Finding a Business Model for Challenger Banks
Updated: Feb 18, 2019
Source of quote: ‘Very questionable models’: The cofounder of a fintech startup addresses the elephant in the room http://uk.businessinsider.com/currency-clouds-stephen-lemon-questions-fintech-business-models-2016-6
Challenger banks are a fascinating bunch. As varied as they are — Monzo, Atom, Tandem, Starling and other UK market newcomers — they have one thing in common: obsession with amazing customer experience, customer-centric propositions and fee transparency.
I love these amazing propositions as much as anyone — however, I had a chance to work on a project with one of the UK challenger banks recently which included deep diving on a business model for one of the considered products in the bank’s pipeline.
The project (along with Stephen Lemon’s quote — even though I don’t think he was addressing the challenger banks at all) got me thinking about what comes next after the amazing customer experience and value propositions? Will the challengers be able to sustain these experiences under financing and profitability pressures?
The Usual Suspects (source: https://letstalkpayments.com)
Consider the following example — Monzo is trying to make itself useful for traveling card holders as it informs on its blog:
“At Mondo [sic], we love to travel and hate to play games with our banks while we are away. You’ll be pleased to hear we don’t charge any fees for using your card abroad, neither at points of sale nor at ATMs. 🎉…We pass the MasterCard exchange rate directly onto you”1
Or another one — Atom Bank has recently (February 2017) announced the best fixed term saving accounts proposition in the market which “annihilates” the rest of the competition as reported by This Is Money:
Put-upon British savers have been thrown a lifeline with the surprise launch of a one-year account paying 2 per cent today…Beating the current top-paying one-year bond by 0.4 percentage points, Atom Bank has sent ripples through the savings market and provided an account which currently beats inflation.2
We see similar amazing customer value deals emerge across challengers. What’s next for the challengers then from a business model perspective?
Case In Point: A Failed ‘Challenger’ Bank in CEE
A graphic example of business model failure: Zuno is (or rather was) an all-digital bank that was launched in Central Europe (Slovakia and Czech Republic) back in 2010 as a project of Raiffeisen Bank International.
I admit that the comparison to current UK challengers is a bit stretched.
After all, these are different markets and admittedly Zuno was not up to par in level of innovation and customer centric approach as its UK peers are (in the end, Zuno was an outpost of an incumbent bank).
Some of Zuno’s assets: mobile application, premium credit and debit cards (source: www.zuno.sk)
Before disregarding my comparison, consider the many similarities between Zuno and its UK counterparts:
“Less bank, more life” was to be Zuno’s main tagline; reflecting its desired appeal to a young, dynamic and active population
Main propositions at launch were “customer transparency, online finance management, free current accounts and favourable saving rates”
Purely digital distribution (web & mobile) with no bank branches
266,000 KYC-ed clients in Czech Republic and Slovakia 200 employees as of March 2016
Approximately 800 million euros in deposits and 80 million in loans
Ultimately, Zuno did not achieve profitability and in total lost approximately 130 million euros over its lifetime. Eventually, Zuno was shut down:, its banking license voluntarily revoked and its customer assets transferred to other banks within the Raiffeisen Group.
What is the main takeaway from Zuno’s failure? It is not rooted in a market maturity issue or misalignment of the value proposition (in fact, the 266,000 accounts in Zuno’s markets would translate to somewhere around 1.1 million accounts in the United Kingdom).
The failure was purely on the business model side and inability to monetize its customer base on the credit side. As Zuno’s CEO at the time pointed out, the only mistake [they made] was that the bank had not started building its credit product portfolio from the get-go, which, in turn, led to their inability to generate revenues in a low interest rate environment.6
Simply put, the business model grounding of the bank’s market operation was amiss.
Challenger Banks Are In Customer/Deposit Acquisition Phase
I would wager all challengers are in a net loss-generating phase of their existence. They make big positioning and product bets to scale their customer and deposit bases which will be monetized in the mid- to long-term timeframe.
On one hand, this is nothing unfamiliar in the startup universum. Snap, for example, has recently reported in its IPO filing losses of $514.6 million in 2016 and “may never achieve or maintain profitability”.
