Organizing Digital Banks and Their Role in Emerging Markets, Part II
Organizing Digital Banks and Their Role in Emerging Markets, Part 2: Background of the rapid increase in challenger banks (Europe & USA)
We, UNCOVERED FUND, are a Japan-based venture capital firm that supports African startups. Africa, with its limited access to financial services, is in great need of digital finance, and in order to examine what kind of development Africa will achieve in the future, we would like to consider where Africa is today, looking at certain regions of the world, and how digital banks called challenger banks and neo-banks have been established around the world to attract new customers, particularly those whose needs and wants have previously not been fully fulfilled by traditional banking services.
In Part 2 and Part 3, we would like to introduce the background behind the successive establishment of challenger banks around the world, region by region. Of course, the spread of smartphones and the development of technology is a major factor, but the social environment and policies also have a significant part to play. In developed markets, the key argument and rationale is “the promotion of innovation and realization of healthy competition.” While in emerging markets, the key words are “financial inclusion”.
In this article, we will focus on developed markets (i.e. Europe and the United States). Emerging markets will be discussed in Part 3 of this series.
Table of Contents
1.Europe: United Kingdom
2.Europe: EU countries
3.The United States
1. Europe: United Kingdom
The UK is home to a large number of established challenger banks. Europe’s leading banks, Revolut (16 million users) and Monzo (about 5 million users), are headquartered in the UK.
Until around 2010, the UK was an oligopoly of the big four traditional banks, with strict regulations and high barriers to entry in the banking industry preventing new entrants. As of 2013, the big four had over 77% of the UK’s 65 million personal current accounts (see graph below), 85% of corporate current accounts, and over 90% of business loans.
In the backdrop of the financial crisis triggered by the collapse of Lehman Brothers, existing financial institutions were forced to cut costs, making accessing loans more difficult and putting customers at a disadvantage. In addition, the number of bank branches also decreased during this period, reducing the opportunities for over-the-counter services.
In terms of the Net Promoter Score (NPS), which measures customer loyalty, four of the five largest banks in the UK (the big four plus Santander), excluding LLOYD’S, are below the financial services benchmark of 49.
In the backdrop of this environment, deregulation was implemented with the aim of creating a healthy competitive environment. In addition, supportive policies for fintechs were implemented at the same time, which is said to have led to a series of new entrants.
Here are some of the Fintech (banking) related policies in the UK that supported new entrants into the sector…
- Relaxation of minimum capital requirements for banks
- Easing of the bank approval process
- Easing of the bank approval process — Facilitation of main bank switching (Current Account Switch)
- Promotion of open banking
- Fintech support policy: Tech City concept
Let’s take a better look at the specific policies…
Relaxation of minimum capital requirements
Specifically, the minimum capital requirement for banks classified as Small Specialist Banks was relaxed in October 2013. The minimum capital requirement for small specialist banks was lowered from 5 million pounds to 1 million pounds.
(A Small Specialist Bank is a bank that provides one or more of the following basic banking services: checking and savings accounts, loans to small and medium-sized enterprises, and mortgage lending.)
Easing the approval process (Mobilisation option)
When applying for a banking license, a company can now choose the “Mobilisation” option, which allows a company that does not have sufficient infrastructure (Staff, IT infrastructure, suppliers, etc) at the time of application to obtain a license within six months of application if it meets the requirements. If the company meets the requirements, it can be approved within six months. After receiving approval, the company is given a 12-month mobilisation period, during which it can develop the necessary infrastructure. If the infrastructure is not in place, the approval will be taken away.
New entrants who are approved through Mobilisation can hire staff and enter into contracts with third parties, using the “approved” status as a kind of trust. Atom Bank and Monzo have used this system to become licensed.
Current Account Switch Service (CASS)
In September 2013, the Current Account Switch Service was introduced to facilitate competition among banks. In September 2013, the Current Account Switch Service was introduced, which allows customers to switch their current accounts between different banks within seven days.
The new bank will also complete the process of changing your Direct Debit withdrawal account on your behalf.
You can choose between “Complete Transfer”, where the original account is canceled and completely transferred to the new account, and “Partial Transfer”, where the original account is retained. If you choose “Complete Transfer,” all transfers and withdrawals to your original account will be automatically directed to your new account. This is a very convenient service.
Promotion of Open Banking
In the UK, open banking policy has been promoted since 2014, and in January 2018, nine major banks were required to open their APIs for account information and connect to third parties approved by the Financial Conduct Authority (FCA) in advance. In January 2018, nine major banks opened up their APIs for account information and made it mandatory to connect to third parties approved by the FCA (Financial Conduct Authority) in advance. This has made it easier for fintechs and other third parties to collaborate with financial institutions. The same policy has been adopted in the EU, and will be explained in detail in the EU section.
Tech City Concept
In November 2010, Prime Minister David Cameron proposed the “East London Tech City,” which can be described as Britain’s version of Silicon Valley, as a way to promote the East London region after the 2012 London Games. Under the Tech City concept, various public support would be provided to start-ups in the Internet, technology, and digital industries. The UK government and the City of London invested 50 million pounds, to develop facilities for entrepreneurial development, promotion, and matching, as well as to establish a support system that includes corporate tax breaks, tax breaks for investment, and free office space for startups.
In addition to this, the city has attracted global IT companies such as Google and Amazon, as well as human resources with high IT skills, companies and accelerators/incubators. The number of venture capital firms in London has increased tenfold in the five years since 2010. As a result of these efforts, a startup ecosystem has been created in London, creating an environment conducive to the growth of IT startups.
