Challenging Banks

Revolut, Monzo, Starling… just a few of the digital challenger banks that are becoming household names in the UK. I opened an account with a digital bank in 2018 for the commission-free travel perks, and now I use it for almost all transactions at home and abroad. It has become a ubiquitous part of my day and I rarely leave the house without it. Then at the end of the month I find myself consumed with buyers’ regret as I look at my spending summary on the mobile app.

And I may not be not alone. An estimated 13 million people are registered with a digital challenger bank in Europe. These overly-chipper, luminescent digital banks have ambitions to become serious contenders in the UK’s banking landscape. Monzo – the one of largest digital banks – reported 3 million UK customers in September 2019, a fivefold increase in their customer base compared to February 2018[1].

This is a big deal for the UK banking sector. For decades the UK has been dominated by a handful of powerful banks - Barclays, Lloyds, HSBC and RBS - who in 2014 accounted for over 77% of the current account market -  and rather unimaginatively are known as the Big Four[2]. Market concentration in the retail banking sector varies internationally. In the US and Japan, the three largest banks make up 20% and 24% of the of the banking industry, respectively. While in in Nordic countries bank concentration for the largest trio is over 85%[3]. The UK has become fertile ground for a nascent but promising FinTech sector with a regulatory landscape encouraging new players into the retail banking market.

The ‘sudden’ rise of challenger banks isn’t so sudden at all. Years of policy development and regulatory change in the wake of the 2008 financial crisis have made it much easier to set up a bank. In 2013 the Bank of England (BoE) made the process of gaining a banking license much simpler and lowered the capital requirements for new entrants. Twenty-one new start-up banks have been authorised by the BoE between 2010 and June 2019[4]. In fact, this month marks the 2 year anniversary of ‘open banking’, the UK regulation that brought great promise of innovation and competition to the retail banking sector. Open banking allows consumers to securely transfer their financial data across banks and financial institutions. EU directives such as Payments Service Directive 2 (PSD2) have enabled this integration across borders. PwC estimate open banking will create £7.2billion in revenue opportunity by 2022[5]. Although it remains to be seen whether these regulations have done enough to induce real competition, digital banks have been growing annually in number and in size.

It seems digital banks are tapping into something else: an appetite of tech-savvy young adults for a new, simpler approach to money management and financial literacy. A recent Kearney survey found that 1 in 3 millennials  consider their primary bank account to be with a challenger bank, much higher than the UK average[6]. The same survey found that these banks are primarily used for every day transactions, holidays and eating out.

Financial literacy itself is not a generational issue. A study by UCL’s Institute of Education showed that adults in England and Northern Ireland perform worse on everyday financial numeracy tasks than adults in many other developed countries - even when using a calculator.[7] Digital banks have been successful in streamlining otherwise very confusing information that individuals would like to know but perhaps don’t have the time or the wherewithal to figure out. It’s a feature that until recently many of the popular high street banks did not offer on their mobile apps.

The sceptic in me wonders if the success of digital banks is ‘too good to be true’. Beneath the glossy allure of fun, user-friendly mobile apps and very responsive customer service these digital banks don’t look as healthy. Annual report figures show in 2018 most of these banks have made consistent losses. For Atom Bank losses increased in 2018 to £80 million compared with over £50 million in 2017. So far, only Starling Bank have publicly forecast their first annual profit to take place in 2021[8]. And then there are the added worries about the toxic culture of these banks and rumours of fraud and poor compliance practises[9].

Bank of England annual stress tests often don’t include these digital challenger banks. However, a confidential stress test carried out by the Bank’s regulator for 20 challenger banks showed overly simplistic, perhaps even naïve,  models for risk management[10]. Reaffirming worries that these banks cannot withstand extreme macroeconomic distress. Notably, Northern Rock made up a rather small fraction of the UK banking sector but contributed to 19% of net mortgage lending in the UK in the first six months of 2007, making it the largest mortgage lender in the country and the first UK bank to be victim of a bank run in 150 years.

Challenger banks may not cause the next financial crisis, but it is a reminder that small organisations can become a significant part of the banking ecosystem.

This article is based on episode 1 of All About The Money for the BBC.

References

[1] https://monzo.com/blog/2019/09/16/three-million

[2] https://www.gov.uk/government/news/personal-current-accounts-and-small-business-banking-not-working-well-for-customers

[3] https://www.nber.org/papers/w9921.pdf

[4] https://www.bankofengland.co.uk/freedom-of-information/2019/new-uk-start-up-banks-authorised-since-2010-as-at-1-june-2019

[5] https://www.pwc.co.uk/industries/financial-services/insights/seize-open-banking-opportunity.html

[6] https://www.kearney.com/financial-services/article?/a/how-convenience-innovation-and-trust-will-shape-tomorrows-banking

[7] https://www.ucl.ac.uk/ioe/news/2018/mar/england-has-one-lowest-levels-financial-literacy-study-says

[8] https://www.ft.com/content/9e004184-e68d-11e9-b112-9624ec9edc59

[9] https://www.telegraph.co.uk/technology/2019/02/28/revolut-failed-block-suspicious-transactions/

[10] https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/letter/2019/review-and-findings-fast-growing-firms.pdf?la=en&hash=6ED2DD2AD9D002AAE5C988029D3CC3898D42A61D