For various reasons I don’t think the challenger banks will be able to afford such liberty with their bottom-line results. The question then remains — how will challengers banks generate enough money to satisfy venture capital expectations, cover their operating costs and create meaningful profit?
Early Monetization Is Materializing
In the short term, the evidence of this can be seen with one of the earliest market entrants to the neo-bank space, Berlin-based N26. The now fully licensed bank has moved on from its previous modus operandi with Wirecard and free of charge service offering.
N26 is now starting to monetise on new users on card issuing, ATM withdrawals and introduction of first paid products such as premium current account with an insurance bundled in.
As we also know N26 has introduced its partnership strategy which will presumably generate incremental revenues for the bank as well. N26 now distributes the likes of Transferwise and vaamo, a German robo-advisor — “N26 is using vaamo’s API to offer clients N26 Invest, a co-branded solution that lets users select from three investment strategies depending on their risk tolerance.”4
Current N26 Pricing — Early Monetization (source: https://n26.com)
However, I would argue that monetization efforts as seen with N26 are only the very first step in a long way to profitability for the neo-banks.
Let’s take a step back and see what lessons are there to be learned on profitability and revenue streams from traditional players in the banking market.
Taking a Step Back: 6 Lessons on Profitability from Incumbents
Note: Profitability of retail banks is a complex and complicated area of study — full academic studies and white papers by consulting firms are devoted solely to discussing its intricacies. For purposes of this article, I will try to keep it simple and put forward a couple of highlights I personally find important in context of implications for the challenger banks.
1. How Do Retail Banks Actually Make Money? (a.k.a the boring part)
Retail banks have two primary sources of income: interest income; and fees and commissions income.
Interest income is primarily earned by a bank lending money to customers and charging interest on the amount lent. A bank earns interest income by lending money to customers at higher rates of interest than it costs the bank to borrow funds from depositors and/or wholesale markets.
Fees and commissions income: banks earn fees and commissions income by charging customers fees for services and receiving commissions from, and participating in profit-sharing agreements with, other product providers. Examples of fees and commissions include fees for use of an overdraft, fees for packaged accounts, and income from the ATM (cash machine) network.7
2. Product Point of View (and Importance of Mortgages in the UK market)
An interesting insight on a UK retail bank product profitability comes from Credit Suisse research. Unsurprisingly, the most profitable products can be found exclusively on the credit side of retail products:
“Among the banks we have studied, we find that mortgages are the most profitable lending product (average ‘clean’ RoE of 28%), followed by credit cards (26%); with SME lending (12%) and consumer credit (7%).”5
In fact, Credit Suisse attributes such a weight to a successful mortgage offering that it is singled out as one of the three key profitability drivers for UK-based retail bank.
From the challenger’s perspective, it is interesting to note that the most profitable retail product is at the same time one the most complicated to distribute digitally:
Source: Oliwer Wyman Research
3. Importance of Interest Income
It turns out that interest income — i.e. charging interest on outstanding liabilities — is an extremely important revenue stream for the incumbents.
(Based on data from Credit Suisse and AT Kearney reports)
What’s more, share of interest income has increased significantly — from 65% in 2008 to around 75% in 2013 according to Credit Suisse research. Beyond cyclical trends, ‘there has been a more structural shift in the industry’s ability to generate peripheral revenues beyond pure interest-related income.’5
AT Kearney reports that ‘Different regulations, such as free current accounts, lending fee limitations, and caps on interchange fees, have impacted (and will continue to impact) banks’ ability to generate fee-based revenues.’ According to CMA, AT Kearney also reported that the share of net interest income in UK retail banks’ total income was the highest in Europe at 82%.
Another point of view besides the regulatory limitations is that traditional banks are simply not good enough at generating ‘innovative’ revenue streams from context and customer relevant 3rd party service offerings, new types of partnerships and beyond banking offerings — which might where the challengers could shine.
4. Importance of SME Businesses
Perhaps unsurprisingly, it turns out SME business is extremely important for the large UK incumbents.
In fact, revenues from personal current accounts for the eight largest banks totalled £7.44 billion in 2014, while SME revenues for the seven largest banks totalled £7.1 billion in 2014.
