Will challenger banks lead the post-Covid recovery?
Neo banks were disproportionately impacted by the pandemic and saw usage drop by 90% at the beginning of lockdown - 30% more than traditional banks.
The differential impact was driven by the nature of the typical spend on a card from a challenger bank vs traditional bank. There was also a massive hit to revenues given the dependence on interchange income generated. But by the end of 2020 the tide seemed to have turned. Leading challenger Starling became the first to turn a profit, Revolut broke even and funding was back on the table. But there was a clear shift with European B2B fintechs raising €5bn last year, compared with €3.1bn for B2C firms.
By building trust with customers, focusing on sustainability, and expanding their consumer offerings, challenger banks will be able to acquire customers but what impact will this have on the economy? Could the development of business offerings (and particularly those focused on SMEs) and new sources of funding help kickstart the economy?
Trust issues
The biggest issue that has always faced challenger banks has been consumer trust. In a market that equates trust with financial security, and financial security with reliability, challengers have struggled. Around a fifth of the UK public perceive challenger banks as less reliable than traditional banks. This trust was exasperated during the pandemic when Monzo customers were locked out of their accounts during lockdown.
For challenger banks to continue to grow and play a major role in the economic recovery, they need to start making inroads on this trust deficit. We have already started to see some challenger banks invest in building trust with consumers. Revolut implemented a donate function to their application at the start of the pandemic, offering a lifeline to local businesses. This move helped enforce the message that these banks are invested in their communities and are here to stay. Starling on the other hand played a key role in providing access to the government sponsored Business Bounce Back Loan Scheme (BBLS) to thousands of SMEs. Providing this support in a time of great need has helped put a different complexion on Starling’s brand for its users.
New product offerings
Consumers still rely on traditional banks for mortgages and loans – the real revenue generating products that banks offer. Challenger banks are still largely used to pay for smaller items of discretionary spending, such as meals out, travel, money transfer, and general consumer spending. Creating new innovative products that are actually tailored to consumer and SME needs will help make challenger banks more attractive to users as we ease out of lockdown and enhance the uptake of financial products to hasten the economic recovery.
New businesses are being forged from the seismic changes that the pandemic has had on the world. These businesses will be agile, and they will need a financial services partner that can match their own innovation and pace. Challenger banks are better placed to facilitate these rapidly changing business needs, kick starting the economy as a whole.
Focus on sustainability
Green finance will be top of the agenda throughout the Covid recovery. The UK government is promising a green recovery initiative to ‘Build Back Better’. UK-based challenger banks have also seized the initiative, showing how ESG banking can be done effectively. Eco friendly challenger Triodos hit their milestone of £1bn in sustainable lending last year, whilst maintaining their steady profitable presence in the UK after 25 years.
Both political and demographic tailwinds are encouraging challenger banks to go down this route. Millennials and Gen Z are the primary users of challenger banks and this group is especially concerned about sustainability issues. A focus on ESG banking as a USP can further proliferate challenger banks, allowing them to thrive post pandemic.
New sources of funding
Leading challenger banks around the world have accounted for a large number of the tech unicorns that have been minted in recent years, but these businesses are either barely break even or are still deeply loss-making. This lack of profitability in combination with high valuations is prohibitive to any potential acquisitions by incumbent banks. This had led to increasing unease around the ultimate path to liquidity for shareholders of these businesses.
However, challenger banks are now increasingly looking to go public through SPAC (Special Purpose Acquisition Company) transactions. This has recently been demonstrated by MoneyLion, a leading US-based challenger bank’s transaction with Fusion Acquisition Corp, valuing the company at over US$2.4bn. Whilst only a limited amount of liquidity was taken by existing shareholders initially, it will provide a public market route to liquidity for existing shareholders.
It is anticipated that this is only the first of a number of SPAC transactions involving challenger banks that are likely to take place over the next two years. SPAC deal activity ramped up in 2020 with 248 transactions raising £83bn in gross proceeds – all of this capital looking for a transaction to be deployed in. SPACs offer a time-efficient and regulatory-light way to go public and raise further funding as needed. Various FinTechs have recently chosen a SPAC as their way to go public, including MoneyLion, PaySafe and Sofi.
Looking forward
Time and time again we’ve seen challenger banks adapt and innovate quicker than their traditional counterparts and surge into new markets. With increased consumer spending on the horizon, a sustainable agenda, and a long-term plan to build highly tailored customer propositions, they can thrive in a post-pandemic world. There will however be one major change in approach from years past; that they will need to have a focus on profitability and become sustainable businesses in their own right.
But they cannot do it alone. They will also need to convince consumers and businesses to join them on that drive – taking up their offerings and paying for the products offered.
