Challenger banking: new horses, same race?

Rebecca Burns-Callander
Principal OP Author

To say that Britain’s modern banking revolution has been a long time coming is something of an understatement. Over the past century, there have been pockets of innovation across various areas of the banking ecosystem, but it is only during the last decade that change has been sustained and significant.

A raft of new players — almost 80 worldwide, according to industry publication Banking Technology — are now driving the sector forward, pioneering new business models and routes to market, and attracting market share from the incumbents. According to research published last year by financial service giant PwC, 15 challengers have launched in the UK over the past three years alone.

However, Britain’s ‘big six’ banks — Barclays, HSBC, Lloyds, RBS, Nationwide and Santander — still hold an estimated 80pc of the UK retail banking market. This market dominance has been achieved through decades of market consolidation: between 1960 and 2010, 26 of the 32 banks operating in the UK were absorbed into these organisations.

This week, we speak to some of the start-ups that are hoping to eat their lunch.

Can the new players make a serious dent in the market? Is that, in fact, their aim? In what ways could these challengers change the way we bank forever?

We will also look at the barriers to progress. Financial services is an industry that has long been resistant to change, partly because it is heavily regulated, and partly because consumers are naturally more conservative when it comes to their money. The twin drivers of consumer demand and political lever-pulling may have helped spur the banking revolution but are they enough to fundamentally change the system for good?

The ultimate hub for your financial life

Imagine an app on your phone where you could manage every aspect of your financial wellbeing, from savings to bills, investments to currency exchange. Many of the new players are taking aim at this, the Holy Grail of “financial wellbeing” — your whole relationship with money. They have cottoned on to the fact that creating a current account opens up a world of customer data, which allows them to offer customers unrivalled financial information and access to tailored products. Many of the new entrants to the current account space aren’t seeking to change the fundamental plumbing behind the banking system but are instead building modern and exciting new customer interfaces, which feel like a new approach to banking.

Monzo, previously Mondo, which was founded in 2015 by Tom Blomfield, has 600,000 current account customers on its the app. The start-up is shortly planning to roll out a cornucopia of financial services, building on this current account relationship. “We are building a hub for your money, where you can visualise every aspect of your finances,” Blomfield explains.

“We want to automatically take care of all your financial admin. For example, if you move house and need to pay council tax in your new borough, Monzo will take care of that. If you sign up for a new gas supplier and a few months later they hike their rates, we’ll be able to take care of moving you to a new supplier. By 2030, Monzo will be a control centre where you can take care of all of that.”

Imagine an app on your phone where you could manage every aspect of your financial wellbeing, from savings to bills, investments to currency exchange. Many of the new players are taking aim at this, the Holy Grail of 'financial wellbeing' — your whole relationship with money.

He is not alone in this approach. Sam O’Connor, founder of Coconut, the banking concept aimed at freelancers and the self-employed, is also looking at the ‘hub’ model. “The current account can be a really rich source of data that enables so much more than just storing value or making and receiving transactions,’ he says, adding that Coconut plans to leverage the power of that information to “become a platform”.

Coconut offers customers a basic bank account, but layers accounting and cashflow management tools over the top, helping freelancers to manage their finances more efficiently and comply with HMRC rules at the same time.

“Our customers are different from normal SMEs,” he explains. “There’s an intersection of business and personal life. For the business, there’s tax, accounting, cashflow management and then on the personal side, you may want a loan or a mortgage and your approval will be linked to the performance of your business.” Coconut allows all this information to be stored in a single repository and could help customers access financial products more efficiently as a result, he explains. Given that 90pc of the 5.7m active SMEs in the UK fall into the “personal business” bracket — i.e owner managers, this is not a niche market. “And there are 55m self-employed in the US,” adds O’Connor, who wants to take Coconut worldwide. “It’s a worldwide phenomenon.”

At Tide, the banking startup aimed at the small business market, founder George Bevis has also embraced the hub model. “The fundamental philosophy behind Tide is that banking shouldn’t be about banking,” he says. “Historically, small business bank accounts have all been identical to consumer bank accounts but there is an opportunity to be helpful to SMEs beyond this. We help to remove their admin burden, make sure they get paid and help with accounting and — in future — cashflow.” Tide pulls in third-party services to offer customers access to loans and other financial products — the same model that Monzo plans to launch in the consumer space.

