Challenger Banks Disrupting Financial Services Globally
The majority of our discussions tend to focus on US banking partnerships, platforms, financial institutions, and fintech companies. As financial services and many of the top fintechs expand internationally, it makes sense to discuss other regions that run banking programs differently. The regulatory environment and industry ecosystem are key indicators in how banking markets developed in the last 20 years outside the US.
The UK is known to have open and progressive frameworks (in comparison to the US) aimed at boosting competition between incumbent financial institutions and emerging upstarts. When it comes to open banking, UK is the global leader. No where is this more visible than with challenger banks — entities similar to neobanks in the US. Other countries (Australia, Latin America, Asia) are starting to catch up with supportive regulatory guidance of their own.
At its core, challenger banks are tech firms that utilize software to deliver retail banking products and services in a seamless, digital way — no need for physical branches or in-person interactions. Online and mobile serve as the main paths for distribution, which allow for faster customer onboarding, transactions, and fulfillment. These entities are able to offer standard banking products (deposit accounts, credit cards, loans, investments) plus value-added features that help customers reach long-term financial goals.
A DIGITAL ALTERNATIVE TO TRADITIONAL BANKS
Just like US neobanks, challenger banks around the world operate without physical locations/branches or staffing for face-to-face transactions. Customers interact mainly via online or mobile interfaces, which offer best-in-class user experiences and rapid onboarding processes. Today’s banking via mobile apps enables payments, transfers, transaction monitoring, and opening additional accounts.
In the aftermath of the Financial Crisis (2008-2009), customers disappointed with traditional institutions switched to online banks due to lower fees and streamlined customer journeys. Over the next 10 years, challenger banks targeted specific users unable to qualify for standard banking services due to cost, credit profile, or income levels (e.g. unbanked and underbanked). Challenger banks made inroads with consumers who lost faith in legacy banks following the global financial crisis.
When COVID-19 limited in-person service activity last year, bank customers were unable to visit branches and needed to make the shift towards online transactions. Traditional banks were slow in digital banking upgrades and many shut down physical locations due to safety protocols and the downturn in customer traffic. As a result, neobanks and challenger banks gained tremendous user growth and transaction volumes as customers transitioned from offline banking.
A BOOST for challengers FROM REGULATION in EUROPE
The EU has led the way in open, progressive regulatory frameworks over the last decade. Regulation enabled easier entry for banking startups to gain licenses and registrations needed to compete with institutions (such as Lloyds, Barclays, and HSBC). Well-known brands (Starling Bank, Monzo, Atom Bank, Tandem, N26, Revolut) used varied approaches in entering the market, through a full bank charter or an e-money license.
Bank charter application and approval is a lengthy, costly process (up to 2 years). Ultimately, this provides the capability to deliver a full scope of banking services independently. This strategy of a traditional approach was utilized by Starling Bank, Tandem, and Atom Bank to help create a competitive advantage at time of launch as an all-inclusive deposit and lending enabled platform (without the need for partnerships).
Fully-chartered challenger banks also monetize off of all their user’s transaction activity (no revenue share) and build trust early as a regulated entity. However, the bank approval process delayed launch timelines for these platforms and initial user growth was lost to existing competitors already in market (through an e-money license). Charters may also be suspended or revoked based on adherence to risk controls and funding requirements.
The e-money license takes less time to process and approve, but comes with a smaller scope of functionality related to money movement. Besides a faster turnaround, a license in one of the EU member states can also provide coverage in all 20 countries in the European Economic Area (EEA).
While many players chose the longer path of bank charter, N26 and Monzo chose the e-money path to gain rapid user growth in their first years, while they waited for a bank charter application to be approved.
The V1 for these platforms was a prepaid card with payments access (instead of a standard user deposit account and debit card). Multiple partners and vendors are required to provide more banking features, which reduced some of their revenue streams. Existing customers with this setup were also asked to switch to current accounts once the bank charter was approved. Platforms had to temporarily delay new user registration until the enhanced banking structure was updated, which impacted customer acquisition for weeks.
Revolut also chose the e-money license path, but with a focus on improving currency exchange for travelers throughout Europe. As a digital currency app, the platform helped users avoid creating and managing multiple accounts in various currencies across the EEA. Revolut added key partnerships with other fintechs to continue its user acquisition (including offering crypto in 2017). They did apply for a bank charter in the UK in the first half of 2021.
