European FinTechs face 'existential threat' as funding dries up

Despite years of hype declaring FinTech investment was set to experience some endless boom, the bubble looks set to burst amid the current recession. With interest having already notably waned, especially in the banking sector, a new whitepaper has warned that Europe's FinTech sector faces an "existential threat" as investment enthusiasm cools amid the Covid-19 pandemic.

At the height of the clamour for digital disruption, the threat and opportunities created by disruptive FinTech firms was said to be of major importance for the financial sector. As financial institutions looked to tackle complex problems such as shifting consumer expectations, regulatory burdens and heightened competition from digital upstarts, many were said to be turning to innovative FinTech platforms for their salvation – something reflected by European investment in the sector at the start of 2019 almost doubling on the levels seen over the first six months of 2018.

However, as early as mid-2019, there seem to have been warning signs on the horizon that the spike in investment had become unsustainable. Despite Europe’s continued enthusiasm, a study from Accenture found that global investment in FinTechs declined significantly over the opening half of last year. This possibly reflected the growing realisation that despite the hype for FinTechs to help banks get ahead of the competition, financial institutions have been slow to actually partner with them – remaining reluctant to upgrade legacy IT systems which would enable collaborations with the digitally savvy start-ups.

Seeing that backing a FinTech today does not necessarily guarantee a return when an incumbent bank partners with that FinTech tomorrow, investors have eased off the huge amounts they had previously been throwing at the start-ups. To that end, a study from Innovate Finance found that almost three-quarters of smaller UK FinTech companies had a cash runway of half-a-year, while even more had become worried about their next funding round – and one-tenth were looking into winding up their business altogether.

The situation has been notably exacerbated by the global coronavirus pandemic and following recession – and now a new study from McKinsey & Company has suggested that Europe’s FinTech sector faces an “existential threat” due to Covid-19 shortening the runway for many FinTechs. The researchers elaborated that fundraising data for the last three years from Dealroom.co point toward as much as €5.7 billion being needed to sustain the EU FinTech sector through the second half of 2021 – and “it is not clear where these funds will come from.”

There are some sub-sectors which are continuing to thrive amid the crisis. Digital investments, digital payments, and RegTech have gained added relevance from the pandemic, as changes to behaviour relating to physical contact have become widespread. At the same time, a surge in corporate and incumbent activity does mean that FinTechs catering to those needs may be able to thrive – for example, American Express recently acquired US-based Kabbage, which offers credit and cash-flow management solutions to SMEs.

However, more broadly, FinTechs look set to suffer from many of the economic impacts the banking sector is susceptible too – without the hefty capital required to weather those storms in the same way. According to McKinsey, the Covid-19 pandemic is expected to have a significant negative impact on overall industry profitability in particular, as household incomes decline and discretionary spending drops.

As a result, European transaction volumes and value could decrease by 10% for domestic transactions and 25% for cross-border transactions, while loan volumes are also under pressure as the broader economy slows down.

These changes will be particularly acutely felt by FinTechs and digital banks, which rely on transaction fees and commissions for the bulk of their revenues – while only a few have been successful in having customers sign up for a subscription or account fee. In contrast to incumbent banks, then, which can generate income from multiple sources beyond transaction fees, many digital banks have a cash-consumptive business model that requires continual investor funding – which is paradoxically unlikely to appeal to investors at present.

Concluding, McKinsey’s paper stated, "FinTechs that are skewed towards customer acquisition (as opposed to driving positive unit economics) are particularly challenged… Given the contracted funding environment, many digital banks cannot sustain a cash consumptive business model in the medium term. Instead, a laser-sharp focus on expanding their revenue engines, coupled with a shift in customer acquisition strategy to pursue more economically viable segments, will be required."