Profitability is no longer a distant dream for challenger banks after Starling Bank tipped into the black late last year. How will this affect the mindset of the digital banking landscape and what do other players need to do to compete and survive?

At Money 2020 in October last year, Sergei Galperin, JP Morgan’s European head of fintech investment, said that challenger banks “haven’t spent a minute of their lives focusing on profitability”, suggesting that growth and scale of their businesses has been their sole concern and returning a profit has “taken a back seat”.

This is probably something of a hyperbolic claim. Peter Ramsey, founder of user experience consultancy Built for Mars, describes it as “ludicrous” and that it would be fairer to say that challenger banks have been prepared to lose a lot of money to gain market share, meaning profitability is less of a focus in the short term.

“Will things change now Starling has turned a profit? Maybe,” Ramsey says, “I think Revolut is just going for growth at all costs, and Monzo is perhaps lagging behind for a number of reasons.”

With Starling Bank attaining profitability in late November 2020 and Revolut looking well placed to follow suit, the needle on the challenger bank business model may indeed be shifting.

Digital acceleration

Covid-19 will have proved an accelerant to this shift, as with multiple other trends in financial services, business operation and consumer behaviour.

Challengers were more naturally equipped than their high street counterparts to adapt to the circumstances presented by Covid policy of remote working, thanks to digitally-centric, cloud-native infrastructure.

“Challengers absolutely had an advantage in terms of being built in the cloud, the flexibility of their staffing and so on,” says Mark O’Keefe, founding director of Optima Consultancy.

“Just looking at VPN capacity and so on: I talk to people working at incumbent banks who are not able to all log on remotely to a particular system at once because there isn’t the capacity on the VPN connection.”

Incumbent banks were also forced to adapt to branches closing and the disruption to the numerous procedures that were reliant on face-to-face interaction, which would have slowed down onboarding processes, potentially afflicting their new customer acquisition.

“We saw a lengthening in the cycle of all the processes that you need to have in place to run a bank, such as KYC/AML,” says Craig Fox, director of fintech at Silicon Valley Bank.

“I think we’re going to see a lot of sales cycles start to shorten, with greater automation in the back office, which we’re seeing happen already at some banks.”

Challengers had quite a head start in this area, so were better placed to capitalise when customers were looking for a new banking relationship to help them manage their business or organise their day-to-day finances during a turbulent period.

“Challengers were all positioned for this, while the incumbents are hurting having to pay for all that expensive real estate, that's for sure,” Ramsey says.

“We all know that Covid accelerated a lot of 'pre-programmed change'. It was happening anyway, but at a slower rate. People don't need physical branches as much, and online support is far more valuable long term. So, when everyone is stuck at home, trying to think of small side-line business ideas and need quick bank accounts, guess who you turn to?”

Consumer confidence

Despite the inroads that challengers may have enjoyed, the magic formula to profitability is addressing the cost of customer acquisition, which has historically been quite high. The task therefore has been for challenger banks to acquire scale of their products and services before their high street counterparts can replicate their levels of innovation in their products and services.

The route to this would appear to lie in expanding the range of services offered to place themselves more centrally in the customer’s financial ecosystem, which would rely heavily on their lending proposition to entice customers to make a challenger bank their primary account provider.

“I think an important element around profitability is consumer confidence,” says Fox.

“One of the big questions has always been what percentage of the customer base is having their salary paid into the account and using it as their primary bank.” This is one hump that challenger banks had been seemingly unable to get over. Research by Accenture in March 2020 claimed that the average deposit balance in UK digital stood at £260 per customer.

A study by Monzo in June 2019 meanwhile had found that only 30% of its customers were ‘salaried’ meaning they paid more than £1000 into their account each month.

This may be changing though. Research by the Centre for Finance, Technology and Entrepreneurship I June 2020 concluded that challenger banks received some 45% of all salaries paid by the CFTE.

However, it can be expected that employees of such an institution would be more technologically minded than average and so be more inclined to use a digital bank as their primary provider, so the 45% is highly unlikely to be representative of the whole population.

“I work in fintech and spend most of my day thinking about fintech, but I don’t have my salary paid into one of the challenger banks,” Fox says.

This is a reticence that will continue to be shared by large numbers of people who will seek comfort in maintaining a relationship with a high street bank because it is the provider of their mortgage or it offers certain insurance products that they may wish to use at some point.

“I would not be surprised if we saw challenger banks start to add mortgage products or brokerage platforms to continue to respond to what their customers may demand,” Fox says.

As such products would be immensely burdensome to offer in house, banks would presumably look to partner with other firms who are able to do the heavy lifting, as Monzo did with Mojo Mortgages in 2019.

Strength in numbers

Partnerships will remain an integral part of the conversation around challenger banks fortifying their business models and improving revenue streams, even stretching to mergers and acquisitions. Monzo, for example, would appear to have been treading water over the past year, reporting losses of £113.8m for the 12 months to July 2020 and continuing to struggle to create revenue from its four million customers.

Ketherine Long, banking analyst at GlobalData describes the Monzo’s business model as “an increasingly expensive charitable cause for the UK market”, criticising the bank for not making the most of revenue-generating products such as loans and wealth services.

“I remain hopeful than Monzo will get there with enough time and smart pivots because we want multiple successful challenger banks to keep competition ripe,” Peter Ramsey says.

“Personally, I wouldn't be surprised to see Monzo get acquired by a large bank and seek profitability that way.”

Struggling to turn large numbers of customers into a profitable business is of course not exclusive to digital challengers. Metro Bank has been in a slump for a number of years, exacerbated by the events of 2020, while TSB’s balance sheet and reputation have been hampered by lingering technical issues.

With such institutions struggling to connect with customers in a digital way, while being forced to close branches and lay off customer-facing staff, it is certainly possible that they will look to challenger banks to support them in their transformation.

“Maybe rather than looking at challengers as being attractive businesses to acquire for incumbents, we should be looking at them as potential suitors to purchase someone like TSB,” says O’Keefe.

“TSB doesn’t have a great digital offering and Sabadell look like they’re ready to sell, so they may be prime for a challenger to try and acquire them.”

Whether or not it is feasible for a challenger struggling for profitability to purchase an incumbent bank is debatable, but there is certainly opportunity in the embedded finance, banking-as-a-service (BaaS) model, providing the infrastructure and the digital capabilities to the likes of TSB or Metro Bank.

“I think this would raise the question about whether it’s even necessary to have a banking licence to build a bank,” Fox says.

"You can basically build a banking proposition for a specific customer base without having to go through the hurdles and baggage required of an actual bank. This is something I’m watching very closely, and I’m really excited about it.”

This may be the direction the conversation around challenger banks goes in 2021 and beyond. Rather than how a challenger bank can become profitable, companies will be thinking about how they can obtain market share and engage with customers without needing to become a bank.

As Starling, Monzo, Revolut and others demonstrate, the journey to profitability is a long and complicated one with no guarantee of the destination being reached.