The landscape for challenger banks, or neobanks, in the UK, many of which offer business banking services including asset finance, has undergone significant change in the last few years. In this article, the financial services team from London-based law practice Freshfields Bruckhaus Deringer considers the lie of the land for the sector.
It has now been some years since challenger banks started making their presence known in the UK. EU regulatory reform in the shape of the Payments Services Directive (PSD2) and the UK’s Open Banking Standards have opened up the sector and made it easier for new entities to establish themselves in the market. Increasing competition in the banking sector and reducing the market power of the big four banking groups are key themes for regulators. The focus on data and payments, and the rise of firms offering account information and payment initiation services, has seen competition grow as these entities become ever more popular with consumers.
However, the conditions over the past year or so have meant that these businesses have faced challenges like never before. We set out below the recent trends and our thoughts on the landscape for challenger banks in the UK for the rest of 2021 and beyond.
Having been some of the top recipients of regional venture capital in recent years, European challenger banks entered 2020 on somewhat of a high.
Since then there has been significant interest in the sector and growing confidence that digital banks are set to be a permanent and important part of financial services going forwards.
Although there has been a relatively smooth upward trend in funding to date, we are seeing confidence in some challenger banks starting to waver and rumours that funding levels are reaching potentially unsustainable levels are starting to play out.
So why are we seeing this dip in investor confidence? In some cases, lower valuations may simply be a result of the challenging market conditions, and it is undoubtedly difficult for many companies to raise funding right now. But in others, concerns around long-term profitability may also be at the heart of a downward trend. Investors have generally banked on growing customer bases, and challenger banks being able to move their customers from the free or low-cost services that attracted them in the first place onto more premium offerings. This is difficult to achieve in practice, and the turbulent conditions of the past year or so have made it even more challenging for banks to become and remain profitable.
Although 2020 brought significant challenges, it also gave rise to opportunities. Consumers were in many cases pushed to switch to digital payments, which – along with related services – are expected to continue to grow over the next few years. Challenger banks are well placed for this as they have been mainly focused on digital services from the start. This is in contrast to the larger, traditional banks, which have had to make rapid upgrades to their online offerings and are still in some cases catching up.
The question is how challengers will compete with the established UK banks going forwards. Challenger banks capitalised on the rise in popularity of digital banking, but the incumbents still hold the lion’s share of the market, with the majority of UK customers relying on them for their primary banking needs. Challenger banks are generally seen as a useful alternative to the traditional banks, but typically only for lower-value day-to-day transactions and services rather than as the main banking provider. Plus customers of challenger banks tend not to be particularly ‘sticky’, ie they aren’t afraid to move if something new (or cheaper) comes along.
With legacy issues and Brexit restructurings behind them, the incumbent banks have invested in technology and re-focused on their core business lines, leaving them relatively well-positioned to retain their position in the market. And despite the uncertainties over the past years, customers are beginning to return to the traditional providers and their improved digital offerings.
Challenges for challengers
One of the key challenges that new banks face is ensuring that business models are viable. How does a challenger bank attract and retain customers in a market where customer loyalty for primary banking needs typically rests with the traditional banks? And when it does attract customers, how does it move those customers on to more premium offerings?
Fee and cost pressures weigh heavily too, with challengers needing to grapple with moving customers towards more profitable products without scaring them away, while operating within regulatory constraints, such as fee caps, across the jurisdictions in which they operate.
Pandemic-related costs have also added to the pressures faced by challenger banks, many of which were already struggling to reach or maintain profitability. A change in consumer behaviour has meant fewer transactions: customers are travelling less, buying less and doing less. And firms have had to make unexpected but significant investments into IT to help their staff work remotely.
All of this has affected appetites for wholesale funding, and existing financing has in some cases also been strained with the potential for contractual breaches and defaults rising. This has, in some cases, fed through to the lending appetite of the entities themselves, with credit and affordability criteria being tightened, and defaults on the rise.
Where entities have smaller, less diversified customer bases, the origination volumes have decreased, as entities seek to preserve their capital.
With the banking sector heavily regulated, being a financial services business in the UK brings with it implementation costs (and remediation costs when things go wrong), which can be significant. The current focus of the Prudential Regulatory Authority (PRA) on operational resilience, and the expectations around the standards that banks are expected to meet, can be daunting, particularly for those entities that are facing the challenges outlined above. The PRA’s expected proposals around a simplified capital regime, and its recent Policy Statement on “Non-Systemic UK banks: The PRA’s approach to new and growing banks”, may well help with this in the future.
Potential emerging M&A themes
There are unique opportunities for potential acquirers in the challenger bank space in the near to medium term, and we anticipate that activity in the sector will continue to grow.
The challenging market circumstances may force non-bank lenders to sell certain portfolios and business lines, with acquirers able to access new markets or build on their existing capabilities, and pick and choose the assets that are most beneficial to them at a price at which they may not have otherwise been able to achieve. There may also be opportunities for challenger banks if larger banking groups seek to dispose of subsidiaries or difficult portfolios in an attempt to rationalise their business and to generate capital.
Consolidations among smaller and specialist entities may enable challenger banks to obtain scale and to access new markets more quickly than might have otherwise been the case. Consolidations may put less diversified banks under some pressure, as growing competitors become able to offer a greater product range.
Strategic acquirers may also look to acquire digital entities and platforms, in an attempt to expand their capabilities and income streams on top of their existing offerings. The challenging conditions of the past year or so may give rise to a lowering of value expectations, making these entities more accessible than they may otherwise have been in the past.
Outlook for challengers
Challenger banks will likely face competition from not only established UK banks but also the major tech companies, which are making strong headway in their investment into payments infrastructure, data and the provision of combined services. To remain competitive and to meet consumer demand, it will be important for challengers to harness the data that is available to them and use it to give customers access to highly personalised services.
Challenger banks will also need to find a way to maintain their growth and win new customers. Although it has been possible for some challenger banks to persevere with existing low-income models as a result of their lean set up and low-cost structure, in the future moving customers onto more profitable services will be important. The ability to adapt quickly to developments in the market and provide customers with access to a wide range of products to meet their changing needs will help to ensure that these entities remain relevant.
For potential acquirers, there are opportunities for consolidation and strategic acquisitions, and for investors funding is still widely sought by many challenger banks, a number of which have an IPO as part of their future plans.
The market in which challenger banks operate is continually evolving and, as it develops, we can expect there to be plenty of scope for activity both for challenger banks themselves and for the regulatory regime to which they are subject.
The authors of this report are: Lauren Moorin (senior associate), Michael Raffan (partner) and Francesca Triggs (trainee solicitor) of Freshfields Bruckhaus Deringer LLP