Unsurprisingly still, banking SMEs is much more lucrative on a per customer basis compared to a retail current account customer.
Estimates based on data available in Competition & Markets Authority, Retail banking market investigation — Retail banking financial performance, August 2015
5 Importance of Costs
Naturally costs are a big part of the profitability equation.
Consider the following — according to Oliver Wyman, 30% of all costs of a typical retail bank in the UK is consumed by its branch network. An additional 20% is eaten up by IT; a huge chunk of it certainly going towards maintaining legacy systems.
In addition, it is estimated that on average, 5–6% of their revenue base is given up by the big retails banks as an effect of impairments.
Typical cost base for a UK retail bank, Source: Oliwer Wyman, Perspectives on the UK Retail Market
I believe challengers have a great opportunity to alleviate the short to mid-term pressure on their bottom-line and competitive positioning if they are smart about their cost base, deployment of resources and investing into the right technology and processes.
6 Importance of Scale and Funding Structure
The following two points are courtesy of Credit Suisse research:
Scale alone is not enough, but is a necessary attribute — Although not enough on its own to determine profitability, our analysis suggests that without scale it is very challenging for a stand-alone business to be in the top quartile of sector profitability.
Funding structure…is one of the most important differentiators. We see a clear positive bias [in regards to UK retail banking profitability] towards a higher proportion of current accounts/low interest bearing deposits.5
Simply put — scale and cheap deposits.
(My) Observations for Challengers
Have a clear strategy that enables customer (and customer deposits) onboarding and retention in the short to mid term timeframe, particularly on low interest bearing products. Keep in mind that scale itself is not enough at all times.
At the same, have a clear mid- to long-term strategy on the credit side of your products. This pertains especially to those offerings which are at the time being difficult to deliver via digital and particularly mobile channels such as mortgages; as these products are at the very core of profitability of retail banking.
Start thinking about how to tap into the lucrative SME market with SME propositions or profit-generating partnerships; especially if you can achieve comparable cost of acquisition to your retail customers as expected upside should be larger.
Traditional banks are not great at generating ‘innovative’ revenue outside of interest income and legacy fees. 3rd party partnerships, value added services that work for the customer and beyond banking propositions are areas which could potentially contribute significantly to challenger’s bottom lines and expand non-interest income.
With exponential growth; keep operational costs under tight control. Choose your IT vendors wisely. Invest early into innovative technology and processes which can potentially decrease impact of impairments on the bottom-line such as new scoring/fraud propensity models and services.
Got a perspective? Please join the debate!
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1 Monzo Blog https://monzo.com/blog/2016/07/06/how-to-travel-with-mondo/ 2 A one-year savings account at 2%: Atom Bank blows away rivals with new inflation-beating rates http://www.thisismoney.co.uk/money/saving/article-4252282/Atom-launches-new-one-year-fixed-rate-savings-paying-2.html 3 ‘Very questionable models’: The cofounder of a fintech startup addresses the elephant in the room http://uk.businessinsider.com/currency-clouds-stephen-lemon-questions-fintech-business-models-2016-6 4 vaamo Partners with N26 (Formerly Number26) http://finovate.com/vaamo-partners-n26/ 5 Credit Suisse UK banking Seminar — 2015 Update, https://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=1050375611&serialid=D3fAivrz0KjVObVAhNsc5e1OnBva50uGToQzZoM6ekA%3D 6 Celý príbeh Zuna: Klienti ho chceli, investori nie https://www.etrend.sk/trend-archiv/rok-2016/cislo-41/zuno-banka-konci-klienti-ju-chceli-investori-nie.html 7 Competition & Markets Authority, Retail banking market investigation — Retail banking financial performance, August 2015, https://www.gov.uk/cma-cases/review-of-banking-for-small-and-medium-sized-businesses-smes-in-the-uk 8 Oliwer Wyman, Perspectives on the UK Retail Market, November 2012, http://www.oliverwyman.com/our-expertise/insights/2012/nov/perspectives-on-the-uk-retail-banking-market.html#.VbIMPPlViko