2. Europe: EU countries
Promotion of Open Banking
Similar to the UK, European Union (EU) countries are promoting “open banking” policies with the aim of promoting financial innovation. In the background, as in the UK, there was an oligopolistic environment of traditional banks. Specifically, the European Payment Service Directive 2 (PSD2) was issued in the European Economic Area (EEA) in 2016 and became law in EEA countries by January 2018. PSD2 opens up APIs for banks and makes it mandatory for them to connect with service providers* authorized by PSD2. In other words, service providers such as fintech companies can connect to bank APIs without individual contracts with banks, as long as they receive prior approval from the government based on PSD2. This allows fintech companies to freely obtain customer data from banks and process payments upon customer request.
In continental European countries, when startups want to run a digital banking business, they often start as payment providers and obtain a banking license when they have grown to a considerable extent. In Europe, although deregulation is not as advanced as in the UK, PSD2 has made it easier for payment providers and banks to collaborate.
* There are two systems, AISP (Account Information Service Provider) and PISP (Payment Initiation Service Provider). Registration or authorization is required to ensure the safety of the providers.
- AISP providers can obtain user account information (registration required).
- PISP providers can use banks’ fund transfer APIs (authorization required).
Single passport system
In the EEA* zone, there is a “single passport system” that allows financial businesses to be conducted in any country within the zone if a financial license is obtained in any of the EEA member countries. This means that it is possible to access the huge market of the EEA with the minimum amount of approval required to obtain a banking license in any one country. As a case, Revolut, which originated in the U.K., did not have a license in the U.K., but used a Lithuanian banking license to operate in the U.K. and other EEA countries*4.
* EEA (European Economic Area) = European Union (EU) + EFTA (European Free Trade Association) regional community consisting of Norway, Iceland, and Liechtenstein
In the EEA, we continue to operate our banking business as a challenger bank. In the EEA, it continues to operate as a challenger bank, and is currently applying for a new license in the UK.
Immigration and Traffic
In Europe, there are a lot of immigrants and people coming and going within the EU, so there is probably a lot of potential demand. In fact, Revolut, which operates in the EU and other countries around the world, mainly targets tourists who come to Europe on business.
In addition, there are several countries in Europe where the percentage of account holders is low (58% in Romania), so there is likely to be demand from the unbanked. However, the UK, where Monzo and Revolut are based, and Germany, where N26 is based, all have high account holding rates, and the overall account holding rate in Europe is 95%. In addition, from their documents and related articles, they do not seem to have a strategy that focuses on the unbanked population in Europe. (The account holding ratio in each country is also discussed in Part 1 of this series.)
Decline in the number of bank branches
Another common trend in Europe, including the UK, is the decline in the number of bank branches. Although it is difficult to say for sure, it is possible that the decline in the number of branches has created dissatisfaction with the services provided by existing banks, and has created a potential demand for the spread of challenger banks.
3. The United States
Oligopoly environment
What about the situation in the United States? In the US as well, the traditional oligopoly environment of banks and the antithesis of existing services are the reasons behind the emergence of challenger banks.
The table below shows the pie chart of the banking market share in 2018. The top four banks alone account for 36% of the market. Compared to the UK, it looks less oligopolistic, but in the past, the share of Giant Banks was much smaller, only 16% in 1994.
Subsequent deregulation, including financial liberalization and the ability to bank across state lines, has led to increased mergers and acquisitions and consolidation of banks.
Increasing cost of using banks
According to a study by FT Partners, the cost of banking has risen, comparing 2013 and 2018:
- Monthly account maintenance fees ⇒ 8% increase (over $13 per month on average)
- ATM fees ⇒ 10.7% increase
- Minimum deposit for account maintenance fee reduction
- Percentage of banks that offer free checking accounts ⇒ 11% decrease (from 37% to 26%)
Cooperation with existing, traditional banks
Given the ever-increasing banking costs, this has only increased dissatisfaction of consumers. Digital banks came into the scene looking to shake things up and make banking more pleasurable, however the US is a relatively difficult country to obtain a banking license, and there is no financial license for digital banks. However, this license is limited to lending and check-paying services only, and cannot offer deposit accounts. Therefore, digital banks in the US are mainly “neo-banks” (mobile banks that do not have a banking license but provide services in cooperation with existing banks).In 2020, Varo Bank (formerly Varo Money) became the first digital bank in the US to obtain a banking license, making it a challenger bank (a mobile bank with a banking license) in both name and reality.
The case of Chime
Chime (with 12 million users), one of the leading digital banks in the US, is also an unlicensed neo-bank, and the accounts that Chime offers to its users are not its own accounts, but accounts with The Bancorp Bank and Stride Bank, which are licensed banks.
In other words, Chime is the interface and front service for customers. They provide the FDIC (Federal Deposit Insurance Corporation) with an account at The Bancorp Bank and Stride Bank. The Bancorp Bank and Stride Bank offer reliable “bank account” content that is insured by the FDIC.
With their strengths in smartphone-optimized UI/UX, Bancorp Bank and Stride are the first two banks in the U.S. to offer a smartphone optimized UI/UX to reach digitally savvy millennials and those who are dissatisfied with existing banking services. For The Bancorp Bank and Stride Bank, it will allow them to reach out to a previously unreachable customer base as their own account users.
For the existing banks, taking on the back-end of a neo-bank is one of the ways to fight against the oligopoly.
Thank you again for reading to the end of this article.
In the next article (Part 3), we will examine the situation in emerging countries. In Part 4, we will discuss the customer acquisition status and strategies of representative challenger banks in each country, and their success factors.
We will hear from each other again soon!
Stay in touch to the UNCOVERED FUND Inc. team:
Email: info@uncovered-fund.com
Twitter: @UncoveredFund | LinkedIn: UNCOVERED FUND Inc.
Looking to have UNCOVERED FUND as a partner for your growing startup? Let’s have a chat by filing in this form.
