Can Challenger Fintech Banks Achieve Scale?

The head of fintech research and analysis at PwC, Aaron Schwartz, shares thoughts on the challenges facing challenger banks hoping to acquire new customers. He is one of several industry leaders who contributed to the 82-page Digital Banking Report, "The Challenger Bank Battlefield".

The true measuring stick of a new market trend often appears when customers have a number of credible commercial options to choose from. This very well may be the case for ‘challenger banks’ in 2017 as several companies, including Monzo Bank, Starling Bank and Tandem Bank, are expected to launch with new services that span essentially all core areas of retail banking. This emerging class of challenger banks, which largely took root in the UK, will join the likes of Atom Bank and N26, which currently offer products including savings and a consumer credit product, respectively.

This new category of alternative competition in banking only appears ready to expand further. In the UK, regulators are assessing authorization from an additional 20 to 30 firms, with even more preparing to apply for a license. Given the concentrated market share in the UK, where the top five banks hold an 87% share relative to 44% in the US, the Bank of England along with UK regulators have taken steps to reduce the burden for challenger banks to seek banking licenses in an effort to increase the number of UK banking options. In the US, the Office of the Comptroller of the Currency (OCC) also has issued recent guidance for the issuance of national bank charters to fintech companies.

The common denominators across many of these challenger banks include strategies that revolve around a differentiated consumer experience, newfound efficiencies, and transparency. However, with a flood of new digital-only competitors expected, and a response from traditional banks that includes a hybrid digital-and-branch approach, companies that simply offer digital-only delivery of existing bank services may struggle to differentiate.

Success and scale for this new class of challenger banks will more likely be defined by those that best capitalize on their structural advantages, many of which may be borrowed from the technology industry.

How to Gain Share in a Zero-Sum Game?

Many challenger banks aim to distinguish themselves with an intuitive and simplified banking experience. In large part, they seek to distance themselves from the staid reputation of the traditional banking industry and appeal to customers with digital-only offerings. These banking solutions are designed to meld into everyday life similar to other social- or commerce-based apps. Many offer more streamlined and timely activities such as account opening in a matter of minutes, compared to days with an incumbent bank, to more accurately align with the reality of consumer expectations.

Still, fundamentals cannot be ignored when assessing the growth potential for these banks. Retail banking is highly penetrated in developed markets – 97% of adults in the UK have a personal current (checking) account. As such, growth in the addressable market (i.e. population growth) and market share shift (adding consumers from competing banks) are more critical factors.

Challenger banks in the UK face an uninspiring average annual population growth rate (less than 1% over the last five years), and despite efforts to simplify the switching process, the Current Account Switch Service program has seen only 3 million accounts change hands since inception, roughly just 1.1% per year. Simply said, traditional banks enjoy a high degree of consumer stickiness.

Challenger banks seek significantly higher growth. Some have opted to compete on price. A peer group of UK challenger banks pays roughly twice the savings rate of traditional banks (0.92% versus 0.44% for the average easy access account), and in the US rates on deposits are three times higher at online versus traditional banks (0.79% versus 0.27% for a 12-month CD)., But in a low interest rate environment, this approach is unproven and typically requires significant scale to succeed.

Other challenger banks look to redefine the banking experience by providing practical solutions to solve new problems, including:

  1. Personal financial management (PFM) assistance in which users can set budgets for different categories of spending, enable automated savings, and receive intuitive alerts based on spending trends
  2. The elimination of common “pain points” such as paper-based forms, substandard customer service, and lengthy periods for approvals/decisions
  3. Added transparency such as alerting consumers when they risk being overdrawn.

These functionalities are several of the methods that challenger banks focus on in their effort to increase new customer acquisition.

Fin or Tech: Lessons Learned From the Tech Side of the Equation

The key factor that will determine sustainable growth and scale for a challenger bank is whether these approaches will provide a temporary or structural competitive advantage. Startups bring speed and agility to their strategy, but traditional banks have begun to respond.

Several now offer account opening capabilities through mobile, while others have embedded personal financial management capabilities directly into their mobile apps or introduced automated savings and budgeting features. Competitive advantages borne through feature or function in a highly competitive market are likely to be temporary and recede over time.

For digital-only entrants to achieve scale, a strategy centered on structural competitive advantages will be needed. We see this in two areas:

  1. Leverage of operating costs: Challenger banks have vastly different cost models from both an operating (personnel, technology) and capital expense (property) standpoint. These digital-first models avoid much of the physical bank branch costs and benefit from lower technology costs in leveraging cloud and open-source technologies.
  2. Ability to establish a network effect: As financial services meld into everyday life, viral growth, or a network effect, can strongly shape consumer adoption.

Intuitively, and backed by strong evidence, digital-only banks are more efficient operating models – a comparable group of online banks has an average efficiency ratio of 46% compared with a range of 50% to 60%-plus for most traditional banks. Many challenger banks have a 30% or lower target efficiency ratio. In this context, success may be defined by operating at this target efficiency ratio due to the inherent structural cost advantage.

The combination of this lower cost model, with new customer volume, may unlock the true operating leverage potential – and this could prove to be the more challenging feat. Customer volume growth very well may be influenced by a viral approach, which is a facet common to the technology industry.

Companies such as Facebook, LinkedIn, and PayPal’s Venmo, for example, have been able to continuously add new users due to a cycle of viral referrals in which friends encourage use of the app across their social networks, which can then expand rapidly. Challenger banks will experiment with social aspects, such as enhanced product functionality when social circles or friends adopt the app, to achieve a viral customer acquisition strategy or network effect.

A characteristic of the technology industry is that only two or three companies normally gain the massive scale to succeed. This should serve as a precedent study for challenger banks as they will always need to innovate to maintain a ‘feature-based’ competitive advantage over traditional banks. But in reality, only a few companies are likely to achieve the needed customer volume and deposit base to leverage their cost advantage to drive sustainable scale and long term growth.

Purchase the Report

The Challenger Bank Battlefield report provides insight into more than 30 fintech challenger banking organization globally. Beyond a review of the strategies and products offered, this report includes an analysis of the competitive positioning of the organizations reviewed.

The report also includes interviews with challenger banking organization founders and financial services industry leaders. The report has 82 pages of analysis and 15 charts/graphs. Finally, the report includes secondary research into the competitive marketplace and guest articles from organizations who are close to those organizations involved.

This Digital Banking Report is the first offered through our redesigned website. It is also the first developed in partnership with Devie Mohan, President and CEO of Burnmark.

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