As economies and businesses plan recovery strategies from the COVID-19 pandemic, we took a closer look at the short and long term implications of the crisis on the Challenger Banking industry.
The COVID-19 crisis arrived unexpectedly and has impacted every single industry globally. With the uncertainty of the duration and full impact of the pandemic, many questions are surrounding the health of the challenger banking market. The banking industry, especially the new entrants of challenger banks, face a future of uncertainty as they navigate through the global crisis.
Pre-COVID Market Climate
Till date, almost all challenger banks have remained unprofitable and require significant capital for marketing and operations to build the company’s customer base. Considering the young age of most, establishing a loyal user-base has been the crux of the business model, as each digital bank aims to monetize them eventually.
Prior to the pandemic, the strategy of many of the challenger banks focused on:
1. Customer Growth
With over 3.5 million users in Europe, N26 is now available in the US and is soon planning to launch in Brazil. Revolut expanded its operations from 30 European countries to Singapore and Australia in 2019 and has garnered over 7 million users. US-based Chime quadrupled its customer base to 4 million in a single year.
Challenger Banks are growing at an exponential rate, both domestically and through their global pursuits. Accenture had predicted UK digital-only challenger banks would triple in size to more than 35 million users in 12 months, forecasted to achieve a 40.4% compound annual growth rate in 2020. Looking at individual banks, it is clear from the massive customer base they are acquiring; they are expanding fast and wide and fulfill the need of consumers.
A year-to-year overview of customer growth for individual challenger banks can be found at https://challengerbanks.co/.
2. Competitive Pricing in a Saturated Market
Concern is rising among challenger banks in light of an increasingly crowded market coupled with a tight squeeze on revenue margins. To attract more customers, challengers are keeping prices low and highly competitive. Simultaneously new banks are coming out every day offering identical products and services in a similar price range.
Traditional banks generate their revenue through the classic business model of lending at higher rates than they pay their depositors. Challenger banks often operate under a different business model whereby they do not lend and instead hope to earn the interest through services they sell on their platform (investment advice, credit cards).
It is tough to create and maintain an unfair distribution advantage, through brand, virality, or other channels, in this landscape. As a result, many of the banks have been focused on the growth of customers rather than profitability, assuming they will capitalize on the more significant customer base later on with sufficient economies of scale.
3. Limited Product Range
Offering only a fraction of all banking services, typically centered around the payment account, has significantly limited the challenger banks' revenue potential. The industry has outliers and is beginning to see a slow shift with the introduction of credit cards, short term loans, and business loans. The long-term strategy for many of the banks is to expand the product portfolio offered.
Competing against traditional banks, who offer a much more extensive range of products, many challengers are struggling to secure a primary customer relationship. Customers more often use challenger banks as a secondary account for specific services and features while retaining traditional banks are their primary account.
4. Reliance on Funding
Globally, twelve challengers have raised $100 million or more in equity financing, with six currently valued $1bn or more. Brazil-based NuBank has raised over $906 million in funding, while US-based Chime has raised $805 million.
However, while investments are coming in, challenger banks continue to operate in losses. Monzo had a loss of £47.2 million as of February 2019, equivalent to a loss of £15.05 per customer. As it continues to grow, the losses are only increasing as the net loss in 2018 was £30.5 million – year on year rise of 54% in losses. Working at a loss is a common situation for many challenger banks.
Accenture estimates challenger banks are losing an average of $11 per customer. With growth strategies based on increasing the user base now and their profit margin later, most challenger banks rely heavily on funding to continue their operations.
Short-Term Impact of COVID-19
Most challengers arose post-2008 crisis and have not had to weather a market downturn. With some now lacking a safety net, how they weather the storm remains to be seen. Public fintechs were significantly outperforming the S&P 500 and Nasdaq until the COVID-19 crisis hit. Since then, many have underperformed.
Almost overnight, spending habits have changed for consumers. Lockdowns have restricted accessibility to their banks’ local branches. With unemployment on the rise and the uncertainty of the economy, they are looking for immediate relief. As such, we see shifts in consumer behaviors and banks' focus.
The short term impact of the crisis has led to:
1. Lower Volumes of Transaction Activity
On average, challenger banks’ app downloads have dropped by 23.38% at the end of March 2020 compared to February. As business conditions deteriorate, it will have a direct impact on operating performance. Revenue fees for challenger banks are often highly dependent on transaction fees, which will dramatically decrease.
