KPMG: Challenger banks outpacing Big5 banking giants

09 June 2015 Consultancy.uk

The UK banking landscape is changing, with challenger banks seeking to capture terrain owned for centuries by the Big Five banks. Recent research from KPMG highlights that small and nimble challengers are doing well, picking up with high RoE and low cost profiles. Although larger challengers encounter higher cost to income ratios, investors remain confident in the long term position of these challengers, with share prices of listed large challengers far outperforming the market.

While the UK’s major banks have had their doors open for centuries, it has only been with recent changes to the wider financial landscape, in part through the FCA looking to stoke competition, that new challengers are seeking to pick off the customers from the established HSBC, Barclays Bank, Lloyds Bank, and the Royal Bank of Scotland.

Challenger banks

In a recent report from KPMG, titled ‘The Game Changers’, the consulting firm explores how the different challengers are faring in the current economic and regulatory environment. KPMG looks at the current state of the field, the various factors that are contributing to the success of new entrants and what continues to inhibit their ability to secure market share from the most dominant players.

The report highlights that the challenger landscape is more complex than one simple grouping, with a divide between new entrant start-ups and more established challengers that – while inheriting loan books – are working under new brands from new operators. The new entrants group contains large challengers, including TSB, NAB and Virgin. The smaller challengers include Handelsbanken, Metro, and Onesavings. While retailers – were they able to fully leverage their financial offerings – make up a third set of new challengers.

Return on equity

Financial advantage
Particularly the small challengers are doing well, with the Return on Equity (RoE) for the smaller challengers running at 18.2% in 2014 compared to 5% in 2012. This is massive compared to even top tech companies, where the RoE for Google stood at just under 15% in March 2015 and Facebook’s under 11%. Larger challengers and the Big Five traditional players had relatively similar RoE in 2014, although the increase in RoE of the larger challengers is significantly bigger than the increase in RoE of the Big Five.

Rapid growth
In total the new competition grew with a compound annual growth rate (CAGR) of 8.2% between 2012 and 2014 on their loan-books. The smaller challengers were however the forerunners, growing at 32.3% compared to the larger challengers at 3.2%. The Big Five in contrary met with a modest shrinkage, of -2.9% on their loan-books. The effectiveness of small challengers, the report highlights, stems particularly from their niche market presence bringing in specialised financial products for those markets. 

Market net interest margin and cost-to-income ratio

Cost to income
One way in which challengers are able to differentiate themselves is through their ability to keep costs down while charging market rates for their products – thus improving their returns. Particularly the smaller challengers have been able to reap higher net interest margins (NIMs) through their use of the Funding for Lending Scheme (FLS), which provided the opportunity to re-price their deposits and diversify their deposit products.

Large challengers have, with the inheritance of higher cost bases, found themselves with relatively high cost to income (CTI) ratios, with the average running at more than 80%. The smaller challengers have managed to reduce their cost footprint with, among others, digital efficiencies and the economies of scale as they grow, thereby reducing their CTI from 65% in 2012 to 53% in 2014. The Big Five have remained relatively stable in their CTI, with it growing slightly from 60% in 2012 to 63% last year.

Challenger bank market performance

Challenges and opportunities
The long term picture looks relatively rosy for the new challengers, with investors continuing to be confident about the expected RoE that these new entrants will deliver. This is seen back in the share value of new entrants that have gone public, with challenger banks’ value generally far outperforming the FTSE 250. The book value multiple of new entrants is also performing well, with particularly the smaller challengers showing envious multiples compared to traditional banks.

The authors conclude: “But for all Challengers, the main point of difference is their culture. Being largely free of the legacy problems of the past contributes to a sense of social purpose that puts fire in the bellies of their executives and frontline staff alike. Only time will tell whether the big banks will combat that fire with fire of their own. Creating a ‘bank within a bank’ – a new Challenger brand free from legacy conduct, technology and culture – might be the best start.”

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The business and operating models of digital-only banks

04 April 2019 Consultancy.uk

In recent years, several digital-only banks have successfully managed to nestle themselves in the banking landscape, with their popularity continuing to increase. Looking at it from the customer’s point-of-view, there is little difference between these FinTech unicorns; looking at the bigger picture, however, reveals significant variation in their business models. Matyas Fekete, a consultant at KAE, explores some of the main similarities and differences in digi-bank business and operating models. 

What about the profit?

