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Challenger Banks and the New Economy

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Challenger Banks (aka NeoBanks) are on the rise. Their growth has been spurred by consumer frustration with the old guard – stemming from the ’08 financial crisis – and a massive war chests to fuel expansion. Now, with several million users combined, the question is are challenger banks the future of the new economy or a flash in the pan?

Love ’em or hate ’em the era of the challenger banks (or neo banks) is here. These digital-only banks have grabbed headlines in recent months because of their eye-popping valuations amid a sea of red ink:

Timeline of Challenger Banks

The question is, are we in the middle of yet another tech bubble or is there something real happening here that will revolutionize personal finance and banking as we know it?

Challenger banks – how did we get here?

As always with these types of early-stage markets, there is a combination of factors that give rise to the inception of the industry, as early-adopters spark the S-curve and pave the way for mainstream adoption, which is where we are at now in the fintech challenger-bank sector.

Lumos Innovation+ – The S-Curve

One reason is simply that, like in many industries over the last decade, the technology of incumbents became outdated and many customers switched accounts for more convenience and better rates. Data from the UK – the home of the challenger banks – shows this to be true.

But there are other reasons, as well, that stem from the GFC (Great Financial Crisis) in 2008 and the subsequent policies of NIRP (negative interest rate policies) in the EU. With about half of the global population being under 30, one recent survey of over 30,000 millennials showed that only 28% considered the big banks ‘to be fair and honest.’ TL&DR of the banking industry is that you have certain continents where the whole industry is imploding, like Europe, and whole generations that will never place their trust (and therefore money) in big banks.

Enter the challenger banks who:

  • appeal to millennials and GenZ – 1 in 4 people under 37 in the UK use a challenger bank, 47% of people aged 18-24 have heard of challenger banks
  • have new, untested, business models that appeal to a more transparent and honest way of dealing with customers
  • are tech-focused, globally-minded, yet still locally regulated

It is estimated that challenger banks in the Western World have ~20mn customers currently, but that number is expected to grow exponentially in the next 5 years, as the Big 3 are on the verge of rolling out their international expansion plans into the US and other markets. Revolut, N26 and Monzo had a combined ~13mn customers in Q3 of 2019. UK-based Starling is on pace to have 1 million customers by the end of 2019, and a series of other neobanks across other global markets have 10s to 100s of thousands of customers currently.

Data Sources – Sifted & CBInsights

Interestingly, Europe is leading the charge within the industry, both from a growth and mindshare perspective.

“What kinds of lessons can US companies learn from European fintechs? To be honest, I think we are more advanced,” he tells Sifted …

“We are three/four years more advanced compared to US companies in terms of product, in terms of regulation, in terms of size. US companies should learn from Europe.”

Sifted with Revolut CEO Nikolay Storonksy

Nevertheless, all of the Big 3 challenger banks are expanding their footprint into North America in the months ahead and have the war chests, expertise and ambition to crack the code in the lucrative North American market in the coming years.

Venture capital investors have been far more excited about the European fintechs (with Oaknorth raising €783m, N26 raising €612m and Atom bank’s 486m, according to data from Dealroom) than their US equivalents such as Chime, Varo and Aspiration.

Europe is Beating the US in Fintech Innovation

Using search volume as a proxy in the UK market, the simple trend is that the old model of banking is crumbling – along with the brands of all the incumbents – and an entirely new set of banking players will emerge in the next decade.

Challenger banks have grown in search by 32% between Jan 2016 – Jan 2019, whereas traditional banks have seen a 22% decline in the same time. Revolut the most searched challenger bank between 2016 – 2018

PiDatametrics

Whether it is one of the Big 3 or some other combination of upstarts that launch in the next several years, the world needs a new set of banks to backstop both the people and the businesses in the new economy. That’s why the question of profitability and long-term sustainability of the business model becomes paramount.

The Big 3 – Bottom Line

While there are many intriguing and compelling challenger banks in the global landscape, we are going to keep the analysis to the Big 3 for now in order to get deeper data and insights based on what’s working, rather than broad trends and high-level data for the industry as a whole.

Revolut

  • Founder and CEO – Nikolay Storonsky (35)
  • Key Differentiator – product design focused on virality, most comprehensive Business Accounts
  • Brand Appeal – the biggest and the baddest, Revolut are the most innovative and the fastest to rollout new features
  • Most Recent Funding Round – raised $250mn at $1.7bn valuation in Q2 of 2018
  • Expansion Territories – Revolut is available across the European Economic Area (EEA), Switzerland, Singapore, and Australia, and has announced plans to enter Canada and the US soon

Financial Metrics of Success

Revolut also processes over $7 billion each month (Jan ’19) in transaction volumes, up from $4 billion per month in July 2018 tearsheet

N26

  • Founder and CEO – Valentin Stalf (33)
  • Key Differentiator – German-based and regulated, N26 has a unique brand and style that appeals to a certain subsector of the market
  • Brand Appeal – ‘Spaces’ sub-accounts are a unique way to save money and help N26 become more of a lifestyle brand in mobile banking
  • Most Recent Funding Round – raised $170mn at a $3.5bn valuation in Q3 of 2019
  • Expansion Territories – available in the EEA, Switzerland and just launched in the US Q3 2019

Financial Metrics of Success

Mr Stalf also said about 30 per cent of UK users had signed up for the bank’s premium account, which charges a £14.90 per month subscription fee and offers a metal debit card FT

