It’s possible that retail banking leaders have been too preoccupied dealing with the impact of the coronavirus on their institutions to notice the string of headlines indicating that the party’s over — for now at least — for some of the challenger banks they compete with.
A May 26 article in Wired, for example, carried the headline “Monzo wanted to conquer America, then along came the coronavirus.” Monzo is among the more successful of the U.K.-based challenger banks that have grown rapidly in recent years. Many similar headlines centered on a pullback in venture capital funding for the fintech sector since the start of the pandemic.
Overall, according to CB Insights, “The Covid-19 outbreak had a significant impact on fintech financing resulting in the worst Q1 since 2016 for fintech deals and the worst Q1 for funding since 2017.” There have been exceptions to this. Challenger bank N26, for example, has successfully completed several funding rounds. Even so, N26, Monzo and Revolut, another leading consumer challenger bank, all announced layoffs in late spring 2020.
If they have noticed these events, retail banking executives may well have thought, “Now’s our time to shine.”
“Traditional lenders are seeing the coronavirus pandemic as weakening the upstarts that have been challenging them since the last financial crisis, with consumers seeking refuge with larger companies to cope with the outbreak’s economic toll,” Yahoo Finance wrote.
Articles in The Financial Brand have explored how the pandemic crisis has provided incumbent institutions with an opportunity to shrink the gap in terms of digital capabilities with fintechs as many of the newer ones struggle facing the first economic downturn of their existence.
Has the pendulum swung back in favor of better-capitalized and increasingly digital banks and credit unions?
The Financial Brand explored that premise with four individuals with deep expertise in the ongoing and multi-faceted competitive struggle between traditional financial institutions and digital upstarts. Their comments were focused around challenger banks (aka “neobanks”) but apply in many cases to other fintech competitors such as online lenders and payment specialists. The respondents were:
Elias Ghanem, Global Head of Market Intelligence for Capgemini’s Financial Services.
Sarah Kocianski, Head of Analysis and Research Manager at 11:FS
Jim Marous, Owner and CEO of the Digital Banking Report, Co-Publisher of The Financial Brand and host of the Banking Transformed podcast.
Alaina Sparks, Managing Director, U.S. Fintech Practice Leader at Deloitte.
People have said the COVID crisis advanced digital banking capabilities of incumbents by three to five years. Do you agree?
None of the four experts agreed. At best, the rapid increase in digital banking engagement was “the beginning of a catchup,” as Elias Ghanem says and quite possibly “may be temporary,” notes Alaina Sparks.
Bluntest was Sarah Kocianski, who “completely disagrees.” First of all, the analyst explains, the largest incumbents had already picked up the pace of digital banking feature introduction before the pandemic hit. Two banks in particular, Chase in the U.S., and Barclays in the U.K., may be “closing in” on the capabilities provided by challenger banks like Monzo and Chime, but they still have a huge amount of work to do to offer a comparable service, Kocianski believes.
“Digital banking features in isolation mean very little without thought being put into the holistic customer offering,” she states. That includes the overall customer experience, communication strategy and technique, and value-added services.
“When financial institutions fully modernize their legacy systems, we will likely see more of a closing of the gap.”
— Alaina Sparks, Deloitte
As indicated above, Sparks thinks the narrowing of the gap between traditional financial institutions and digital-first challenger banks could be short-lived. The reason: The change has been driven by consumers who were seeking the trust of a traditional banking provider during the crisis. As that fades, consumers’ desire for a “delightful experience across products” will return. Such an experience, Sparks states, is enabled by “digital-first, cloud-native companies that can innovate at great speed.”
“When financial institutions fully modernize their legacy systems,” she adds, “we will likely see more of a closing of the gap.”
COVID-19 has been the tipping point for digital banking delivery, Marous observes, and while some banks and credit unions already had basic digital banking capabilities in place — digital account opening, for example — many others were “faking digital,” as he puts it — providing digital capabilities that still required a visit to the branch.
Allowing consumers to conduct business online or by mobile device is only the first step, adds Marous. “Being able to match the digital experience of most fintech alternatives requires eliminating steps and making engagement as easy as Amazon, Zoom, PayPal or other digital solutions.”
Downloads of challenger bank apps dropped as consumers pursued a flight to safety. Will that swing back soon?
None of the respondents were particularly surprised by this trend, nor did most think it was indicative of a fundamental shift. As Marous notes, “Consumers were less likely to open new financial relationships early in the pandemic.” But more recently the growth in new digital savings accounts has skyrocketed because consumers want to be prepared for a future crisis.
“I do not believe the slowdown in downloads of challenger bank apps had to do with a ‘flight to safety’ as it did with scaled-back marketing by challenger banks and a change in consumer focus,” according to Marous.
Capgemini’s Ghanem cautions against drawing any strong conclusions from the drop in app downloads during the pandemic. He points out that the firm’s World Retail Banking Report 2020 found that post-COVID, more than 30% of consumers are expected to shift to fintechs, having become used to digital.
Consumers will likely feel more comfortable downloading challenger bank apps and opening/re-engaging with these type of accounts once there is greater economic stability, Deloitte’s Sparks comments, especially if the challengers rapidly innovate new products in response to COVID market needs.
Investor interest in fintech providers has declined during the pandemic. Will this pattern reverse?
As noted earlier, the economic impact of COVID-19 decreased the appetite for fintech startup investments. As a result, Ghanem, citing CB Insights data, says the first quarter of 2020 witnessed a 15% decline in the deal volume across the globe. This particularly hurt smaller non-cash generating fintechs, he notes.
“Investors will be cautious for a few months and look for safer options,” the Capgemini analyst believes. However, he adds, sentiments will become positive again sooner or later.
