The Fintech Perfect Storm
Fintech as a trend has been huge since the first challengers hit the scene in 2014, starting with Starling and followed by unicorns Revolut, N26, and Monzo over the next two years.
In Q2 2019 over $8.3bn was raised by Fintech and Neobanks alone, with mega-deals driving the numbers in the main. Outside of the general concerns for VC valuations in the wake of the WeWork S1 announcement, the main concern for me with Fintech in particular is that it’s not all VC fun and games any more. In this maturing market, these start-ups are now acquiring full bank licences; they have fiduciary duties to their clients and those duties include their own sustainability.
I’m going to go in a bit here, but hear me out.
Banks have come under increasingly intense regulation in the wake of the financial crisis of 2007 to 2008, with Basel 3 and MIFID just to name a few of the larger recent additions. Overseen by an increasing number of regulators, both national and international, they look into rigorous numbers of KPIs such as Capital Adequacy Ratios and Liquidity Coverage Ratios that tell you in a nutshell just how healthy a Banks Books really are, and how safe your funds are as a client.
I will save you very specific and boring jargon limited to bankers, but fundamentally we have a problem here that I will explain.
If a bank owns risky assets, it should have something tucked away in the case it all goes wrong and the asset goes up in smoke; a common sense measure shown by Capital Adequacy Ratios. Generally this is made up of HQLA (High Quality Liquid Assets) including cash at hand, Government short dated bonds, and at the worst level Publicly Traded Equity and Corporate Bonds. These make up the bedrock of the Bank and provide it with a buffer to systemic shocks that may affect the values of their loans and deposits.
Consider Monzo as a great example of this general market of loss leader fintech neobanks. With their massive losses of £47.2m for 2019 they are the most aggressive loss leader in the cost-centric Fintech market. While this year is going well for them in terms of funding, their CET1 ratio is 126% a number above the required 100% for systemically important institutions. That has reduced 70% YoY and to quote their last filing “Monzo’s Capital Resources consist solely of paid up share Capital.” Currently that capital stands at around £115.6m. If they continue at their constant expansion of losses, worst case scenario losses expand to £67.3m which would make sense given the beginning of their US operations. Best case scenario in my mind is a £37.7m loss for the year 2019–2020 leaving a meagre best case capital without further raises of £77m or worst case £48.4m left.
With their continued aggressive expansion of assets and their huge moves in client overdrafts, their risk assets are colossally growing from £200k to £19.3m, a path they see as driving potential future incomes for the firm. These are unsecured loans, with their client focus and marketing acquisition strategy on students and budget conscious consumers. The repayment probability will be heavily liable to economic downturns as we will be foreseeing with the recent yield curve inversion. We can predict that as Monzo continue to add to their loan portfolio it will be a high risk one to say the least, even without considering the looming possibility of recession. Currently approximately 20% of their loan portfolio is given a high risk rating, their carry values reflect this with significant discount, yet for all this risk they are working on loans starting at 3.7%, much lower than even Starling Bank’s 15%. To say the relationship between risk and reward is skewed at Monzo is an understatement.
On top of this we are seeing that the users of Monzo are using it simply as a back up to a main account, regardless of efforts to transition most to full main accounts with Monzo, again adding exponential potential for deposit flight in a downturn from Monzo.
Here we see the Risk Weighted Assets expanding exponentially, their Tier 1 Capital Depleting at an alarming rate due to a loss leader business model and market conditions that will leave them wanting. So then, what is the plan to capitalise the bank and remain within banking regulation on required capital? That’s easy,
More VC money
Monzo has been forced in a competitive market to focus on user acquisition to justify further investment from Venture Capital. This is leading to further losses, a deeper need for further investment and an aggressive cycle of a venture capital dumpster fire. VC’s are becoming obsessed with betting on what will be the leading NeoBank, sacrificing profitability for huge growth leaving it simply as an after thought. To this end, they are nearly 5 times larger than Starling in users, yet are further from the goal of profitability. With Starling a British Fintech Darling, with twice the capital in the bank for the half the annual losses, I still see systemic risk, yet Starling seems to be aiming to pull up from the usual VC cash at hand nose dive before a hard landing with its monetisation drive and newer features. Starling are beating with their incredible results as Britains Best Bank by a small margin in terms of customer feedback but by fundamental stability they seem leaps and bounds ahead in quality. In terms of numbers of users, Revolut has just crossed 7 million, Monzo is at 2 million, so they are losing the user race, so where do monzo and the other 40 UK and EU Neobanks fit in the market?
