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Fintech

A turning tide for challenger banks?

Republished By Plato
Republished By Plato

Date:

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The climate has changed for fintechs and challengers this year. They are entering unchartered territory in a rising interest rate and recessionary environment with tightening funding and incumbent fightback. Their competitive edge around niche propositions,
superior customer experience and rapid growth is being eroded by a number of factors.

Funding

Challenger banks are no longer able to comfortably attract funding on the basis of their large target addressable markets alone. Funding has declined by nearly 80% since the 2021 peak levels across all categories with banking and lending more impacted than
say wealth tech or payments. This was true across the world except Africa. As a consequence, since April 2022 fintech valuations dropped across all segments and geographies by an average of 60% although revenue has continued to grow. Investor scrutiny has
shifted from growth and customer acquisition to the underlying drivers of profitability and cashflow like margins, customer retention, customer credit quality, share of wallet and operational costs.

Incumbent fightback

With their diversified product portfolios, sizeable lending business lines and large IT budgets, incumbents are better able to withstand the adverse macroeconomic environment. They have been rapidly closing the gap on digital and technology with compelling
digital propositions on a wider range of products post-Covid. They are moving to public cloud and have IT budgets that dwarf the VC funding available for neobanks (up to 11X in 2022) , and are also using M&A to close gaps in digital functionality. Bank of
America is spending billions on core modernization and digitization and already reaping the benefits – 82% of their wealth management clients are digitally active. JPMC, Capital One and PNC are all investing in cloud native technology. Many are also starting
to focus on many of the challengers’ niche segments such as Citi’s focus on SME, Natwest’s acquisition of Rooster Money to focus on financial education for children or PNC Bank’s acquisition of POS firm Linga to target restaurants. Many continue to invest
in their digital subsidiaries to directly compete with neobanks such as Standard Chartered’s Mox in Hongkong, Natwest’s Mettle and JPMC’s Chase in the UK.

Competition

Apart from incumbents, competition is intensifying for challengers across the board. The target segments are getting saturated with the number of challengers entering the market. Those aspiring to become superapps lack the scale or ubiquity to attract customers
in the face of payment, e-commerce and technology platform giants. In the ancillary product areas, they face competition from specialized vertical fintechs such as Robinhood in wealth, Klarna and Affirm in BNPL or Coinbase in crypto-wallets. In the US, they
face competition from digital wallets, embedded finance and other forms of account to account payments.

Regulatory headwinds

The regulatory arbitrage that challengers successfully capitalized on in many jurisdictions is also closing. In the US, for instance, products like wallets are coming under regulatory scrutiny with deposit insurance and regulatory capital required. Reg Z
or Truth in Lending and Reg W which regulates non-bank transactions between depository institutes and affiliates are all creating a level playing field between regulated and unregulated entities. Also, the lucrative interchange fee model is under threat. In
any event, challengers forego the advantage once they scale and increase their accounts and assets beyond the $10M Durbin limit.

So, what next? Challengers face an uncertain future. Some will run out of cash, some will get acquired by incumbents or even the more successful challengers, and then there are those that will succeed independently. This will be the subject of my next post.

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