expansion through an Irish banking license that would open up access across Europe.

At best, this is a costly endeavor that could take years to recoup the investments required to expand. The company is fortunately backed by two major investors, both of which "indicated their intention and ability" to continue financially backing the bank's mission.

If Starling were a publicly-traded corporation, many investors would not find the prospect of investing in an unprofitable bank appealing. By comparison, major banks are known to offer stable growth along with an attractive dividend.

Bottom Line: Business Model Isn't Built For Profit

As is the case in every industry, providing a (mostly) free service means profitability is hard to obtain. Online banks can, in theory, monetize their customer base by legally selling personal information to other companies but this wouldn't be well received by its clients. 

The fact remains that an online bank's business model isn't built to generate a profit. Great news for customers, not so much for investors.