A group effort

In the consumer space, UK rivals Revolut, Atom Bank, Starling and Tandem Bank are also making waves. Revolut recently became the first of the challengers to achieve unicorn status (a billion-dollar valuation). Many of the founders behind these companies deny they are in competition with each other, and claim they are all vying to steal market share from the dominant players. “Barclays, Lloyds, RBS, HSBC and Santander hold the market share,” says Monzo’s Blomfield. “Every customer who comes to us comes from one of those banks. I don’t feel like we’re in competition with each other, I think we’re in competition with [the likes of] RBS.”

Change has been accelerated by regulatory changes, such as Open Banking and PSD2 (we will return to the topic of regulation in-depth later in the series).

However, there seems little doubt that only one or two players can survive using a hub model. Three-quarters of UK consumers only have a single bank account. The network effect will help to determine the winner, as consumers move towards the brand most trusted by their peers.

There is another possible scenario, however: that another player will move into this market, and supplant all these challengers in one fell swoop. If a major tech titan — Google, Amazon or even Paypal — made a play for banking, it could be a game-changer. The combined clout of brand awareness, consumer trust, and the capital reserves maintained by such companies represent significant firepower. We will return to this theory later in the series, and debate the likelihood of a “Google Bank” by 2030.

The specialist model

As well as the mass-market plays, there are many specialist banks that were created to service small but lucrative sections of the market. These banks will never become a ‘big six’ bank, nor do they want to: they are simply nibbling away at the edges.

Lord Adair Turner, former chairman of the Financial Services Authority, is now adviser to OakNorth, a new bank that provides debt finance to fast-growing firms. He believes that by 2030 the incumbents will still have the majority of their market share but that there will be a handful of successful challengers, who focus on a specific banking product and do it better than the high street banks. OakNorth doesn’t offer current accounts; it is highly specialised. “OakNorth is illustrating that if you keep your business model very simple, you can have a stunningly low income cost ratio,” Lord Turner says. “You can build systems that turn the business of banking into a computer. Oaknorth raises term deposits from individuals over the internet, keeps its banking systems in the cloud, and uses state-of-the-art technology to keep costs incredibly low.” Among the specialist banks operating in the UK are: Aldermore; Shawbrook; and Paragon.

“My gut feel is that there will be more and more Oaknorths picking off a particular bit of the product proposition,” says Lord Turner.

“Big banks are sitting on natural advantages: ubiquity; brand reassurance; the ability to gather information on the customer, which gives better insight into credit worthiness and liabilities; and the current account as an anchor product. But they are struggling with the fact that they have legacy systems that bog them down with cost, which makes them less effective. My guess is that in 15 years, in small business and consumer, the market share of the big five will have fallen but they will still be dominant. If it’s 95pc today, it’ll be 85pc — but not 50pc. They will still be dominant.

As well as the mass-market plays, there are many specialist banks that were created to service small but lucrative sections of the market. These banks will never become a ‘big six’ bank, nor do they want to: they are simply nibbling away at the edges.

There are countless niches within banking that require specialist attention and Alex Letts, founder of U Account, believes that there will be hundreds of flavours of specialist bank by 2030. He has aimed his start-up resolutely at the “underbanked”, he explains. “My customers fall into two camps,” he says. “The majority have a standard bank account but, because of their poor credit record, the bank won’t give them an overdraft yet they get access to unauthorised borrowing, which results in fines and huge fees. These customers want to get away from these current accounts because they don’t have the discipline not to get overdrawn, so they come to us to save money. Other people have access to a basic bank account, which gives them a debit card and access to basic banking, nothing else. The banks cant monetise these people at all, so they get a s**t service until they leave.” Letts believes that, unlike the “hub” theory, the banking industry will continue to break into fragments, but that the incumbents will still maintain a stranglehold on the market. “Anyone who tells you that a challenger will replace RBS or Barclays is a dreamer,” he says. “We are all creating new operating models and platforms and ways of working that will either be successful in their niches, or the big banks will buy them out.

“The banks will think, I’ll have a Monzo for our hipster companies and a Monese for immigrant customers, and a U Account for the underbanked, and they will have a whole portfolio of brands that sit behind their firewall.”