Unlike in the UK, in most of continental Europe, bank accounts and corresponding banking services are historically paid-for services. The fact that digital banks offer most of their services free of charge has undoubtedly helped them build a large customer base. On the other hand, despite comparatively low set-up and minimised operational costs compared to that of traditional banks, and given the lack of revenue stemming from the typically no-fee model, profitability has proved difficult to achieve. Monzo, for instance, recorded a net loss of £30+ per customer in its most recent financial year. 

In the start-up world, it is customary to focus on expansion rather than profit – see the case of Uber, for instance. Still, while profitability might not be their number one priority in their early stages of development, it must be a long-term goal of any business. With their ever-growing customer base, digital banks are increasingly under pressure to turn their business from loss- to profit-making. 

Credit where credit is due

Digital banks pride themselves on their fair (often meaning “free”) proposition and have so far stayed clear of offering loans (including credit cards & overdrafts), traditionally amongst the most lucrative products for traditional providers. Though somewhat reluctantly, newcomers are also realising that offering lending products is one of the most straightforward ways to offset losses made on their free, often high-cost services (e.g. overseas ATM withdrawals). Monzo, N26 and Starling have recently started offering credit products to their customers, with their loan offering expected to be extended to a wide range of services, from mortgages to overdrafts. Correspondingly, creating a lending portfolio can also pave the way for launching an interest-paying savings offering – a proposition seen as a basic banking product that is yet to feature in most digital banks’ portfolios. 

The business and operating models of digital-only banks

The premium customer

While most digital banks offer most of their products for free, some have extended their offering by paid-for premium services in order to create a revenue stream. As these premium features – including different types of insurance, unlimited free transfers/withdrawals, faster payment settlement or concierge services – are often offered in a subscription format, customers are typically prompted to pay for the full package rather than just the desired service(s), providing a significant revenue stream for the bank. Revolut, for instance, was amongst the first digital banks in Europe to break even earlier this year, a feat largely due to revenue from its premium subscription.

SMEs like digital too

Traditional banks typically service small and medium sized businesses under their retail rather than corporate banking arm. Having their product offering tested with consumers, and consequently gaining a reasonable customer base, digital banks have also identified SMEs as an ideal segment to extend their target audience to. The five FinTechs profiled have already gone, or plan to go, down this path by following up their consumer solution with a business account. While both propositions are typically built on similar features, some providers charge businesses a monthly subscription (e.g. Revolut), while others apply additional fees to specific services (e.g. TransferWise), banking on the expectation that businesses are more likely to be willing to pay for banking – something they are already used to doing. 

The marketplace model

While most digital banks offer a wide range of banking services, some of these tend to come from partnering with third-party providers. For instance, Starling Bank’s only proprietary product is its current account, which serves as a basis for the provision of ancillary services, ranging from loans to insurance, to investment opportunities. Instead of developing these services in-house, Starling enables a select group of partnering financial service providers access to its platform in exchange for a fee. In effect, Starling is using its customer base to create a market for its partners, charging a commission for each acquired customer. 

In such cases of digital banks applying this marketplace model, the majority of their income often comes from partners rather than customers. Naturally, only banks with a large enough customer base can be successful in this set-up, underlining the current intensity of competition amongst digital banks.

Banking as a Service

While customer-centricity is heralded amongst the main USPs of digital banks, some are looking beyond offering consumer-facing services to diversify their revenue streams. Starling, which is among the few digital banks built on its own proprietary platform, has recently leapt into the Banking as a Service (BaaS) industry, making its technology available to other start-ups looking to launch a digital bank. Naturally, this raises the question whether the two offerings could threaten each other’s success. Generally, as long as such partners operate in different markets, the two business lines should be able to thrive alongside each other. Further along the line, however, such partners could easily end up expanding their banking solution into the same market(s) as they aim for global success, and by doing so, becoming direct competitors. 

Different approach, same result?

It is fair to say that consumers in Europe looking to bank with a digital-only provider would have a difficult time finding relative advantages/disadvantages amongst the leading players in the industry. Still, despite the limited surface-level variety, exploring the business models of leading digital banks reveals different approaches to the challenge of making money. Alongside the more straightforward method of offering paid-for premium features/subscriptions, some are banking on the value that access to their customer base offers to third-parties, while others outsource their technology to neobanks wanting to focus on the Fin rather than the Tech. With competition amongst digital banks heating up, it will be interesting to see which business model(s) prove to be the winning formula in the long term.