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Will Challenger Banks Rule the Market?

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With the rise of challenger banks emerging within the UK market it is important to now consider the longevity of these businesses. Since the new RBS banking competition fund of £775m for SME investments, the fintech sector has exploded with nearly over 100 challenger bank start-ups in the UK alone.

The most well-known of these challenger banks include the likes of Monzo, Starling, Revolut, N26 and Atom. With four out of five of these major contenders being British we must look further into the effects that these new banks will have on our market. More importantly, even if these new banks attract reasonable numbers of customers and balances, can they reach critical mass?

Using Monzo as an example we can see that although only being launched four years ago they have over 1 million customers. They have recently doubled their valuation to £2bn after raising £113m in their latest round of fundraising. These new challengers are using the after effects of the 2008 credit crisis to their full advantage along with strong marketing campaigns to entice new customers.

These banks excel at appealing to the younger generation. Being predominantly digitally based, traditional banking methods are changing. Users are able to open a bank account over an app on most smart phones using the likes of facial recognition and fingerprint ID along with a driving licence to open an account. The main attractions of these banks are fee-free spending abroad, apparent ease of money management and the ability to easily send money and split bills between friends.

Monzo has also teamed up with AXA announcing plans to roll out travel and phone insurance sales through the app. This multi-disciplinary sales approach appeals to a younger generation that often go with the easiest and most convenient method of purchase when looking to buy goods.

Monzo is not the only challenger with plans of selling insurance through their app. Competitor Starling Bank has also recently partnered up with Direct Line to allow them to apply for home insurance through the Starling app. This use of a new technology platform is similar to that of how Tesco Mortgage Intermediaries created a platform to create a more fluid lending process between customers and brokers within the mortgage market. Although the new platform was attractive to customers, it was unable to compete with the financial backing of long-standing mortgage brokers. These brokers’ ability to match increasingly competitive rates led to new CEO Gerry Mallon shutting down the service. Other casualties of the mortgage price war include AA Mortgages, Fleet, Amicus, Secure Trust and Magellan Homeloans.

Not only challenger banks are struggling – Nationwide recently reported a 3% decline in its annual net interest income. As the second biggest UK-mortgage lender this is indicative of the current market conditions. Considering the limited growth potential in this market it is strange that challenger banks, especially those under CYBG, are fighting to keep their 4% share of the mortgage market. This is potentially an explanation of the newer challengers’ expansion into the insurance industry rather than a bank’s typical investment in the mortgage market.

A more important question here is; can these challengers can achieve a reasonable return of equity when high street banks are taking profit of their back books of around 80% of their run-rate profit?

Fitch Ratings’ recent report highlights the concern that these new challenger banks are severely underestimating the risk within the market. This also means that they are underestimating potential losses. Atom, the UK’s first digital only bank, currently holds £1.5 billion in customer accounts and has invested £1.2 billion of this to SME businesses and homeowners. Although these seem like very impressive numbers Atom is still reporting losses and having to continue fund-raising. Atom is not the only one, although fintech challengers now take 33% of revenue share in financial services, majority are still reporting losses as they are focusing on investments in order to cover their CET1 requirements.

This theme of negative returns within fintech challenger banks could be due to loosening of underwriting standards with the pure intention of increasing volume of users while also simultaneously overestimating their ability to mitigate losses.

Although sold as ‘new ways of banking’ few of these challengers are covered by the FSCS. Meaning the likes of Revolute, N26 and more are creating current-account-like accounts in longstanding banks such as HSBC and RBS that are separate to their own in order to hold user’s money. Meaning that if the challenger goes under customers’ money is likely to be protected. However, if the bank goes under they may not be as there is a grey area in the banking rules in relation to this.

When looking deeper into the financial ramifications of these challenger banks there are positives. An increase in competition can encourage better rates for customers which should help financial growth within the economy. However, when looking at the results of challenger banks in the mortgage market it should be argued that the fintech challengers should learn from this such as when Loot, First Global and Finn (by J.P. Morgan) collapsed.

Although challenger banks are looking to compete with the likes of the big four and increase their growth it should be understood that the significant financial backing and resources that these long-standing banks have allows them to compete at a different level than these smaller SMEs attempting to enter the game. For this reason challenger banks are likely to follow a similar path to that of Bitcoin; to having extremely fast growth and investment from others, and even potentially achieve a profitable level for a few years, however, as the novelty of new companies lessens profits will decrease and losses will increase and the majority market share will remain to be held by traditional banksHowever, this may not be a bad thing as traditional banks are now trying to compete with these challengers by upgrading their online services in order to meet current demands as technology advances at unprecedented rates in the banking world.

Considering the obstacles these challengers face, the only hope  for fintech challengers to have longevity within the market is two-fold. Firstly, for a review of the Pillar 2 capital requirements to ensure that challenger banks are supported through their growth but also adhere to the legal requirements that protect our banking system. Secondly, these challengers must make sure that they are covered by the FCSC as this will increase confidence in them as customers know their money is protected from unpredictable market changes.

In summary, with more support from regulators and help to ensure they have the correct financial backing to promote growth and move towards profitability there is a chance that a few of these challengers might gain a solid footing within the market.