Pressing their advantage

Innovation is not limited to new players: the incumbents are making bold plays of their own. Lest we forget that high street stalwart HSBC kick-started the current era of innovation by launching First Direct, the first telephone banking service, back in 1989. Right now, HSBC is reportedly experimenting with using blockchain in live transactions, while RBS has introducing a ‘freeze your card’ option — the same feature introduced by Monzo just months before — to help customers combat fraudsters.

Banks have very deep pockets and they are not afraid to spend big to win the war for the current account. After all, once you own the repository for a customer’s salary, you can start offering debt and credit products, and that person becomes a small but profitable little cashcow, well worth the cost of a free current account. Some banks are flexing these financial muscles by buying innovative young fintech firms. According to CB Insights’ research, the largest US banks have acquired 18 fintech startups since 2013; a small number but deal volumes are accelerating, the report said. Separate research from KPMG found that UK fintechs attracted $4.2bn total investment in 2017, up from $0.7bn the previous year.

Later in this series, we will further explore how the issues of trust, data, and consumer apathy affect the industry’s speed of evolution. However, Conrad Ford, founder of Funding Options, the online marketplace for SME funding, comments: “I think that the timeframes in which things will change are overstated.

“There’s a common preconception that banks are dinosaurs and fintech start-ups will come and take over. We underestimate the power of these brands. We may not love them but we know them.

“I once heard a top VC say, ‘Every investment we’ve ever made, whatever the sector, comes down to whether the incumbent can innovate faster than the start-up can acquire customers.’ Can banks adapt to the digital world faster than fintech player can acquire customers? At the moment, the banks are winning because of the staggering size of their customer bases. The fintech players still have tiny market share and banks aren’t asleep at the wheel.”

The challenge of legacy technology

While many banking start-ups have focused on changing customers’ experience of banking, some are seeking to rebuild the foundations of the system itself. Antony Jenkins, former chief executive of Barclays turned start-up founder, is at the helm of 10x, a new banking technology play that means to do away with the legacy systems on which UK banks rely and sell a new, bold infrastructure back to the incumbents.

He explains: “Financial services is an industry entirely driven by data. But, traditionally, financial firms have handled data very badly. In a bank, there are 4,000 to 5,000 applications for delivering a service, and the system is designed around the product rather than the customer. At 10X, we’ve gone back to first principles to build a platform that starts with the customer and uses modern technologies to deliver a banking experience that’s 10x better than what we have today: much cheaper, fairer and better for society.”

Jenkins and his team are creating a new platform, on which new products can be easily created and launched, without messing around with existing legacy technology. Lest we forget that the systems operated by today’s high street banks are still run using Cobol, the vintage programming language first designed in the 1960s.

10X is building the “hub” envisioned by Monzo’s Blomfield — but they are planning to sell it back to the market leaders. “Our solution will be like the app you use on your phone. It will be like your Mail or Outlook app, managing multiple accounts and calendars, in a way that makes the consumer feel in control of their finances.”

The man on the street may not have heard of payments processing company, but over the last six years, the fast-growing company has been quietly winning business from the likes of Samsung, Virgin, TransferWise and Adidas. The company allows its customers to take cross-border payments quickly and easily, and has built its own proprietary systems for doing so. Its rivals are the likes of WorldPay and PayPal yet Checkout — despite its low profile — is growing 50pc year-on-year.

According to chief executive Guillaume Pousaz, the business is now launching a marketplace model, which muscles into banking territory even further. The regulated marketplace will allow customers to process all their payments on

Pousaz claims that the incumbent banks could see their market share eroded as a result. “Transferwise is eating Barclays breakfast, I’m eating their lunch, and Revolute is eating their dinner,” he says. “The banks need to rethink their operational model, their service model. Barclays is smart and innovative but they come from a legacy base so have far more innovating to do than, say, us.”

He echoes the view that the banks will survive this period of transition, however. “In financial services, there is enough food on the table for everybody,” he adds. “If there wasn’t, the regulator would soon clamp down [on the monopoly]. So there will always be a huge number of players in this industry. By 2030, there will be a few fintech that have achieved the same global standard as the banks… but today’s banks will still be around.”