Challenger banks have faced a huge challenge of their own this year

In common with many businesses, so-called ‘neobanks’ have had a tough 2020 – but that has only served to underline the solidity of some of their more traditional rivals on the high street

28/09/2020

Juan Torres Rodriguez

Juan Torres Rodriguez

Research Analyst, Equity Value

The so-called ‘neobanks’, which have sprung up in recent years to challenge the incumbent giants of the high street by shunning physical branch networks and interacting with their customers solely through web platforms and mobile applications, have faced some challenges of their own in their short lives. Chief among these has been the potentially existential threat they now face as a result of the Covid-19 pandemic.

Of course, they are hardly unique in wishing this year had never happened but, while many businesses can at least hunker down and hope for the best, the neobanks may not have the luxury of time on the side. As one of the largest players in the market noted in its annual report in July, the uncertainties brought about by the pandemic “cast significant doubt upon the group’s ability to continue as a going concern”.

Informing your investor base there is a good chance you could go out of business is quite an admission for any company – and even more so when you are one the great hopes of the fintech world. One pandemic-related issue facing the sector is that many neobanks make most of their revenue through interchange fees on their debit cards, which have seen a big fall in spending over the last six months.

Not ‘first choice’

More broadly, neobanks are still struggling to be seen as ‘first choice’ – either by customers or regulators. On the former point, many people still use neobanks for secondary accounts, preferring to have their main one with an incumbent bank. As for where they stand in the eyes of the rule-makers, neobanks were initially excluded from offering loans to small and medium-sized businesses under government rescue schemes.

In short, the issue here is not so much attracting customers as “converting popularity into profits”, as the Financial Times put it in an article back in July. And if people choose to use neobanks for simple day-to-day spending rather than, say, ‘stickier’ long-term products, these companies will have to investigate other avenues for generating revenue, which could materially change their risk profiles.

At the same time, neobanks are facing stiffer capital requirements from the regulator. Addressing the chairs of smaller UK banks and building societies in July, for example, Sarah Breeden, executive director for UK deposit takers supervision at the Bank of England, said: “Many of the new banks authorised since 2014 seem to have underestimated the development required to become a successful, established bank.”

She continued: “A common theme with new firms that encounter problems is that they have not anticipated, and put in place steps to mitigate, the risks they face. Inadequate underwriting skills can translate into loan losses further down the line, just as poor anti-money laundering procedures can result in problems with financial crime and costly remediation programmes.”

Concrete illustration

A more concrete illustration of the regulator’s intent came almost immediately afterwards as it emerged that the Bank of England had raised the capital requirements of Monzo, one of the UK’s largest neobanks, as it undertook a round of fundraising. That meant, as this FT article observes, its “capital requirements were temporarily more than twice as high as many mainstream UK banks”.

This time last year, here on The Value Perspective, we urged Don't let fintech unicorns blind you to high-street banks’ positives, arguing the legacy issues that had affected the more traditional UK retail banks over the last decade were “largely under control – and, in certain cases, more than acceptably compensated for by solid balance sheets, attractive yields and profits (not just valuations) that can be measured in the billions”.

One extraordinary year later, no bank – old or new – is having an easy time of it but investors looking at the sector should now not be blinded to how the best of the more established players are already very well-capitalised and, as such, should pose considerably less of a risk than the younger generation.

Author

Juan Torres Rodriguez

Juan Torres Rodriguez

Research Analyst, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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