Overall, the challenger banks that started with the e-money license path now have higher user counts (over 25M for Revolut, Monzo, and N26) and spent less cash overall than their bank charter competitors (Starling, Tandem, Atom Bank).
CHALLENGER BANK ECOSYSTEM OUTSIDE OF EUROPE
Australia is another up and coming hub for challenger banks due to recent regulatory changes in 2018. New regulations were in response to improper conduct and practices from established banks. The big 4 in Australia are: Westpac, ANZ Banking Group, National Australia Bank, and Commonwealth Bank of Australia — representing nearly 75% of financial services (IBISWorld).
Licenses were now available that authorized entities to manage deposits as authorized deposit-taking institutions (ADIs) .
Similar to the e-money license in the UK, challenger banks could use this registration to launch their program while they awaited a full banking license (about 2 years away).
There were four leading challenger banks that took advantage of new licensing:
Volt was first to receive the initial ADI license (May 2018) followed by the complete license issued in January 2019. Choosing to build up momentum with users before launching banking services, the company focused on branding and relationship-building with customers. Volt decided to start with a savings offering and leverage its license to build a Banking-as-a-Service (BaaS) platform to provide white-labeled services to fintech startups.
Up opted to partner with licensed banks (Adelaide Bank and Bendigo Bank) to avoid filing and waiting for license approval. This allowed the challenger bank to launch its platform in October 2018.
Judo targets small businesses by focusing on lending products — the platform gained its full license in April 2019 and is valued at $1.2B (as of December 2020). The pandemic impact to small and medium sized businesses elevated loan portfolios by adding $800M.
Xinja initially launched a prepard card and mobile app, then added a high-yield savings account (offering 2.25%). Unfortunately, the challenger bank couldn’t maintain sufficient revenue to pay out the interest on deposits and had to shut down. Xinja gave up its ADI license (issued in 2019) and returned customer funds last October. Remaining account holders transitioned to the National Australia Bank.
Latin America has tremendous market opportunity as up to 70% of the population lacks banking services (not having a deposit and/or credit account). In evaluating the high adoption of mobile and volume of remittances, there’s a strong formula for challenger banks to succeed against incumbents. There are now more than 40 of these entities throughout Latin America.
Brazil is the first country in LATAM that comes to mind with challenger banks. Traditional banking infrastructure is heavily skewed against consumers when it comes to fees and customer service. Once startups (such as Nubank and Neon) emerged in the last decade, Brazilians were quick to make the switch. Nubank is among the largest challenger banks in the world and also serves Colombia and Mexico.
Argentina and Mexico are close behind when it comes to market potential for challenger banks. With Mexico’s proximity to the US, many non-Mexican fintechs and banks (besides Nubank) have shown interest in launching their own platforms throughout the country. An additional boost is being provided by the country’s regulators who are focused on increasing financial inclusion for the millions of unbanked in Mexico.
CHALLENGER VS. NEOBANK
In our discussion, the themes of regulatory support towards open banking (either through new licensing or data sharing from banks) paved a path forward for challenger banks worldwide. E-money or ADI licenses and bank charters were provided by regulators to increase competition and improve their country’s banking ecosystems. More choices for consumers and businesses has created better products, user experience, and access to financial services.
Neobanks (the US counterpart) are mostly built through a partnership with a licensed community or regional bank interested in growing their national footprint and deposit share through fintech firms. Bank partnerships are the default choice due to multiple regulatory agencies with oversight of the financial system in the US — as a result, there’s no definitive or clear guidance in supporting innovation from new banking startups.
A fintech charter has been discussed and reviewed, but still lacks approval from major governing bodies. In the last year, multiple organizations finally received approvals for bank charters (full or modified) in order to act independently from existing banks. The first consumer neobank to be approved in 2020 was Varo Bank.
Despite market leadership in banking services, the US and its regulatory frameworks are still behind in spurring innovation and industry growth. The ability to hold deposits, facilitate money movement, and provide credit from non-bank entities is lacking due to regulatory hurdles from federal and state entities.
Until the regulatory landscape becomes clear, founders and teams may hesitate or delay investing in companies that may not be allowed to operate. A fintech charter may not be the silver bullet for the US to catch up to Europe, but much needed collaboration between government agencies and industry groups should help drive the industry forward in the next years.
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