What does the future hold for challenger banks and fintechs?

Birendra Agarwal

To understand the future for fintechs and challengers, it’s useful to look at how they got here. As someone who has advised many startups and now consults for fintechs, I know they function in many of the same ways as startups in other verticals - they are often still solving the first problems of growth; LTV:CAC, product-market fit and so on.

They are also usually attempting to address only part of the customer need, while a mainstream bank is always trying to serve the needs of the customer front-to-back, often across multiple products.

Instead the fintech may have a particularly exciting play in one area, so rather than the bank spending another two or three years - the typical development cycle - with the right Open Banking architecture, they could instead plug in the fintech’s solution and improve their overall offering to the customer. In that sense, it represents a partnership with that fintech down the value chain.

The fintechs’ growth strategies will vary greatly depending on their road maps for growth. If they make money as a provider, then they’ve got to sell to, and integrate with, as many banks as possible. In other cases, they may not want to provide their solution to the bank, for example if they feel have a strong enough proposition to go it on their own, and go direct to the market (see more about this case in our article on the threats to incumbents from challengers and fintechs).

So, outside of the fintechs’ strategies for growth, what does the future hold for them?

1. Looking beyond the initial growth phase

Of course the fintechs have to be much more mindful of the LTV:CAC of their customers than the banks, which could make them hesitant about getting into a straight fight to acquire customers with competitors. However, examples like OakNorth show that if they build great products, they are able to raise the money to help them acquire customers without having to partner with banks.

The question instead becomes, what is the survivability of the current model? The fintechs are paying a lot of money to acquire customers and are not yet profitable. When does the PE and VC money run out?

It’s very important for me when working with fintechs to investigate if there’s a clear underlying business proposition that will survive beyond the initial phase of aggressive growth—ultimately they will have to find a realistic path to profitability. At this point the metric ceases to be a critical mass of customers, and becomes: are you profitable?

Their problems of profitability are compounded when they grow above a certain size, as the regulator will start to take a much more keen interest in their affairs. After all, one of the big challenges the incumbent banks face is the high cost of regulation.

This is on top of the issues of legacy infrastructure in technology and personnel structure. However, even without this problem of legacy infrastructure, the successful fintechs will face the challenge of what the regulators call systemic risk, i.e. is the company becoming big enough to be considered as part of the overall risk in the economy.

There are worse problems to have of course than growing too big, but as so many fintechs are operating in areas like credit risk and different lending propositions, they will need to be keenly aware of this looming issue.

2. The new paradigm of coopetition

This next point is less a prediction, than a statement of the reality that’s already here. A few years ago, all of the talk around banks and challengers was around competition, but that’s increasingly not the case. Fintechs and incumbent banks have realised they need each other, are interdependent, and we’ve entered a new state of ‘coopetition’ with various iterations on the theme. So, are the fintechs looking to be acquired by the incumbents? Well, let’s look at the different types of fintechs.

Fintechs and incumbent banks have realised they need each other, and we’ve entered a new state of ‘coopetition’.

In some cases the fintechs have realised they are not going to survive on their own, and need the banks’ help to really achieve their desired valuation. On the other hand, you have fintechs like OakNorth trying to go it on their own, and instead seek investment from the Vision Fund and private equity in a more conventional tech startup play. Then you have the digital banks like Monzo and Starling, and others who also started with a current account offering, who are probably not thinking about being acquired anytime soon.

Of course that doesn’t mean it won’t happen. One phenomenon we haven’t covered here is the looming disruption of the big American tech providers. Amazon and their ilk certainly have the ability and the inclination to acquire a challenger bank or any number of fintech providers. It’s clear that GAFA intend to enter the FS market, and will have evolving strategies already in place. They may be waiting for a tipping point to act, and this seems more likely than an incumbent moving to acquire a challenger, which leads us to our next point.

3. The inevitable acquisitions

One strategy for challengers is to partner with other fintechs who offer complimentary solutions, or move to acquire them. For example a digital bank like Monzo can’t afford now to invest in the serious manpower required for credit risk research and technology development. They might grow big enough to be able to acquire a fintech with a great credit risk solution further on down the line, and as startups, the challenger banks have a head start in seeing these types of deals from both sides. If this smaller fintech has the technology and has already solved the problems that arise in developing a new credit risk product, the bank could instead go out and acquire that business or partner with them.

This is the growth strategy for a lot of fintechs - tackle a niche with a great product, mature that product, reach a critical mass of customers, and then look to be acquired by a bank. As a result, private equity money is more easily available as the private equity companies know this, and are looking to pump and dump.

The private equity firms are looking to get in now, knowing that these fintechs have always planned to sell to the highest bidder at the time of maximum likely valuation based on maximum likely scale, and that both the likelihood of a successful exit is high, and the runway is short.

4. After the era of unbundlers, comes the age of convergence

Having to deal with multiple providers, or finding that certain provisions are no longer served is not always an ideal customer experience.

The customer finds they need to use more and more different providers for their required front-to-back experience, or come to miss aspects of the old value chain - for example wanting more details on a property they want a mortgage on, and finding there isn’t an estate agent in the process who can help anymore.

Again, the principles behind Open Banking and platformisation can provide the potential solution. You’ll probably always have different providers for different aspects of the banking services, but the customer doesn’t need to know this, any more than they need to be privy to AWS infrastructure.

The question becomes who’s providing the best platform and the best seamless customer experience, or who owns the interface with the customer.

Ultimately, the customer doesn’t even need to know which of the services are provided by which of the banks or which providers, and in this way Big Tech like Amazon or Google could win. It could be that my card is provided by Curve, and my loan is powered by Funding Circle, but that information doesn’t need to be exposed to me.

In this potential future, there are maybe four or five platforms providing the best customer experience and mix of services, and it’s at this level that the customer actively makes their choice. The big trend from tech is reaching a segment of one - where every single user has a slightly different product experience - one that is built for them, and these platforms will compete to provide the best provision.

Conclusion - there’s only one certain beneficiary

Until one or two players really figure it out, you’ll continue to see challenger banks and fintechs popping up and finding gaps to fill. Whether the space will calm down soon, or new winners will emerge, it’s almost impossible to say.

It could be that we’ll start to see real mass migration of customers to challengers, in which case we would see acquisitions from the incumbents as well as from GAFA et al, and this is part of way the current challenger banks will not exist in the same incarnation they do now.

The banking world is changing rapidly - some players will die an ugly death while others will win handsomely, but a few years down the road the consumer is going to have a very different financial experience - across banking, wealth management, lending, everything you can think of.

But just as in the dotcom bubble, whose boom and bust we may take for granted these days, our lives will be transformed as a result. That’s the one thing we can be sure of - that the customer will benefit.

Birendra Agarwal is an entrepreneurial banking and FS tech exec working at the intersection of banks and Fintechs. His expertise spans Capital Markets, Transaction Banking and Wealth Management with a particular focus on Digital and FinTech. He was previously CIO Commercial Banking at Lloyds and Managing Director, CIO, Global Fixed Income, Currencies and Commodities at Citibank. He has been an advisor to many startups and is now Managing Partner of Envision Consultants.

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