Banking on challenges and opportunities

Traditional banks up their tech game as challenger and neobank disruption intensifies
by Tim Cooper

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Key terms

Challenger banks tend to process most of their savings business online.

Neobanks do both their savings and lending operations exclusively online.

EU Payment Services Directive aims to improve security, reduce fraud and open up payment markets to new entrants. It requires banks to open their data to regulated third parties via application programming interfaces.

Open banking
allows challenger and neobanks and other fintech companies to access banks’ data to benefit customers and remove competitive barriers.

UK Open Banking regulations represent the country’s implementation of PSD2. It requires the biggest banks to use a common standard for this, making it easier for third parties to access data and provide reliable service to customers.

Challenger banks and neobanks are digital providers that aim to compete directly with traditional banks by improving customer experience, for example, in mobile banking or point-of-sale credit. Through tools such as artificial intelligence (AI), which allows for greater personalisation of products and services, these challengers benefit from changing customer needs and the rapid digitalisation of society in general.

A report from PwC on the UK banking market titled Who are you calling a ‘challenger’? divides challenger banks into four broad groups: mid-sized full-service banks (such as the Co-operative Bank), specialist banks (such as Shawbrook), non-bank brands (such as Sainsbury’s Bank), and digital-only banks (such as Monzo). But, says the report, the label ‘challenger bank’ isn’t necessarily helpful because their “distinctive offerings mean they do not need to compete directly with the main high street banks to succeed”.

And they are succeeding, with the global neo and challenger bank market predicted to grow to US$280bn between 2022 and 2028 at a compound annual growth rate of 46.5%, according to market research firm Facts & Factors. The report says that in 2021, North America dominated the global neo and challenger bank market, but penetration of digital banking is widespread throughout the globe, with Asia-Pacific “predicted to experience the fastest growth rate in the near future”, boosted by “easy and convenient banking services and the expansion of digital-only banks in nations like Australia, Japan, China, and India”.

Impact of open banking

Open banking regulations, such as the EU’s Payment Services Directive (PSD2), Open Banking in the UK (see Review article that describes its development), and Brazil’s Open Banking Initiative, have accelerated the disruption.

The implementation of open banking, particularly the well-known PSD2, has supported rapid growth of challenger banks in Europe, with the UK, France and Germany among the leaders, according to research published in January 2022 by education provider CFTE Fintech Unicorns. In contrast, the necessary regulatory changes are coming slowly in the US, it says.
The implementation of open banking has supported rapid growth of challenger banks in Europe

The move to open banking in the US and in other countries – such as India and Singapore – has been led by the market rather than regulators. This means financial institutions have recognised the commercial potential of API-based collaboration with third parties and created their own rules and infrastructure.

Meanwhile, traditional bank branches halved in the UK in the six years to 2021, according to consumer choice body Which? And in the US, 9% of branches – 7,425 in total – closed between 2017 and 2021, with more than half of those – 4,000 – closing since March 2020 as a result of the Covid-19 pandemic, according to the National Community Reinvestment Coalition, a grassroots association.

While its bricks and mortar branches are rapidly closing, the US has the highest number of ‘top challenger banks by market capitalisation’, according to the CFTE research. The list shows seven top challenger banks from the US, six from the UK, two from China, and one each from Argentina, Brazil, Georgia, Germany, and Russia.

However, Brazil’s Nubank is the most successful challenger bank, with US$41.5bn market capitalisation, according to CFTE.

Trust driver

Traditional banks have struggled to offer a good digital experience due to legacy IT systems and a lack of experience in innovation (see article on ‘the opportunities and threats of digitalisation’). Customer experience has suffered because of cost-cutting exercises. In contrast, challenger and neobanks have built their infrastructure from scratch, with no legacy systems, making them more agile and user-led.

But the market faces another challenge with the move over the past decade of technology giants such as Google and Apple into financial services. Apple Pay and Google Pay have helped these tech giants to monetise the powerful customer data they hold, disintermediating banks.

