Take your mind back 10 years to the financial crisis. US banks gave out a flurry of subprime mortgages, created collateralized debt obligations, house prices fell and interest rates rose, and then the bubble burst. Subprime borrowers could not meet the higher interest rates, the defaults flooded in and banks were faced with serious liquidity problems. Despite the Feds best efforts, Lehman Brothers filed for bankruptcy, Indymac collapsed, Bear Stearns was acquired by JP Morgan Chase and Merrill Lynch was sold to the Bank of America and economic upheaval was felt worldwide.
10 years later, a monumental loss in consumer confidence for traditional banks can still be felt. A recent YouGov survey found in France 27% of people surveyed believed banks were a force for good, while only 37% in Italy and 55% in the UK trusted banks. This low confidence has only been exacerbated by the recent cyber-attacks. For instance, in April this year, seven of the UK’s largest banks were either forced to shut down their systems or reduce their service as a result of a hacker using software which cost just $11 to rent.
Equally, the Payment Services Directive 2 introduced in January this year has reduced barriers to entry to the banking industry across Europe. In particular, the Directive enabled third-party access to account information, meaning new firms can access customer data previously only available to traditional banks and can use this to contact customers to gain business. While the EU’s common standards have allowed for quick expansion without new banks having to worry about regulatory compliance. This historic low in consumer confidence and open regulatory landscape has created a rare opportunity for new entrants to capitalise on this resentment in a once thought impenetrable market.
So, who are these new entrants seeking to seize this opportunity and disrupt the UK financial landscape? Introducing the Neobank.
What on earth’s a Neobank?
Neobanks or ‘challenger’ banks are essentially online-only banks i.e have no physical branches. They can be separated into 2 types:
- Companies with no banking licence and only offer a ‘user service’ and rely on a traditional bank for the processing payments or use a partnership model.
- A complete full-service online bank with a banking licence, such as Monzo (the focus of this article).
The challenge to traditional banking
The most pressing question for these new banks is what exactly they can offer consumers that traditional banks cannot?
- The Fees – Neobanks require minimal overheads to operate (website maintenance) meaning they can price more competitively than traditional banks.
- Functionality – Traditional banks mobile banking apps have been consistently criticised for being anti-user friendly. They frequently crash and are riddled with security concerns. Whereas, Neobanks can offer a sleek, secure and easy to use service. The reason why Neobanks can offer a more secure service according to a report by PwC is a result of culture; they focus on securing data using technology and quickly adapt to the latest threats. Whereas, traditional banks are less tech-orientated and as a result are significantly slower at adapting to change.
- Wider Customer Base – as the barriers to entry to set up a Neobank are significantly lower than that of a traditional bank, they can afford to accept customers with poorer credit ratings than that of a traditional bank.
- Easy to Set Up – Neobanks offer a streamlined paperless sign-up process, as opposed to having to go into a branch to set up an account. For instance, N26 paperless sign-up process takes up to eight minutes and can be done entirely from your smartphone.
- Special Features – Many Neobanks offer built-in budgeting and saving tools within the account. For instance, Monzo’s target feature allows users to set budgets, categorise expenditures and receive live updates on the rate of their spending.
Make or break – The problem Neobanks face now
The biggest problems Neobanks currently face is customer acquisition. Despite low consumer confidence and an open regulation, changing 150-year-old consumer habits remains difficult, especially in a market which is quickly becoming oversaturated. This is highlighted by the fact the three largest UK Neobanks, Revolut, Monzo and N26 have only 2.5 million customers between them compared to the largest UK traditional bank Llouds which boasts 30 million customers. The fundamental issue is trust, the current perception seems to be that despite the public not trusting traditional banks to give them the best value for money, they do trust them to keep their money safe. But, as the cyber-security attacks on traditional banks continuously increase, it is debatable how long this perception will last unless something drastic is done.
Another big concern is profitability. Both Monzo and Starling are yet to break even, due to pitching their services below cost to attract new customers and investing heavily in licensing. While Revoult, the first Neobank to break even on a monthly basis, are unable to monetize their service. If these banks are going to have any chance to compete in the long run they need to find a way to monetize their service effectively while remaining an attractive alternative. This leads to the big question, whether in order to be profitable Neobanks simply need to amass more customers or fundamentally change their business model?
The final issue they face is lack of relative capital. Despite Neobanks attracting significant investment, such as Revoult which raised $250m last year, this pales in comparison to the money available to traditional banks. Unless Neobanks can either attract far more investment or create a truly unique product, it is questionable whether they will be able to effectively compete in the long-run when traditional banks have so much more capital to invest.
The response of traditional banks
UK banks are well-known for being slow to adapt to technological change and this no exception, likely due to the fact Neobanks have not drastically gained market share as of yet.
Lloyds is seeking to collaborate with Neobanks rather than directly compete, with CEO Antonio Horta Osorio suggesting “partnerships between banks and fintech companies will become even more important as they work in a symbolic relationship”. Moreover, Lloyds is set to invest £1 billion annually on its digital strategy over the next three years, which is triple the amount invested across the entire fintech industry in the UK last year.
HSBC is taking more direct action, creating a stand-alone digital banking startup known as ‘Project Iceberg’ and promising to invest $15bn-$17bn in technology-based growth over the coming years. Equally, RBS has collaborated with UK Neobank Starling to create its own digital bank and is planning to switch 1 million customers from subsidiary NatWest to this new bank to boost customer acquisition.
Impact on law firms
The growth of Neobanks can only mean good news for law firms. Many law firms are looking to expand to attract large fintech clients to provide regulatory advice as the market continues to grow. For instance, Slaughter & May recently launched its Fintech Fast Forward programme, aiming to offer legal support to financial and legal support start ups in the sector. On the other hand, traditional banks are looking for advise on their own fintech strategy and to be constantly updated with any developments in the sector. For instance, Herbert Smith Freehills recently advised Sabadell and TSB Bank on the latter’s migration of services from its existing fintech services platform to one provided by the former’s in-house services company, Sabadell Information Systems
It is evident the current UK banking market has not been drastically disrupted yet, but if Neobanks are able to create a more attractive model and traditional banks continue to lag technological developments, this picture could change. One only needs to look at the success in the Chinese market to see the potential impact fintech companies can have, where Ant Financial and Tenecent have completely disrupted the Chinese financial system. The difference is they offered a different service to that of Neobank, providing a combined social media, e-commerce and payment system, similar to Paypal, and offer the largest money market fund in the world, which is a mutual fund which invests in short-term debt instruments. Unlike the UK fintech companies, this service is so attractive largely due to the 3.93% return on surplus funds, that customers are moving money from their current accounts into their Alipay digital wallets. Their success is highlighted by the fact Ant Financial handled more payments than Mastercard, completed over $8 trillion in transactions last year and is now worth 50% more than Goldman Sachs.
In terms of profitability, it is unclear whether a low-fee online bank can be successful in the long-run. But, If UK Neobanks could emulate a similar model to Ant Financial, creating an equally attractive only money market fund, or a service so attractive that customers are prepared to switch accounts, they may be able to cause a similar disruption to the UK banking landscape.
Oliver is a member of TCLA’s writing team. He is a recent law graduate from the University of Nottingham.