Monzo

  • Founder and CEO – Tom Blomfield (34)
  • Key Differentiator – built a ‘cult-like’ customer base in the UK through multiple equity crowdfunding campaigns and branding
  • Brand Appeal – coral-pink Visa debit cards have curb appeal IRL
  • Most Recent Funding Round – raised $144mn at a $2.5bn valuation in Q2 2019
  • Expansion Territories – Monzo is currently only available to UK citizens, and is planning to launch in the US imminently

Financial Metrics of Success

The branchless bank is now making £4 on each customer it signs up to the platform, versus a £15 loss per customer last year CNBC

Bottom-Line Data

> Revolut had revenues of £12.8mn but lost £15.2mn for FY 2017

We see businesses operating at material scale where they have built the backbone of the business off recurring revenues” instead of traditional balance-sheet lending, said George Robson, who manages Revolut’s premium services. “We’ve seen it done in other sectors and believe it can be done” in financial services too.

FT

> There is no official P&L data for N26

“Our cost base is about one-fifth or one-sixth of the cost base of a traditional retail bank. Our revenues are also lower but overall we have better margins,” said Mr Stalf, adding that his long-term goal is to get between 30m and 70m customers.

FT

> Monzo lost £47.2mn in the year ended Feb 2019. Monzo has started offering loans to UK customers in Aug 2019 to boost revenues; profitability remains a ‘long-term goal’

The move into customer loans marks a major step in the company’s attempts to increase revenues and move toward sustainability.

FT

Based on the combination of the above, it’s hard to get a full read on what the challenger banks’ P&L will look like in 3-5 years. They all have huge investor interest at sky-high valuations, intriguing unit-economic numbers, but seem to be structured towards several more years of major annual losses in the name of growth. Based on available data, however, this is an intentional, long-term strategy to maintain a step ahead of the competition.

Regulatory Strategy

Given the explosive growth, the regulatory strategy of these companies will become paramount to future growth and profitability.

“Fifty-one percent of consumers trust a fintech more when it is regulated.”

Business Insider

Seeking a full banking license and launching a bank in a new country is costly, so many companies are opting for partnership or simply obtaining an electronic money license and offering a slimmed-down set of services.

Launching a fully-fledged bank in a new country takes £20m of capital

FT

Here is a snapshot of what they are doing as of Q3 2019.

Revolut

  • Obtained an EU banking license in Lithuania in December 2018 that would enable them to passport into other European countries in 2019 and protect customers under the European Deposit Insurance Scheme (EDIS)
  • Began the process of preparing for a UK Banking License in late 2018
  • Most recently, have sought approval from the Central Bank of Ireland for ‘electronic money license’ that would allow them to carry out payments across the European Economic Area. Ireland is its 4th biggest market with more than 310,000 customers
  • Expansion into markets like Australia is done using an ‘electronic money institution’ license

N26

  • Full EU Banking license, regulated by the German regulator BaFin, who took steps early this year to make N26 improve their AML and compliance practices, something that now requires them to file monthly updates
  • In the US they are working with Axos Bank as a launch partner; they will seek their own US Banking License once they have 1-2mn US Customers
  • Planning to launch in Brazil next year. Expansion model is currently unknown

Monzo

  • Monzo received their UK Banking License UK in April 2017
  • Similar to N26, they are partnering with US-based Sutton Bank for US launch and will eventually seek their own banking license as well

All three companies also seem to be on a hiring spree of seasoned, industry veterans as they expand and seek new licenses. Poaching top talent from incumbents is one other signal that the shift is underway, even amidst a complete lack of regulatory clarity for banking licenses in new markets.

Banking in The New Economy

The structure of the economy has shifted dramatically since the original banking business model was invented. We now live in a world where interest rates are at 5,000-year lows, personal debt is at never-before-seen highs, and the emergence of the digital economy is starting to become progressively more visible each and every year. This ‘new economy’ will cause a shift in many industries, including banking.

To help individuals in the new economy improve their personal finances requires a few key areas of focus:

  • Limits to a never-ending debt spiral for consumers to afford the basics in their lives
  • No hidden fees and banking business models that don’t consistently exploit information asymmetries to gouge customers
  • Integrated financial-planning tools to help customers visualize their spending and build plans for long-term savings and retirement

Adjacent fintech businesses in areas like small-business lending (OakNorth) and growth capital (Clearbanc) will develop simultaneously, helping businesses hire more people at high wages in growth industries. Those employees will thus have more money in the bank(s) of their choice, and hopefully this will create a vicious circle to the upside, spurring both savings and investment back into local economies.

New economy or not, however, the banking business model will still need to be profitable. While the majority of incumbent banks have clearly lost trust with the younger generation of customers, they have not lost mindshare with investors on many continents, as they continue to pour out record profits. And while the models being tested by challenger banks around ‘recurring revenues’ may prove to be effective, it’s hard to see how that model will scale across the banking sector globally. Lending will still be at the backbone of the banking business model long-term, and fees will be earned for certain services. Most importantly, customers will still need to trust whatever financial institution they deposit their money with and the regulators who backstop that institution.

Overall, it seems that the inception of the challenger banks, globally, is a real trend and an inflection point in the history of banking. Which companies get the largest slice of the pie and using which business model is largely tbd. But in any respect, consumers will be the biggest beneficiaries as the microscope on fees and pricing will force the industry to reshape itself for the new economy, permanently.

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