A 2021 report from the pan-European challenger bank N26 and Accenture, based on an Accenture global study surveying nearly 50,000 respondents across 28 markets, shows that Brazil has the highest level of trust in digital banking, with 78% of digital-only bank customers saying they trust digital banks with their data, followed by Ireland and the US (68% each).

In other countries, trust in traditional banks is higher, and incumbents have maintained more market share to date, with 83.2% of consumers favouring traditional over challenger or neobanks, according to an EY survey, published in October 2021, of 12,000 consumers in developed and emerging markets. For example, more than three-quarters of consumers in the UK, France and Germany say that their main financial relationship is with a traditional bank, and 8% say that a neobank is their primary bank.

Traditional banks in the UK are responding to this by upping their digital game. A survey by fintech platform Yobota of more than 250 UK banking and financial services firms shows that 60% have launched digital products over the past 12 months.

According to the survey, investment priorities in 2022 include eco-conscious tools (69%), banking-as-a-service (BaaS) solutions (58%) and embedded finance products (44%).

Embedded finance and banking as a service

Embedded finance involves a non-financial business integrating money services – such as lending or payment processing – into their offering. For example, a shop could offer point-of-service credit, including through increasingly popular buy now pay later (BNPL) services, for goods sold in-store.

This eases access to services for customers. Previously, consumers may have had to apply for such credit in a bank branch.

Between 2022 and 2029, the global embedded finance sector is expected to show a compound annual growth rate of 24% to reach a value of US$776bn from US$241bn, according to a study from ResearchandMarkets.com.

To meet this demand, financial institutions are increasingly offering BaaS. These are bundled offerings, often white-labelled or co-branded, that nonbanks can use to provide banking-related services to customers.

Yobota’s research suggests that, rather than a threat, BaaS is a “fantastic opportunity” for traditional banks to reach more customers by teaming up with non-financials. This can help them reinvent their services and better meet end-users’ needs.

Democratising finance

Disruptive technology can do more than improve user experience. It can foster financial inclusion too. Fully digital services provide a quality product for less and make banking available to more people.

From Vietnam to Columbia and the UK, technologies such as open banking are helping millions of people access financial services, according to a 2021 report by Serasa Experian. The report claims that in the UK, Experian’s data has cut the number of people who find it hard to get credit because they are invisible to the system by 620,000 in two and a half years. In Indonesia, it has helped 180 million people obtain a credit profile for the first time “by leveraging data from their mobile phone use”, and in Colombia, its alternative data has helped 45,000 people on low incomes build their credit history to access mortgages and government subsidies, it says.

Covid-19 has accelerated the democratising power of digital financial services such as challenger banks and neo banks, particularly in developing economies, according to the World Bank’s Global Findex Database 2021. It shows that around 40% of adults in developing economies (excluding China) who’ve made a digital payment using a card, phone, or the internet, did so for the first time after the pandemic began.

Who will win and lose?

Alexander Weber, chief growth officer at N26, says digital banks are able to react quickly to market changes and are more customer-centric.

“Technology makes it possible to deliver a more relevant, personalised experience and support customers’ decisions,” he says. “In contrast, some traditional institutions' digital experiences are still slow and frustrating, causing dysfunctional relationships.”

However, Sanjiv Somani, managing director and CEO at Chase in the UK, which acquired digital wealth manager Nutmeg in June 2021, says that winners and losers cannot be simply categorised into new and old players. Some new firms may struggle to attract enough customers to become profitable, while some traditional banks are already launching competitive digital offerings but have the high cost of maintaining a legacy branch network. Winners will be those that serve customers best, he adds.

"We will reach an inflexion point when businesses fail because they don’t realise that those kinds of trends are converging" JPMorgan Chase, which operates in over 60 countries and has 58 million digitally active users, says in a press release that it is investing US$12bn per year in technologies such as AI and blockchain. It argues that cutting-edge technology is one thing, but you also need a “critical mass of loyal customers, and enough scale to fine-tune best-in-class products”.

