The Rise and Challenges of the Fintech Challenger Banks

Airbnb in the temporary accommodation sector, Uber in transport, Wealthify and other ‘robo advisors’ in personal finance and Amazon in…it increasingly seems like everything. As consumers, we are naturally inclined to be supportive of ‘disruptive’ tech companies that shake up the establishment status quo in different industries. That is especially the case when we feel like these fresh-faced newcomers are on our side. We cheer their stated mission to give us a better deal than the traditional companies that have been operating a shady cartel for years that has allowed them to charge us far more than we ‘should’ be paying for goods and services.

That’s the narrative that is almost always skilfully spun by the PR folks behind start-ups employing the latest technology in the world to make sure we get a better deal. If anyone’s ever pitched for investment for a start-up, or had any other connection to what is in itself now the serious industry of start-ups and their raising of capital, they will be aware of the emphasis that is placed on the ‘story’. You can’t just say “I thought there would be a demand for X and I could make money from a business providing it”. No, that doesn’t cut the mustard. You have to have a compelling narrative of how you, as a pained consumer, suffered from Y and ruminated “but if there were X, Y wouldn’t be a problem”. You then set about making your life’s mission the quest to spare other poor, pained consumers from the anguish you yourself faced. The new business is their champion, more than it is even your business.

Investors want to be sold that narrative as they know that’s what will subsequently have to be sold to the start-up’s future customers if it is to be successful. There’s usually at least a central kernel of truth to the consumer champion narrative of tech start-ups but, frankly, that’s not really the point. It’s the David against the exploitative Goliath brand that gets tech start-ups up and running.

More than most, the banking sector lends itself to that narrative. Traditional banks are huge in scale, hugely wealthy, irritate us with their charges and inefficiencies and are regularly, sometimes with merit, cast as the villains when economies suffer a rough patch. To many of us, banks are greedy, exploitative, emotionless and rich – the classic ‘baddy’. Despite that, the banking sector has been one of the slower ‘big business’ sectors to be challenged by new, nimble, tech-powered start-ups.

There’s several reasons for that, not the least of which is that despite our grumblings, we rely on our bank to keep our money safe and despite their shortcomings they have largely done that. Even when they run into trouble they are taken over by another bank or, in the worst case scenario, bailed out by the government. They are also pretty reliable. They may not be ‘tech’ companies but despite the odd hiccup, such as the recent week-long system outage suffered by TSB, their tech is pretty reliable. How many of us have really ever been left without access to our bank accounts for any length of time? As a result, most of us still adopt the ‘better the devil you know’ position when it comes to our bank. A ‘new’ bank is a risky bank and if there is one thing we are usually least willing to take a risk with it is our bank balance.

But there is a wave of tech-based start-up challenger banks or non-bank financial services companies that offer many of the facilities and services traditional banks do. Usually it’s through a simpler, faster and more intuitive digital interface and almost always at a fraction of the cost. They promise to make our banking experience both less painful while simultaneously offering better value. And fintech challenger banks, which are usually online or even mobile app only, have had some success.

Revolut, which launched as a pre-paid foreign exchange debit card in 2015, expanded into foreign exchange transfers and travel insurance and now also offers accounts, calls itself a ‘digital banking alternative’. The company became the UK’s first fintech ‘unicorn’ in April, having successfully closed an investment round that valued the company at £1.3 billion. Revolut also grew its customer base from 1 million last November to 2.5 million now and believes that by October it will have passed 3 million. The company reached break-even last December. Co-founder and CEO Nikolay Storonsky, a Russian former investment banker, says he wants Revolut to be “the Uber of banking”. The company also recently applied for a U.S. banking license and has aggressive plans for international expansion.

TransferWise is another, even bigger, fintech company whose co-founders also hail from further east, this time Estonia, but is based in London. High profile investors include Richard Branson and Andreessen Horowitz as well as asset managers such as Baillie Gifford and Old Mutual and several of Silicon Valley’s big name venture funds. Founded in 2011, TransferWise claims over 3 million users.

In the case of both companies, they only recently started offering ‘accounts’ which come with debit cards and resemble traditional bank accounts. Their main customer base is focused on foreign exchange transfers and they have used that to start moving towards new services that reveal longer term ambitions. The two companies have been described as ‘stealth banks’ as a result of this sideways approach to revealing themselves as ‘challenger banks’.

In the UK, Starling and Monzo are the two most developed online-only ‘neobanks’ challenging the high street banking establishment. The two have banking licenses, though Monzo started with pre-paid debit cards first, and compete with the incumbent high street bricks and mortar on a roughly equal footing in terms of the banking services they can offer. Starling says it has 210,000 account holders, up from 43,000 last November with an average deposit value of £900. Monzo’s homepage includes a counter which says the online bank has over 926,000 account holders at the time of writing, though with an average deposit value of just £150. Monzo was actually founded by a team that met working at Starling, which was founded in 2014 with the former successfully crowdfunding its initial investment round in 2016.

Other UK digital-only challenger banks include Abacus, Amaiz, Atom Bank, blockchain-powered Babb, Boffin and Coconut.

Challenger Bank Challenges

Despite their degree of success in attracting account holders disaffected with tradition banks, digital-only banks face a multitude of challenges if they are to develop to the point where they become a genuine threat to the established banking sector. The barriers to growth in the consumer-facing financial services industry are heightened by regulatory requirements. That makes the kind of guerrilla ‘growth hacking’ tactics employed by agile tech companies disrupting other industries less feasible.