It is simply my opinion, but I do not foresee profitability in Monzo for the next 2 years at the least with their ambitious US roll out and expansion focus. With their much publicised “Net Contribution Margin” of a whole £2 per account, assuming a linear relation thats 23.5m users to add to reach profitability, or based on more common sense diminishing marginal cost, a conservative estimate of 6m new accounts, which if we include their incredible growth figures and presume they sustain at such a rate even in a cluttered market, it is still 3 years out.
In fair-weather markets, raising further VC money on the dream of profitability with their current growth rates will be no problem, they will continue to live in a badly incentivised system of Venture Capital, itself a product of the global return hunt in a world of negative rates and vastly pumped markets. What happens in a recession, as has been predicted in the next 6 months with the previously mentioned inverted yield curve?
Well LPs and GPs are locked into deals and will find it hard to continue to raise additional funds at the break neck pace we have seen over the previous 5 years. They become conservative with deals, smaller sizes, limited deal numbers, conservative bets, and from the numbers, Monzo is far from a conservative bet in a cluttered market. We can easily see that there may be some reduction in possible raise potential or at the very least it will cap valuation gains.
Its efforts to secure further funding has already flirted with scrutiny, With its last round open to the public, alledgedly Monzo allowed their own account holders to go overdrawn in order to purchase their shares in the offering via Crowdcube. An odd 1929-esque move that would leave Galbraith spinning in his grave. Even before the Great Crash, at least the brokers weren’t daft enough to lend on margin to buy their own shares.
While progress has been incredible at Monzo in terms of users, they are addicted to Venture Capital Funding like a tweaked out Meth-head with profitability a pipe dream as distant as ending the Israel-Palestine hostilities over a cheeky pint.
Its truly an Icarus Story, in pursuing the highest possible user acquisition and the most absurd valuations. Its shares are valued at 551 times operating revenues, compared to Lloyds Bank 7.1 times Earnings. Earnings? A bank that makes a profit?! Madness!
Mass market Fintech selling on a low cost model is dying if not dead. The Market is utterly saturated, and the next recession when it comes, will clear the field of those who reached too high, too quickly. This story is not quite such a pointed attack at one firm, arguably Monzo is far ahead of the other 40 Neobanks in this same situation yet all of them pursuing this full licensing will encounter the same issues of meeting capital requirements and fundamental stability with such business models.
Banks have a Fiduciary Duty to Depositors and Clients, Start-up mindsets and ping pong table at WeWork Valuations are doing no favours to the end users. One of their largest risks is that users do not trust the bank with all aspects of their finances, and that is simply from the fact that, sometimes, we don’t want a start up culture or visionary status, we want stability.
Business models have to change to address this core issue of stability, while the idea of zero cost sounds great, Fintech is so much more than simply the eradication of cost, it is the improvement of service and finanicial inclusion for millions. If the aim is solely free users, these companies are charities, if the aim is truly service and to be a full bank, then we can only hope for incumbents that will be able to overcome the horrendous incentives in Fintech from Venture Capital and focus on stable growth.
So what is a solution?
Profitability and monetisation.
They need to pull out of a nose dive. Having millions of users that make no money makes you a large charity not a business.
Private Funding Rounds need to stop.
These firms are massive with huge valuations, they need to be public and more answerable to shareholders.
Consolidation.
It won’t be a choice soon, when you fall out of capital rules as a bank, unless you recapitalise quick, you’re bought or you flop. We can either wait for the next recession and have them all pop, or we can realise that in the VC gamble on who will be the largest loss leader in Fintech, there are a huge number of failed bets about to be called. This market is ripe for some solid M & A activity, I would hope for more M and less A, if we stay on this course, the old world Banks that are somewhat more stable will just pick them up pennies on the pound and they will soon lose their energy and innovation in a tidal wave of grey suits and grey hair. I don’t want to ring a deathbell for Neobanking, just daft business models.
Conclusion
We can only hope for a new wave of fintech more committed to their obligations as financial institutions with stability as a bedrock of their models. Leave the move fast and break things attitude to Facebook, Banking needs a more careful touch.
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