Commenting on the UK high street retail sector, Sanjiv says: “There are a number of retailers that have been around a long time and are the darlings of the UK high street, while others went bankrupt. That comes down to knowing and serving customer needs. But banking has high fixed costs because it is heavily regulated. So, you need a minimum scale too.” Sanjiv adds that the next three years will define the shape of the new market.

“People used to change their partners more often than they changed their bank accounts,” he says. “But as more younger people accrue money, that will shift the market towards digitalisation and customers’ need for speed and easy-to-use interfaces. We will reach an inflexion point when businesses fail because they don’t realise that those kinds of trends are converging. It’s like boiling a frog that doesn’t realise it’s too late to hop out.”
Challenges

Holvi Payment Services, based in Finland, is a pan-European digital financial service for small businesses. Its co-founder and CEO, Tuomas Toivonen, says: “The decades-long bull market in technology has ended. Fintech companies no longer value growth at any price, but frugality and revenue growth.”

Despite this, digital transformation will continue to accelerate, says Tuomas. A growing number of banks will experiment and expand towards a more open, collaborative platform approach. Some may try to enter the race for the next lifestyle ‘super app’, offering everything from financial services to transport, shopping and gaming. Others may try to use their open banking connectivity and focus on selected services to drive growth of embedded finance.

“Banks will accelerate end-to-end digitalisation, which may include initiatives such as the implementation of ewallets, and use of customer data and analytics, for example, to offer services to customers with short credit histories. The easier the service is to use, the better."

Both traditional and neobanks are affected by inflation, rising interest rates, slowing economies, and decreasing trading valuations. Both will be forced to adapt strategies by, for example, diversifying revenue streams and providing better value to users as they become more cost-conscious, says Maurizio Raffone, chief financial officer at Credify, a Singapore-headquartered embedded finance platform.

During difficult economic conditions, retail and corporate clients will want banks that have the financial capacity to support them, Maurizio says. That requires an ample variety of products and a strong balance sheet. But many challenger and neobanks have neither, he says.

Banking licences

Obtaining a banking licence can be a long and complicated process. The Bank of England (BoE) recommends that firms develop a robustly tested proposition that includes consideration of inherent risks.

The BoE outlines the stages and provides further details of the UK’s banking licence authorisation process, including an optional pre-application stage comprising three meetings (initial, feedback, and challenge meetings); an application stage in which the PRA and FCA decide whether to grant new bank authorisation; and another optional stage called ‘mobilisation’, in which the new bank “operates with deposit restrictions while they complete their set up before starting to trade fully”.

In the US, applicants for federal banking licences need to provide detailed information, including biographical and financial information for relevant stakeholders (such as shareholders), their compliance and risk management records, the business plan, articles of association and bylaws, according to Thomson Reuters Practical Law. They will also need to apply to the Federal Deposit Insurance Corporation (FDIC).

A banking licence gives protection and safety to your customers. Not only do they know your organisation has met a strict set of government regulations, but the licence also provides financial protection.

In the UK, for example, banking licences provide customers with up to £85,000 protection under the Financial Services Compensation Scheme. In the US, the FDIC protects up to US$250,000, and in Europe, the European Directive for Depositor Protection protects up to €100,000 per customer.  

Emoney deposits do not generally get the same protection, although, in the UK, they must be safeguarded so it can be reclaimed in the event of bankruptcy.

Alexander says a full licence gives customers the best of both worlds: the innovation of a digital pioneer with the credibility of a bank.

Survival of the fittest

Digital transformation is well underway in the banking market, but much business is still up for grabs. Even though financial conditions are tighter, more disruptors will likely enter the market, and more traditional banks will up their investment in digitalisation.

Many will fail as the sector grows more competitive. Banks with a strong product and sound business model will have an edge, but those with the best tailoring and user experiences are most likely to come out on top.

Seen a blog, news story or discussion online that you think might interest CISI members? Email fred.heritage@wardour.co.uk.
Published: 03 Nov 2022
Categories:
  • Fintech
  • International regulation
  • Corporate finance
Tags:
  • open finance
  • Open Banking
  • financial inclusion
  • digitalisation
  • digital banks
  • challenger banks

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