"Challenger": used to describe the new generation of banks that are, for the first time, taking on the dominance of high street players like Lloyds and Barclays in the UK, it’s a term attracting more and more buzz around the industry right now. The likes of Metro, the first bank to get a licence in 100 years, led the way and now digital-first players like Atom, Mondo and Tandem are really galvanising momentum in the space as they look to capture a growing appetite for change among bank customers sick of poor service from their banks.
For many it’s an exciting time, with these new players promising the first real shake up of an industry that hasn’t budged for hundreds of years. With less (or no) branches, no ancient legacy systems and technology designed for digitally-savvy consumers, the promise of cost savings, transparency and efficiency is great. But the hurdles are massive. To be allowed to fish in this pool these new banks are subject to (necessarily) strict regulation - just like the traditional banks. Despite pressure to increase competition in the sector there are contraints on growth that are holding that back and regulating challengers in a way that protects customers but enables innovation remains difficult.
One problem facing the challenger banks relates to their capital requirements. KPMG head of challenger banking Warren Mead described the current regulatory regime a “potential inhibitor” to challenger growth, suggesting that it favours incumbent banks over the emerging challengers.
“This is particularly true with regard to the regulatory capital regime,” says Mead, in the firm’s challenger banking report from May. “In theory the rules apply equally to all banks, in practice however, they don’t. Challengers have to hold more capital in comparison to the big banks.”
That’s because of perceived risk and here's where not having that legacy becomes less advantageous. As challengers don’t have years of in-house data to show regulators, current testing make these players seem riskier than established players, explains Mead. Without all that data, challenger risk is measured using a ‘standard’ model rather than the advanced model incumbents use and the result, is a higher risk weighting and a bigger capital requirement. He says that can result in a new bank having to hold “several times” the capital of an established bank against a loan to the same counterpart.
“If challengers are to thrive in the mass market, something must be done to recalibrate the regulatory regime,” says Mead. “To attain the ‘advanced’ model rather than ‘standard’ designation requires access to data that few challengers have, as well as a huge commitment of time and money.That doesn’t mean they are riskier propositions. In fact, given their focus and simpler business models they may well be less risky. However, when the regulator applies the same tests across the board the new generation of institutions are placed at a disadvantage.”
Clearly, if challengers are getting hit hard on this, it reduces the cost savings they would otherwise be able to pass on to customers through having newer models, less (or no) branches and digital-first services. That in turn makes it tough to compete with the big players. Especially when added to other big costs such as the high price they have to pay to access payments infrastructure dominated by the big banks. While this is something the Payments Services Regulator is working on, the process is still ongoing and the climate remains tough for these new players.
Pressure on regulators
There are growing calls for this to change, spearheaded by a campaign urging ministers and regulators to implement softer regulation launched by the the British Bankers’ Association (BBA) in 2014. Writing at the time, James Barty, the BBA’s Director of Strategy, said the same levelling of the playing field needs to happen in banking as it did in supermarkets: “Customers are the biggest winners from competition. You just have to look at how easyJet, Ocado and Lidl have shaken up their industries by providing new goods, services and price structures.
“The best way to promote competition is by creating a more level playing field for players of all shapes and size. It’s vital that we don’t treat all banking markets as the same and introduce rules, regulations and costs that smother changes that are already driving competition.”
While the Basel Committee on Banking Supervision has acknowledged current capital requirements need to be adjusted, its proposals haven’t been entirely reassuring for challengers. In fact, in December the chief of Prudential Regulation Authority (which is part of the Bank of England) Andrew Bailey wrote a letter to challengers telling them UK authorities would push back on moves (with the latest in December) from Basel that would require challengers to hold more capital. The BBA described it as a “step in the right direction” in some ways but flagged up areas of concern for challenger banks.
Ultimately then, these are challenging times for both the traditional banks that are grappling with cost models and implementing new approaches to old systems, and for the new entrants trying to build something new without that legacy.
That said, the past two years have been an exciting time for this space, with some of the outriders in challenger banking going public and KPMG noting that challengers outperformed the Big Five last year, continuing to grow in a shrinking market due to the cost advantages of their models. Meanwhile, momentum is growing among the digital players, with successful crowdfunding rounds from Mondo and Tandem pointing to demand for change from customers.
Not all these new entrants will make it. Some will fall by the wayside as many startups do in the attempt to disrupt old industries while others will get bought by banks that are looking to buy what they can't build themselves. Banking is an old and complicated industry and in many ways its disruption is only truly beginning so there's plenty to be optimistic about.