Revolut garners its revenue through consumers making international payments. However, there will be a substantial drop in their revenue stream with the travel bans in place and a global decrease in traveling. Tide generates their income through fees when consumers open new business accounts with them, which is again on the decline as consumers navigate through the crisis. Challenger banks globally can expect significant changes in customer spending habits resulting in low activity.
2. Consumers Reverting to Traditional Banks
With the uncertainty of the economy, many customers are reverting to their primary banks; in most cases, the traditional banks. Being decades older and having survived through previous financial downturns, incumbents have established an underlying trust with consumers. A perception that challenger banks are too young to have established. With limited mobility, core banking services are often all that is required, and rather than the untested, new challenger banks, customers are looking to ensure the safety of their money with traditional banks.
3. Immediate Need for Digitalization
As COVID-19 continues to spread, alternatives to in-person banking and physical exchanges in retail banking are looking more attractive. With consumers forced to use online or mobile banking alternatives, the use of non-branch banking solutions has increased dramatically. Challenger banks and other financial institutions that were digital transformation leaders are likely to benefit from this behavioral shift.
4. Concerns on SMEs and Consumer Defaults
The declines in business revenue and individual income are driving-up the need for short term credit very quickly. As interest payments are being re-negotiated and deferred while borrowing increases, a massive credit crisis is looming for businesses and individuals. Qudian Inc., a US digital lender, said in mid-March that 20% of its loans that have come due were unpaid as of February, a doubling of the rate compared to last quarter. OakNorth, a UK- based business and property loan provider for SMEs, has only seen one default till date. However, with the unexpected arrival of the pandemic impacting their clients, is likely to see a lot more stress on their business.
1. Profits to the Forefront
Till date, challenger banks have seen an abundance of funding provided, with Starling raising £60m as recently as February 2020. However, COVID-19 will dramatically reduce funding, as investors may start considering challenger banks higher-risk investments, and high valuations are reduced. Monzo adjusted its valuation in £1.25bn in May, compared to the £2bn valuation secured at its funding round last June. The pandemic is forcing loss-making tech companies to adjust their valuation to attract scarce funding from more cautious investors.
With lower funding expectations, many challenger banks will have to restructure their growth strategy. Rather than focusing on establishing global dominance at all costs, they will need to readjust their approach to realize profits faster. One method we are likely to see is the exiting of challenger banks from non-core business areas and creating a more profit-focused product portfolio.
We recently interviewed Jeroen De Bel from Fincog on this topic.
2. Customers Sentiment Towards Online Banking
Seeding from the short-term need for digitalization, it is likely to become a long-term requirement for all banks to support online banking entirely. The banking industry was already seeing massive shifts into technology, and the current pandemic has only sped up the process. Digitalization will no longer be an added convenience, but a necessity as challenger banks and incumbents alike go entirely online. There will be wider adoption of digital payments among the non-traditional fintech consumer segments such as baby boomers and older GenXers.
3. Incumbents Banks entering the Market
Incumbents, now more than ever, see the value and necessity of providing a fully digital service. As traditional banks push to innovate and accelerate their eventual digitalization, they are likely to implement products/ services similar to that of challenger banks. Some incumbents might want to directly acquire challengers' technology stacks to upgrade their technology, rather than create partnerships.
We have already begun to see big banks partnering up with fintech startups to provide these services. While challenger banks have brought the ideas into the market, which players will ultimately succeed in the long-term is still unclear. They may have been the first-movers, but if incumbents deploy similar features, with the backing of decades of trusted relationships with their clients, they could very well recapture the market entirely.
4. Exit Options Changing Significantly
According to the findings in the Rosenblatt survey, the main threats to fintechs will be cheap mergers or acquisitions, driven by opportunistic buyers looking to capitalize on the company’s shortage of liquidity. Investors expect business-to-consumer companies like personal finance management apps to be worse affected. It is estimated that an economic downturn could wipe out $76 billion of the fintech market value and spur a wave of M&A activity in the sector. Devaluation among challenger banks will start a race among incumbents to pick them up for cheap, so founders might only get low offers, if any at all.
The challenger banking market was already expected to bring much change to the banking industry, and the COVID-19 has only accelerated these changes. Going digital is no longer an option, but a necessity and challenger banks are one step ahead of incumbents at this point. However, with fewer investments, an oversaturated market space, and almost no profits, it remains to be seen which challenger banks will come out the other side of this crisis as the real winners. Simultaneously we can expect to see significant shifts from incumbent into the digital space.
The challenger banking space can expect significant shifts in the coming months and years and is an industry worth keeping an eye on.
This post is part of our upcoming The State of Challenger Banks report. Make sure to subscribe for the launch.