Concern is rising among the UK’s challenger banks in light of an increasingly crowded market which, coupled with a sizeable squeeze on revenue margins, is inhibiting the desired move into the retail banking sector.
With recent data from the Bank of England highlighting consumer credit at a rate which is close to the peak of the financial crisis in late 2008, the sector is facing increased pressure and scrutiny from the FCA and the Bank of England in a bid to prevent another financial collapse.
Consumer credit grew 10% in the year to June, to almost £201bn, and, consisting of credit card debt, personal loans and motor finance, has accumulated much faster than household income over the past 12 months.
The pressure on lenders has been felt already, as while consumers have been encouraged to borrow by record low mortgage rates and credit card rates, problems will start occurring when interest rates start to rise and the charges become unaffordable. For challenger banks, this presents a sustainability risk.
What’s more, as the challenger banks are growing, so is their consumption of capital, which is causing a share level drop in capital reserves. This, coupled with ongoing funding pressures, is opening up an even greater level of scrutiny as the Bank of England tightens up on lenders.
In recent months, chief executives at some of the UK’s largest challenger banks have voiced concerns regarding the vast consumer credit problem, and with a slowdown across the housing sector and capital points weighing on fledgling banks, the situation isn’t looking promising.
As challenger banks come under more and more pressure as a result of market saturation and an unstable UK economy, there is an even greater need for these nascent companies to diversify in order to prevent combustion. Opportunities outside of the conventional retail banking sector offer a safer bet, and in order to remain competitive (and indeed solvent), these companies should be looking to explore alternative lines of business.
Challenger banks need to find a niche. With the focus traditionally on lending products or customer service, the most logical product to build would be a reliable and efficient payments product. There is a gap in the market for challenger banks to dominate in this space.
While the demand has opened up opportunities for fintechs, the reliance on correspondent banking will remain, but the innovation at the front-end of these systems is changing all the time. Traditional banking infrastructure isn’t sustainable given the relative inefficiencies of the systems used, and as both financial institutions and customers are seeking more cost-effective and timely payment options, the climate is ripe for challenger banks to capitalise on these opportunities.
Payments services provide a relatively easy revenue stream for a bank as they don’t require large amounts of capital – deviating away from the traditionally risky lending business and diversifying into payments is not only a lot simpler, it makes better business sense.
The most complicated piece around payments processing is operational infrastructure, which is the reason why banks have historically experienced lower margins than the more adventurous parts of banking such as lending and trading. However, the increasing number of effective and reliable outsourced payment providers is starting to provide banks with a comfort that outsourcing heavy operational infrastructure can make sense. This renders the payments business low risk from a capital perspective, and easily outsourced.
Operationally, traditional payment processing has incredibly high fixed costs – there are usually sizeable operational teams, and there tends to be low margin. When this is outsourced and the heavy human resource is no longer required, it becomes a high margin business.
Supplementing that, it provides a consistent revenue stream. Lending products, whilst annuity in nature, can often have variable and uncertain returns and timescales – whereas payments processing products tend to generate consistent and predictable revenue streams each year and then build upon it, creating a highly sustainable revenue model.
In terms of the traditional core banking space, most SME and mid size business customers don’t have access to the suite of capabilities that are provided for multinational corporates, so for challenger banks, that’s a perfect opportunity to capitalise on that space.
The industry has already seen a perpetual rise in fintechs and digital disruption to the traditional banking sector, but a hybrid bank which adopts new technologies and can support and enhance the capabilities of heritage banks could well be the answer.
Fintechs have the potential to help banks claim back a proportion of business from third parties, largely by utilising the required intelligence and capabilities that banks inherently possess (and that third parties may not), such as access to fraud and security checks and richer transaction data. Naturally, a side-effect of gaining back some degree of market share is that it will enable banks to hold more liquidity in the banking system, which will contribute in some way to the future stability of the UK financial economy.
As rising regulation with the likes of PSD2 is set to affect the financial sector further, it is becoming ever more crucial for these young challenger banks to embrace the changes and opportunities as the economic future of the UK remains steeped in uncertainty.