The Challenges facing the Challenger Banks: what’s holding back a European invasion? (1/2)

Recently, I sat with Monica Murthy of Empire Startups to speak to founders of 20 UK Seed/Series A companies as part the TechNation Fintech Programme’s international showcase. One topic dominated much of the conversation — the state of European Challenger Banks and their expansion to the US; therefore, this post articulates my answers to a topical question on the issue.

The TechNation programme’s focus of exploring the US Fintech ecosystem and testing the prospect of expanding to the US mirrored two important aspects of our work at Octopus Ventures: supporting European Companies expanding to the US and coalescing specialties in the Future of Health, Money, and Deep Tech. Given the program’s subject and my focus on the Future of Money, the founders’ questions probed at aspects of the US market of particular relevance to UK FinTech companies, including the consumer banking experience.

The US Market and the Challengers’ Appeal

Right out of the gate, the first question posed by a founder was: “When will the challenger banks/digital banks in Europe (e.g. Monzo, Startling Bank, N26 etc.) expand to the US??” Quite simply, European Challenger banks, or neobanks, have made many, many, many, many overtures of expanding into the US for years now. With unicorn valuations aplenty, record amounts of funding, and expansionist ambitions that stretch beyond Europe, many of these Challengers see a move to the US as inevitable.

But as we sink further into 2019, none have taken the Louganis plunge. Why not?

In answering this question, I’ve drawn on my answers in that session, research and learnings from my work, and numerous conversations with fellow investors, bank representatives, and entrepreneurs.

The sizeable market opportunity

First, let’s set the premise. It’s a universally-acknowledged-as-to-be-established truth that the consumer banking experience for many Americans is an exercise in frustration. Paltry interest rates on savings, countless account fees (earmuffs, Europeans: checking account fees are still ubiquitous in the US!), long, painful signup or switching processes, and a general lack of transparency are some defining features of the banking experience.

So, it requires no stretch of the imagination to see how a young, dynamic US customer would clamor for these Challengers’ digital offerings. Their popularity amongst investors in Europe is at a stratospheric high, commanding 3 of the 5 largest fintech deals there in 2018. Most, like Monzo in the UK, for example, offer value-addition on the existing retail banking experience. They do so by providing digital-only distribution, no-fee current accounts, high yield savings accounts, money management tools, and general transparency. Others excel at providing niche products, such as Revolut’s low foreign exchange or cryptocurrency wallet. Needless to say, all could fill some current existential gap in the US.

And capturing a piece of the US market would be a significant win for the Challengers themselves. With the US depository services market standing at a whopping $204.5bn, and market share of the four largest operators accounting for only 29.2%, several Challengers can win big in the US at the same time.

Tight unit economics define their evolving business models

Playing in the US market requires surmounting a series of challenges. The most formidable one — inherent in the very business models of the Challengers — is financial sustainability. No matter what their current models rely on — freemium subscriptions, fees (interest, interbank, transfer, etc.), frequent product rollouts, or more — all are dependent on and successful in achieving low unit costs and rapid user growth.

Take Monzo, for example. With its unmistakable “hot coral” card and its association as the hip alternative to the stuffy incumbents, it has grown like a weed in the UK, snapping up 1.4M customers and counting in a short period of time. Much of this customer growth comes from significant word-of-mouth referrals and organic marketing; therefore, it operates on a customer acquisition cost (CAC) considerably cheaper than the sizable amount traditional banks face.

Yet, these low costs aren’t just a laudable fact, they are a necessity, as the Lifetime Value (LTV) of the average Challenger bank’s customer is considerably lower than that of a full-suite traditional bank. Why?

For one, Challengers generate limited fee income from the current accounts (laden with net-negative revenue additional features). Even in their hottest markets, customers commonly use their Challenger accounts and cards as supplemental to their main ones, thereby limiting per-transaction revenue maximization. Moreover, the low earnings profile of their young target demographic limits interest or asset-based revenues. This profile can also limit upsell opportunities in cases where the banks’ current account serve as an on-ramp to higher-margin lending products.

Given these constraints, many flirt with low to net-negative contribution margins, prioritizing user growth in the near term while betting on hitting a future inflection point that yields exponential revenue growth. So far, this approach has bought them some time in their smaller, comparatively homogenous native markets. But will this secret sauce travel well?