Revolut, for one, has already encountered problems and has already been accused of prioritising rapid growth at the expense of compliance. Combating fraud has to be balanced with a quick and easy customer onboarding process. Traditional banks carry out user checks before they open a new account and accept deposits. Revolut does this afterwards. The advantage is cutting down bureaucracy, which is a major complaint directed at traditional banks.

However, it can also store up problems. The Sunday Times recently reported that ‘scores’ of Revolut customers were locked out of their accounts while more stringent checks were carried out in the wake of a notification made to the National Crime Agency around suspected money laundering over its system. Account owners who claim to be ‘innocent victims’ of the crackdown not being able to access funds while abroad is not the best way to build a brand.

A follow-up report in The Times included a quote from an unidentified KYC checks provider that claimed Revolut had recently approached it regarding a partnership. The start-up reportedly attempted to negotiate a price for new customer checks around 10% of what it would usually cost. That raises concerns around how much of the company’s adherence to regulatory compliance is little more than a box ticking exercise with no real regard for quality controls. Investors will be concerned about the future damage to reputation, and the size of the fines, such fast and loose attitudes to regulation might lead to.

Trust is perhaps the biggest challenge facing the challenger banks. As consumers, we complain loudly about ‘rip off’ charges applied by traditional banks to things like foreign exchange transfers, overdrafts and consumer loans. We are more than happy to take these services at a significant discount from fintech challengers. However, when it comes to entrusting them with our money as its primary custodian, we are less sure. As demonstrated by the low average deposit value, the vast majority of account holders at challenger banks still also have an account with a traditional rival. And it tends to be their main account into which salary is received and savings held. Small sums are paid into the challenger account, often for a specific purpose such as withdrawing cash abroad at a superior exchange rate or making FX transfers. Until challenger banks gain the trust necessary for account holders to make them their primary bank, they will struggle to grow.

Size means something in banking and the scale of the challenger banks is still, in comparison to the establishment, tiny. And banks and financial markets have always been built on scale. An accumulation of pennies from lots and lots and lots of transaction. Until challenger banks reach scale, we won’t really know if their model works or not.

An indication of the size problem and pecking order was provided early this week with the news that Starling have entered a deal with RBS to help the latter build its own ‘stand-alone digital bank’ by integrating the former’s digital payment services infrastructure. Why would a small challenger, whose core competitive advantage is its technology, hand that over to a traditional rival?

The reports covering the deal stated that the value of the deal is ‘unknown’ but that Starling will benefit from ‘efficiencies of scale’. Boiled down, it sounds more like Starling needs the money. If a fintech challenger bank has to sell its USP to its competition to try and survive and grow, is that not an indication that perhaps the best most online-only challenger banks can hope for is to eventually be bought out by a traditional rival? It’s certainly a concern.

At the end of the day, actually making money is the biggest challenge for challenger banks. Challenger banks and non-bank fintechs now providing many of banks’ more profitable services, such as FX transfers, insurance, loans etc. are a thorn in the side for traditional banks. They don’t make their profits by providing well-managed current accounts. They make them from providing overdrafts, transfers, insurance and the other much higher margin services the cost of which fintechs are slashing.

But that is a problem for fintech challengers themselves. If they provide the traditionally higher margin ‘rip-off’ services at low margins, how do they then make enough money to grow and establish themselves? The goal is to do so through scale – attracting large numbers of low margin customers. But they don’t have scale and large numbers of low margin customers. They have small numbers of low margin customers. The only way challenger banks might reach that scale is through significant investment. That’s not a particularly unusual position for a tech start-up to be in but is complicated by the fact challenger banks are offering essentially the same services as traditional banks. Just at a better price point and through a better website or app but with the drawback that consumers don’t yet trust them enough to hand over all their money. It’s not the same as Uber or Airbnb, who tap into the ‘gig’ and ‘sharing’ economy, changing the model of providing a transport or temporary accommodation service by crowdsourcing it.

The Road Ahead

Will the challenger banks grow into a genuine challenge to traditional banks? It’s hard to tell at this point. The Starling/RBS deal demonstrates the scale of the challenge faced. Despite the criticism of Revolut’s ‘guerrilla’ growth strategy, playing hard and fast with regulatory controls, and the risks that poses, there is a strong argument it’s working better than the more deferential approach adopted by Starling and Monzo.

At this point, if odds were to be given on which will persist as stand-alone businesses and which are likely to be gobbled up by a traditional bank within the next few years, surely they would be more in favour of Revolut and TransferWise achieving the former and Starling and Monzo being consigned to the latter group. That may well, of course, not turn out to be the case but they already look like they are facing an uphill battle.

The new open banking directive that means banks must, at their customer’s request, offer direct and convenient access to account details is a significant opening for fintech challengers. It means they can potentially piggyback services onto accounts held with another institution and provides a possible backdoor market entry point.

Challenger banks are facing more challenges than the disruptors in perhaps any other sector. There is some promise but also plenty of obstacles. From a consumer point of view, however, their challenge is still good news regardless of the potential outcome. It is forcing traditional banks to up their digital game and will also force them to cut fees in some of the services, such as for international transfers and exchange rates offered, that challengers have highlighted as obviously carrying too much fat. It will be interesting to watch things play out and hopefully at least some of the new breed will carve out significant market share and shake things up to the benefit of the end consumer of retail banking services.