“There is still the question of profitability, though, which is likely to come from scale,” Sparks adds. There could be some struggles in the banking fintech space in the near term if funding is not directed to the unprofitable segment of fintechs, she believes.
Transaction-related fees make up a high percentage of the revenue of many challenger banks, and sharply curtailed purchases during the pandemic — as well as travel — has impacted payment revenues.
“Digital banking features in isolation mean very little without thought being put into the holistic customer offering.”
— Sarah Kocianski, 11:FS
Stepping back a bit, 11:FS analyst Sarah Kocianski notes that the long-term trend for fintech funding has been one of fewer deals, at later stages. She believes that is likely to continue. When it comes to challenger banks specifically, N26, Aspiration and Starling have all raised significant sums during the pandemic, Kocianski states, although it’s likely discussions around those funding rounds began before the full impact was felt.
“It seems probable that once fintechs have reassessed their future plans and adjusted them according to current and likely future circumstances,” Kocianski maintains, “we will start to see funding pick back up.”
Even so, there is no doubt that many fintech valuations have taken a hit, Ghanem observes. That makes it even more interesting for traditional players to invest in — if not buy — the most promising challenger banks, in line with The Godfather adage: “Keep your friends close and your enemies closer.”
Do you expect more consolidation among challenger banks (or fintechs in general) over the next 12 months?
In a word, the response from all four experts was, “Yes.” Marous, however, doesn’t limit the prediction to fintechs.
“I believe there will be a wave of consolidation of both fintech firms and mid-sized traditional banking organizations,” he predicts. Many fintech firms will not find the funding to continue post-pandemic, he explains, while many mid-sized traditional financial institutions don’t have the leadership, vision or capital to compete with either very focused smaller banks on the one hand or very well-funded larger financial institutions on the other.
“We would say it is a perfect time for traditional players to go [fintech] shopping and we expect acquisition activities to go up in the coming months.”
— Elias Ghanem, Capgemini
Capgemini’s Ghanem views it a little differently. “On one side we have cash-crunched startups trying to stay afloat and on the other side we have traditional players trying to innovate, but at a conservative cost. We would say it is a perfect time for traditional players to go shopping and we expect acquisition activities to go up in the coming months.” Ghanem states that the industry may also see increased acquisition of fintechs by Big Tech players, trying to gain — or expand — a foothold in financial services.
By contrast, Kocianski expects fintech acquirers will fall into two camps: incumbent financial institutions and larger fintech players. “The incumbents are likely to pick fintechs with advanced technology in areas such as KYC and AML,” she states, “or payments.” The large fintech players are more likely to look for a startup that provides services complementary to their own. For example, a big payments player might look to acquire a fintech that provides checking accounts, she states.
In what ways are incumbents still vulnerable to fintech challengers?
Despite the hurdles challenger banks face, leaders of incumbent retail banking institutions should not think that they now have beaten back these built-for-digital competitors. All four of our commenters found incumbent vulnerabilities.
Alaina Sparks cites the pace of innovation, customer experience and affordability of service as fintech challengers’ key differentiators. “Fintechs will become even more competitive as they broaden their suite of services, enter into compelling partnerships within and outside the industry, and attract and retain more profitable customers,” the Deloitte analyst maintains.
Banks and credit unions are vulnerable to having parts of their business chipped away bit by bit by companies that can do the same thing but better, faster and cheaper, says Sarah Kocianski. “If traditional institutions don’t look to reassess the ways in which they make money and operate, they stand in danger of moving towards obsolescence.”
“Most legacy banks have not come close to providing the ease of engagement available from the best fintech firms or challenger banks.”
— Jim Marous, Digital Banking Report
Marous responds a bit more graphically: “For an incumbent bank to state that they can now open a new checking account entirely on digital channels is not enough. That’s like a restaurant saying they no longer have rats in the food storage area. Most legacy banks have not come close to providing the ease of engagement available from the best fintech firms or challenger banks.” That is what consumers want, Marous maintains, now more than ever.
Pointing more specifically to where traditional institutions fall short, Capgemini’s Ghanem says the culprit is lack of innovation in the middle- and back-office processes, which he says leads to broken digital journeys, making banks vulnerable to surviving fintech challengers.
Which are the challenger banks most likely to succeed?
11:FS’s Sarah Kocianski gave a very specific response to this question:
“In the U.K., Starling is in a very strong position, especially after it’s recent capital raise. It has been active in lending under various government [COVID] schemes which is good for customer numbers and future revenue.”
In the U.S., Kocianski says Chime has done well in accumulating customers and getting those customers to have salaries deposited in Chime accounts — likely because of its “get paid early” feature. “That’s key to keeping customers regularly using an account and makes it more likely they will use Chime as their primary bank,” she states.
Finally, Kocianski says Varo Money “is in an interesting place” being very close to acquiring a national banking license, along with the Moven merger. The key to Varo’s short-term success will be a successful transition of the Moven customers.
Marous responds that the challenger banks that already have scale, differentiation and brand equity, including N26, Monzo, Revolut and Chime, will be most likely to succeed. He also believes that digital payment solution providers like PayPal and Square and digital savings/investment providers like Betterment and Acorns are threats to traditional institutions.
“These firms have taken major parts of the financial relationship and integrated them into daily life,” Marous states. “And, let’s not forget Goldman Sachs’ Marcus, which is methodically building a highly integrated digital bank with partners we use every day like Apple Pay and Amazon.”
“The real threat to incumbents will be the challenger banks that survive this crisis or the new challengers who are born in this pandemic,” Ghanem states. Capgemini research, he says, finds that 36% of consumers that have tried new players would continue with them after the crisis.