The Foreseeable Challenges in Moving and Sticking

A squeeze on cost and revenues in the US threatens unit economics

Given cost and revenue constraints, it’s no wonder that the jury is still out on the long-term financial sustainability of the Challenger Bank model, regardless that some profess to have broken even. And the prospect of expanding to the US seems daunting on this front, as it would apply even more pressure on both ends of the income statement and demand a quicker route to sustainability.

Once in the US, the European Challengers wouldn’t be able to replicate the low-cost structure that’s allowed them time to move up the curve in Europe. In addition to the baseline costs of developing a new presence, the companies will have to spend to educate the US market on their value proposition as referrals likely won’t scale with US expansion. In an increasingly ultra-competitive landscape (more below) in which they’re unknown, they’ll likely need to pour funds into traditional marketing (Revolut’s middling efforts to organically build buzz with a US waitlist only prove this point.) They’d be forced to create differentiating features native to this market, many of which must be net-negative, at least at the onset. And navigating complicated federal, state, and local regulation will only add to their mounting CAC and general cost base.

Though alternative unit revenue opportunities exist in the US, on balance the prospects look no more promising than in Europe. For those European Challengers reliant on fee revenues, they’d still need to offer zero-fee/high savings rate offerings, frictionless onboarding, etc. — and the resultant low margins or losses — in order to entice a critical mass of early adopters. For those reliant on freemium models, the lower US customer penetration/awareness suggests that usage will disproportionately lean towards “free” rather than “premium” at the onset. Admittedly, one could argue the opposite: that being accustomed to paying account fees might make the US customers more willing to pay for premium accounts. But then the customer is trading the old for a de facto fee-based checking account — only with a shiny, new patina.

For those using per-transaction revenue models, there is the credible argument that high earnings from interbank card transaction fees in the US could yield high unit revenues (NB. This would apply only to Challengers partnering with banks unregulated under the Durbin amendment.) However, there’s little evidence that the US customer would transact more frequently with a Challenger’s card than the European customer does (in fact, the cash-dependent US payments system suggests otherwise). Therefore, in comparing an equal number of customers in Europe and the US, one might gain in unit revenues in the US but equally lose in total transaction volume.

The complexity of operating in the US should not be underestimated; Challengers will likely eek out margins and chase that elusive low CAC for a long, unforeseeable period upon expanding. This means that any Challenger that takes the plunge will face immense pressure to retool its business model to a sustainable one quickly, before its war chest zeroes out.

US customer expectations come into conflict with the value proposition

US customer expectations of what the Challengers stand to offer will differ from those of their European customer. Perhaps to their surprise, this will likely have an adverse effect on their competitiveness in the US. To some extent, credit cards and third-party apps in the US have attempted to fill the void created by lackluster current accounts. They’ve done so by offering functions (money management, low FX rates, low or zero fees, seamless bank integration etc.) and engaging in an arms race of side perks and rewards such as dining and travel points, lounge access, event bonuses and travel insurance.

These cards and apps in the US reflect the American service + perks paradigm within which many young, active residents operate or aspire to. They’ve also conditioned the US customer to believe that “more is more”, counter to the “less is more” ethos of the Challengers’ digital offering. Thus, a foreign Challenger’s current account or card offerings might struggle to compete.

Say, for example, a US customer wishes to transact cheaply on foreign travels. On one hand, Revolut’s primary offering of a digital currency exchange app with interbank foreign exchange (FX) rates is indeed appealing. But the Chase Sapphire Reserve card, a US credit card, offers not only competitive FX rates but also a bevy of other rewards — the dining rewards, travel allowances, lounge access package, and more mentioned above.

Granted, the Reserve card is costly and limited to the few that meet its stringent credit requirements. However, it (and others like it) stands as a real alternative to Revolut’s card and appeals to a similar target demographic. Moreover, its perks are negotiated using the capital and leverage of a bulge bank backer, JP Morgan Chase. To achieve a comparable set of perks requires sizable capital and negotiating power with providers that would only add additional strain to the Challengers’ economically precarious model.

Can the Challengers choose instead to recondition the US customers’ mindset? Perhaps. Can they do so at reasonable cost and effort? Unlikely, given that this requires market education, which in turn requires more spend and time.

Low switching costs are both a gift and a curse

Though frictionless onboarding or cancellation of a Challenger bank account is one of its major selling points, this quality has the potential to hurt customer stickiness. Research shows that the average US customer holds onto an account for 16 years, and an off-cited rule of thumb is that a customer with a checking, savings, and credit card combo from one bank will stay there for 50 years. Validity questions aside, this points to a broader assumption: being a one-stop shop in banking in the US has induced customers to stay longer with incumbents (and produce higher LTVs).

