Despite their low costs, nimbleness and a digitally-native background, challenger banks are struggling to generate decent profits, and now the incumbents are catching up with the tech. So what can challengers do?
Why aren’t more digitally-native challenger banks turning a profit? For most, the burdens of large physical footprints and ageing technology are absent. Staff numbers are low and operating costs are relatively modest compared to market norms. Given these advantages, it is surprising that so few challenger banks have achieved profitability in recent years. As the global economy enters a phase of accelerated digital transformation, in the wake of the Covid-19 pandemic, the success or failure of the challenger bank model is an increasingly important issue.
In The Banker’s first ever Top 30 Challenger Banks ranking published in January 2021, which covers the activities of institutions granted a banking licence in the past 10 years and that are bank holding companies, only eight entries achieved a growth in their pre-tax profits over the 2019 review period. The reasons underpinning these poor profitability numbers are complex but, in some cases, it starts with the fundamental nature of challenger banks’ business cycles.
Wrong emphasis?
In a report by Deloitte, “The DNA of Digital Challenger Banks”, published in 2020, the researchers note that most entities start out with an initial value proposition followed by the rapid expansion of a customer base, before further capital raising occurs to fund the next stage of development. As a result, some digital challenger banks are still putting growth ahead of profitability.
The Deloitte report says: “The majority of digital challengers have not yet reached a self-sustaining business model as they prioritise growth over profitability. On average, 70% of accounts are not used on a monthly basis and the average blended balance for deposit accounts is often low. Thus, challengers often rely on continuous capital raises to fund their business expansion and their huge valuations are driven by investors who believe these challenger banks will be able to monetise their ever-growing customer bases in the future.”
Traditional banks have become much better at acquiring new customers by catching up in terms of their digital capabilities
Beyond this issue, digital challenger banks are also grappling with the question of how to structure a value proposition that will prosper in the long term. In some cases, earlier entrants into the market opted for hyper-specialised structures that focused on single product or service offerings. While this may have been effective in the initial stages of the challenger bank revolution, the strategy offers diminishing prospects over a period of years.
“When [digital challenger banks] first entered the market, it was all about launching quickly and simply with one product. The problem with that is: how are you going to attract a larger revenue share from your customers? How are you going to make them stick and how are you going to get them to use your bank as their main bank?” says Alexa Guenoun, chief operating officer at Temenos, a banking software company.
“Being a super specialised, super narrow offering is becoming an issue. If you look at the successful digital challenger banks, what they are doing is different. They are looking at launching a proper bank. It’s [an offering] that could be your main bank,” says Ms Guenoun.
The right partner
As digital challenger banks opt for greater sophistication, their choice of technology or technology partner is playing a vital role in their drive for profitability. For one thing, if they decide to develop their own technology stacks alone, this can add a layer of cost and difficulty to their operations that can weigh on performance for years, as it demands large capital investments in the hardware needed to support the cutting-edge technology that underpins the operation.
“Spending time and money on building a stack is not going to get you anywhere. What successful [digital challenger] banks have done is to partner with a third party on the technology side at a fraction of the cost of developing their own tech,” says Ms Guenoun.
To this end, software-as-a-service (SaaS) providers are helping many digital challengers to escape the costly pitfalls of going it alone. Temenos, for example, launched its Banking Cloud proposition in May 2021, which it bills as the next generation of SaaS. This includes complete banking services for all industry segments, as well as a sandbox for rapid innovation and a marketplace to foster collaboration with fintechs. According to Temenos, the use of Banking Cloud reduces the cost of operations to 10% of legacy systems.
Aurelie L’Hostis, Forrester
Maintaining a technological advantage will be vital if digitally-native challenger banks are to remain competitive. This is because many legacy banking peers have caught up — at least in terms of their front-end offerings — in the race to attract new customers. “Traditional banks have become much better at acquiring new customers by catching up in terms of their digital capabilities. As this [landscape has changed], it has become much more costly for challenger banks to operate,” says Aurelie L’Hostis, a senior analyst at Forrester’s financial services practice.
In a sign of how the competitive landscape is beginning to pinch many challenger banks, some are turning to the use of fees and other penalties to generate revenue. “Many of these banks started out by saying that they wanted to be more transparent and friendly. [But] what we are seeing is the introduction of new fees, on things like ATM use or overdrafts. As the competition has increased, they have had to introduce these fees and to think about how to make money. That’s why we have seen many of the challenger banks looking at premium business models and subscriptions,” says Ms L’Hostis.
Serving the underbanked
Over the longer term, digital challenger banks will need to consider new strategies to prosper in a more challenging operating environment. This could include tapping into market segments that are beyond the scope of legacy institutions, including through financial inclusion initiatives. Underbanked and underserved communities, for instance, represent something of an untapped frontier in the global financial marketplace. From the US to Nigeria, a large constituency of people around the world are currently unable to access mainstream financial services.
These population segments may be excluded from the financial system due to lack of official documentation, or because they are from minority communities. By combining their traditional agility with cutting edge technology, digital challengers could carve a niche for themselves in this domain.
“Where we see challenger banks really thriving is in markets where parts of the population have been underserved by traditional banking providers. In Europe, there are challenger banks looking at how to serve religious minorities, for example. There is also a lot of discussion around diversity, inclusion and environmental, social and governance, so it’s another way to offer finance that targets an underbanked, underserved population. By doing this, you are contributing to the UN’s objectives and goals of financial wellbeing, protection and inclusion,” says Ms L’Hostis.
For most challenger banks, the path to profitability is a journey that will take time. But as the world emerges into a new post-pandemic normal, and the numbers of digital banking entrants grows, the operating environment is likely to become more competitive. As such, getting the right mix between strategy and technology will be vital if these entities are to prosper in the coming years.
If, ultimately, financial inclusion plays a prominent role in this story, it will be another example of the way in which market forces and new technology are reshaping the global financial landscape for the better.
