upstarts and the economics: the challenges facing banks

Banks are now the second cheapest sector of the stock market across the developed world. At risk from rising competition and technological disruption, banks are viewed with suspicion by many investors, with profits held back by lacklustre growth, increased regulation and record low interest rates, commonly said to be staying lower for longer.

The business model of many banks is under intense scrutiny today, with UK and European banks having recovered only haphazardly from the financial crisis. While UK banks restructured more quickly than their European counterparts, they have been hampered by a series of miss-selling scandals. Since 2008, UK banks have set aside more than £79bn for fines and customer refunds. Lloyds, the most egregious in terms of mis-sold PPI, is expected to pay back close to £22bn, roughly equivalent to 60% of its current market value. A sluggish economy after the Brexit referendum has also kept investors away. Yet perhaps the worst place to be a bank has been Europe. As well as having to deal with the original financial crisis, European banks were hit by the rolling turmoil of the eurozone crisis. While the economic pain was mainly felt on the periphery of the eurozone, the interconnected web of European banking meant almost all continental banks had a difficult ten years. In recent years, measures intended to support the eurozone economy – such as negative interest rates – have hampered the profitability of eurozone banks, and their ability to lend to the real economy. Under negative rates, European banks are charged for holding a portion of their reserves with the ECB. Since their introduction, European banks have paid the ECB more than €20bn, detracting from profits and capital generation. The ECB recently cut deposit rates further into negative territory, leading to sustained top-line pressure for banks in Europe which are already struggling to generate profits above their cost of capital. We believe the normal bank lending process breaks down in such an environment and arguably exacerbates some of the problems negative rates are intended to solve.

Dealing with the upstarts

Investors are also concerned about the threat posed by new challenger banks. These include upstart digital rivals like Monzo, N26 and Starling Bank, but also companies like Klarna, which threaten to cut banks out of traditionally profitable areas like credit card lending. Unencumbered by legacy technology, the challenger banks are more nimble than the traditional high street banks. They start with clean technology able to process banking transactions in real time. Established banks are largely reliant on old technology infrastructure that has been updated over several decades. In many cases, those systems are also the result of different systems being bolted together after mergers or acquisitions. By contrast, the challenger banks have been able to offer customers a fluid banking experience. Monzo, for example, is designed primarily to be managed on your mobile phone. All payments are categorised according to spend, helping people to budget and manage their money. You can round payments up to the nearest pound to help you save, pay back friends using their phone number, or even access your monthly salary a day before it is paid into your account. Klarna is perhaps the best example of banks being cut out of the picture altogether. The Swedish start-up allows people to shop online without having to pay for their goods immediately, effectively working like a credit card, with the important exception that it doesn’t charge interest.

Instead, Klarna makes its money from retailers, who are happy to give it a transaction fee for making it easier to shop online. For cash-strapped millennials who love to shop, Klarna allows them to spend without having to wait for online refunds from returned clothes that did not fit1. But if you use Klarna, why would you want a traditional credit card which might charge you interest?

Challengers are catching up, but have a long way to go

For the meantime, the challenger banks are yet to make a significant dent in the traditional banking industry. The ‘Big Four’ UK banks2 retain a tight grip on their customers. Lloyds in particular benefits from advantages of scale, responsible for a fifth of all mortgages in the UK and one pound in every four on all credit card borrowing. While its Goliath-like dominance helps it to maintain strong profitability. Monzo, by contrast, has never turned a profit. The ultimate marker of business success is profitability, but this is perhaps the wrong metric on which to judge challengers like Monzo for now. Digital banking is still relatively new and people clearly like it, with adoption levels increasing. Monzo saw 260,000 account openings in June following a TV marketing blitz, with the bank hoping to reach three million customers by the end of 2019. Most importantly, the challenger banks are making traditional banks sit up and take notice. RBS is partnering with external companies to shape its response. Its strategy aims to shift the bank from ‘super tanker to speed boat.’ As part of this, RBS is soon launching a new digital only bank called Bo, intended as a direct competitor to Monzo. While there is a concern that the new bank might simply cannibalise RBS’s existing customers, it has little option but to try new things. RBS is also working to improve its products and services. Paperless mortgages, one of the selling points of its NatWest television adverts, were helped along by a company called Vizolution, and third party software from Ezbob lies behind its digital lending platform for small and medium businesses. The bank is increasingly willing to reach out beyond its in-house team as it strives to up its game.


In the short term, attitudes towards the banking sector are predominantly determined by how well the economy

is doing. That leaves the sector effectively stuck in limbo as far as investors are concerned. Banks offer what is known as a ‘leveraged’ play on the economy; a recession means they are more likely to take losses on their loans, while a strong economy usually sees falling loan defaults, higher loan growth and rising profitability. The longer term picture for banking remains more complicated. We will probably see some digital rivals coming through and establishing themselves, and it will

be particularly interesting to see how new business models like that of Klarna develop. The next recession will be an important stress test for the emergent bank competitors, and I would expect the big banks to be around for some time yet.

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