In some ways, the inefficiencies of these incumbents have also induced stickiness. Switching cost for US banking customers are quite high, and the process can be painful (multiple conversations, opaque bureaucracies, fees, etc.). The US customer usually bears most or all of the cost (in contrast to the mobile phone industry, for example, in which companies woo new customers by taking on cancellation fees from their old carrier). This means that many might be slow to shed dependencies on their traditional banks, though the quick onboarding offered by Challengers would alleviate some of the pain on the other end.

In turn, the ease with which a customer can open and close a Challengers’ account raises questions about their potential stickiness in the new context. Will US customers bounce in and out of them — or perhaps between them — given that they lack full-suite banking options? That most European customers tend to use their Challenger accounts as supplementary to their traditional accounts already raises stickiness and revenue maximization questions there. Nothing indicates these questions won’t persist, or perhaps heighten in the US, where customer penetration and knowledge is low.

US competitors hold distribution channels and other competitive advantages

A qualitative difference between traditional banks and the European Challengers is how well they understand young, digital-engaged customers, and how efficiently they’ve developed distribution channels directly to this demographic. Product development, branding, and engagement tailor-made for this demographic is a key competitive advantage of theirs, one they’d hope to rely on in the US.

However, a growing number in the crowd of US competitors possess similar competitive advantages, potentially nullifying the European banks’ sweet sauce. After a sputtering start, formidable US Challengers are beginning to emerge from the diffuse field, with some possessing the same branding savvy, access to an active demographic, and growth potential. Notably, Chime, a rapidly growing US Challenger bank that just achieved unicorn status, is using equal savvy, tight unit economics, and a depth of knowledge of the West Coast market and customer to build a formidable presence in the region and beyond.

Moreover, they hold their own advantages for competing in the US, some that the European Challengers might struggle to match. For one, traditional banks are also leveraging their enormous scale of customers in rolling out digital offerings (e.g. Goldman Sachs and their high yield Marcus account). Also, one can’t forget the looming threat of the social media or ecommerce tech titans (Apple, Amazon, Facebook, etc.) and other Fintechs (SoFi, Transferwise, etc.). Once these big tech players begin providing accounts, they stand to marry the scale of a JP Morgan Chase, the customer savvy of Instagram, and the brand recognition of Coca Cola.

US regulatory requirements make the prospect costlier and more challenging

The topic of the US fintech regulatory and how it influences the development of Fintechs in the US is one that is so meaty, it could dominate an article just by itself (which I’m itching to tackle…but not yet). Simply put, the regulatory landscape to operate as a bank in the US is unique, complicated, and ever-shifting, involving a maze of federal, state, local regulatory regimes with differing requirements.

The challenge of obtaining a banking license remains a significant impediment. To operate in the US, a Challenger could obtain a national bank charter, state bank charter or a partnership with a licensed national or state financial institution. Getting its own charter would provide autonomy and maximize margins for the Challenger. But a conservative US regulatory climate meant that, up until now, it was impossible to do so.

Even today, with the path to obtaining a Special Purpose National Bank Charters laid out, challenges from state regulators and legislation make doing so a costly, uphill battle. Commanding considerable cost and a litany of capitalization and compliance requirements, this option is far more expensive and demanding than most Challengers can bear (SoFi and Square famously withdrew license applications in the past). And state charters are similarly difficult and costly, with the added challenge of providing limited scope for a Challenger’s operations.

The option of partnering with existing licensed institutions doesn’t come without its own wrinkles. Though less onerous, the revenue share requirement places an additional squeeze on a tight economic model. It comes with stringent requirements, oftentimes monitored by the banking partner. And the partnership model can lead to a conundrum: the European Challenger partnering with a national bank might end up partnering with a would-be competitor, making the relationship potentially short-lived with no “interchange arbitrage” opportunity. This likelihood is lessened in partnering with a state/regional player with state licenses, though this would limit the Challenger’s national scope.

Ultimately, the regulation question has proven to be one of the death knells of expansion plans so far. Some clarity and ease of licensing is expected from federal regulators soon. Does this mean that the US will finally see the European Challenger imports arrive sometime in 2019?

Do I think the European Challengers will ultimately be successful in expanding to the US this year? And if they do choose to, how can they do so successfully? Next, I’ll reveal my predictions on their chances, who stands to win the US consumer banking market, and more…

Next Post (2/2): Can They Do It? Predictions on the Challenger Banks’ US Prospects

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