Are challenger banks a challenge for incumbent banks?

Earlier this year, I was part of the panel discussion on the role of challenger banks at the European Fintech Awards, and one of the main questions was whether the challenger banks were to lead to a revolution or if they are merely digital lipstick.

First let’s review some highlights in the rise of the challenger banks. As the dust settled on the 2008 financial crisis, a new breed of banks started to enter the market, as the Bank of England even lowered the capital requirements to set up new banks to fuel this development. Many of there were app-only banks, promising to simplify the banking experience for the millennial generation and beyond. While some dismiss these newcomers as just a fancy app, notable transactions tell a whole different story. BBVA started their challenger banks shopping spree by acquiring Simple for $117 million, followed by investing $68 million in Atom, setting the post-money valuation for Atom at $230 million. In order to cover the next generation SMEs as well, BBVA also acquired Finnish challenger bank Holvi for an undisclosed amount this year. BBVA is not the only one, as French banking group BPCE acquired API-based challenger bank Fidor for an undisclosed amount. When Mondo (now Monzo) decided to raise £1 million through crowdfunding, 1861 people bought equity in the company in only 96 seconds, days after investor demand for the bank crashed crowdfunding website Crowdcube.

In addition to high valuations, the challengers also outperform incumbents on several metrics. According to KPMG, the average return on equity for challenger banks is between 9,5 % for larger challengers and 17% for smaller challenger as opposed to larger banks at 4,6% in the UK market. Key factors behind the outperformance is due to lower legacy IT costs as well as a simplified product portfolio providing a CTI (Cost-to-income) ratio just below 50% for the smaller challengers as opposed to 80% CTI ratio for their incumbent counterparts.

In order to analyze challenger banks, it is useful to look at the different types of challenger. These can be roughly divided into incumbent initiated challengers, full licensed challenger banks and virtual challenger banks.

Several European banks have launched or are planning to launch their own challenger banks. AXA wish to change the everyday banking experience with mobile-only banking service Soon and BNP Paribas is attempting the same with Hello Bank., while Customers Bank in the US has launched BankMobile to get rid of fees and provide a more meaningful banking experience for millenials. Unicredit is taking a concierge-approach to everyday banking and is set to launch Buddybank in 2017 as a wholly-owned startup. The name of the start-up is meant to reflect a buddy who is someone who is always there for you, readily helps and gives good advice.

Several challenger banks are seeking to become fully licensed startups banks, and the likes of Atom, Tandem and Starling are benefiting from the simplified process and lowered capital requirements for setting up a bank in the UK. This is however not limited to the UK. Dutch challenger bank Bunq obtained a permit of their own to stay independent and make ethical decisions of their own as well as guarantee that savings should be safe under the Deposit Guarantee Scheme. German challenger bank Number 26 recently got their full banking license with an ambition to become a mobile-only European borderless bank.

Moven has shown us that you do not need a banking license of your own to grow in the challenger bank space. Startign out with CBW of Kansas as bank partner, Moven has expanded to Canada through a partnership with TD bank. Branded as TD Myspend, it is a companion app to the TD traditional mobile banking app and allows users to track their spending habits and get everyday banking advice. Lunar Way is taking the same approach in Scandinavia and is utilizing incumbent banks as providers of banking infrastructure and focus solely on the mobile-only customer experience. Monese is another virtual challenger bank targeting expats and immigrants who are having difficulties obtaining a UK bank account and promise to deliver basic everyday banking services such as current accounts and payment options through their mobile only solution under the license as an Electronic Money Institution.

Regardless of the type of challenger banks, these share some common characteristics in addition to being mobile-only.

Presentation. What may be perceived as just an app is all about customer experience and interaction due to changes in consumer behavior. Consumers trust peers and peer reviews over established brands, and challenger banks are leveraging this by including social interactions at the core of the functionality. Visual content like video is growing at a rapid pace, and while incumbents are merely replicating the paper-based income statement of yesterday in mobile channels, challengers like Atom is utilizing the Unity game engine to create a different visual experience.

Everyday banking is more than providing a mobile banking app showing a list of transactions and the ability to transfer money. Every challenger bank is attempting to provide an everyday banking experience in a contextual meaningful way. As Brett King og Moven states it: Budgeting is not the answer, think of Moven as a personal trainer for your wallet. Unicredit’s Buddybank acknowledge that in order to be relevant in their customers daily life they need to offer something beyond banking with their concierge-based approach to everyday advice.

Banking as a platform. The center of gravity for challengers differ from incumbents. While  incumbents built around core banking, challengers like Fidor shift the center of gravity from the core to their API layer. This gives challenger banks agility as well as a flexibility to expand offerings through strategic partnerships such as Metro Bank, which offers loans through Zopa and N26 using Transferwise for money transfers. The implementation of PSD 2 will also strengthen this development.

The common characteristics of the challenger bank landscape should act as key learnings for incumbents looking to reinvent themselves. The XS2A-rule under PSD2 will strengthen the strategic position of those who manage to create relevant everyday banking services across bank accounts. Banking as a platform is an inevitable scenario and clever use of technology will most likely change the face of retail banking where user experience and simplicity is integral. Challenger banks with an app-only presence are not limited to the constraints of traditional online and mobile banking interfaces in the same way direct banks benefited from not having any branches 15 years ago.

However, challenger banks are facing challenges of their own, but I will cover that in a separate post later on.