For major lenders trying to cut costs, the rising popularity of online banking could be a convenient trend. Mobile banking usage by UK retail customers increased by more than half during the two years to October 2016, according to ebenchmarkers data. What’s more, research consultancy CACI predicts that banking app transactions will more than double by 2022, while desktop and laptop interactions will decline by almost two-thirds.
For high-street banks trying to reduce their cost-to-income ratios, changing customer behaviour has led to a shift in investment. Earlier this month, Lloyds Banking (LLOY) announced plans to cut a further 1,230 jobs and close 49 branches, as part of its three-year plan to improve its digital services and drive down costs. It will also increase staff training to 4.4m hours a year, including digital roles.
But it’s not just the desire to cut costs that’s driving digital investment. Several digital banks have been granted banking licences by the Bank of England over the past three years. They include app-based bank Monzo, current and business account provider Starling and small and medium-sized enterprises (SME)-focused OakNorth.
Open banking: start of a revolution?
Investment in digital channels has been spurred by the EU’s second payment services directive (PSD2), introduced as ‘open banking’ under the auspices of the Competition and Markets Authority (CMA) in January. The regulation aims to ensure “more competition, greater choice and better prices for consumers”, while better integrating the internal market for electronic payments within the EU.
The UK’s nine largest retail banks have been forced to invest in ‘application programming interfaces’ (APIs) that allow customers to share their data securely with third parties, ranging from challenger banks to start-up financial technology businesses. The idea is that smaller rivals will be better placed to compete for customers' business, by having access to customer information such as spending habits and regular payments made. However, customer consent is required. Given the column inches dedicated to the threat of cyber attacks and data leaks, some customers may be understandably wary about granting that permission.
Banks have had to provide the initial APIs for free. However, Dave Tonge, chief technical officer at third-party aggregator Moneyhub, as well as working with the Open Banking Implementation Entity to define the standard for UK banking APIs, reckons there is the potential for add-ons that lenders could charge for, once the dust settles. Mr Tonge says some banks are looking to go further than just providing balance information, transaction history and the ability to initiate payments. That could include enabling customers to open new accounts, he says.
Start-ups: threat or opportunity?
One of the advantages online-only start-ups typically have over mainstream counterparts is agility; without the same legacy IT systems and branch networks, they can adapt more quickly to customer needs. What’s more, some of these newcomers are having no problem attracting new users. Take one of the more prolific newcomers, Monzo, which gained 240,000 pre-paid customer accounts in the year since the product – which closed in earlier this month – was launched in March 2016. Meanwhile Atom Bank, backed by Spain’s BBVA, built a book of residential mortgages and business loans totalling £99.3m in the year since the app was launched in April 2016.
But are these start-ups really a threat to the mainstream players? OakNorth may have become the first UK digital bank to report an annual profit for 2017, but the vast majority of digital-only challengers are lossmaking. For example, Atom Bank incurred a £42.2m pre-tax loss during its first year, while Monzo reported a £7.9m loss in the 2017 financial year from a £1.7m loss in 2016.
Crucially, these banks must grow their loan books faster than the hefty upfront operating costs. Henley Business School’s Professor Brian Scott-Quinn, who is also a non-executive director at digital SME lender Civilised, reckons lenders' eagerness could result in a reduction in the average credit quality of some start-ups’ loan books.
Professor Scott-Quinn also thinks diversification could be an issue – the digital start-ups typically offer a small number of products, for instance overdrafts on current accounts or SME loans – as well as more onerous capital requirements. Smaller lenders must usually take the standardised approach when estimating the risk parameters to calculate their regulatory capital. That requires them to hold a higher level of capital against their loan books, potentially limiting returns. That’s opposed to the internal ratings-based approach used by the larger lenders, which leaves them with more capital to invest.
Tom Blomfield, chief executive of Monzo, says building up funding has not been an issue for the start-up. He says Monzo is the “polar opposite” of traditional banks and has a loan-to-deposit ratio of just 1 per cent. But how does the digital start-up intend to turn profitable? Mr Blomfield says the business has reduced the average loss per customer account per year from £50 to £20 by increasing the efficiency of its operations. It makes money via three methods – lending, interest on the cash balances it holds with the Bank of England and by earning a 20 basis point card issuer fee each time its card is used to make a transaction.
It provides a current account with a £1,000 overdraft facility to just 5,000 customers, but that will very shortly be rolled- out to others. It is also considering a product that would enable customers to finance larger purchases. Yet there’s a fourth method, which Mr Blomfield describes as the “holy grail” and the reason the app was founded. That would be to build a “retail control centre” that would enable account holders to not only view their various bank and credit card accounts in one place, but also switch providers for services including utilities, mobile phone, mortgages and insurance, although the latter two would be subject to regulatory approval. Beyond simply finding relevant offers to help people save money, the focus would be on making sure the switching process is “seamless”. Mr Blomfield describes it as like “the next generation of price comparison”.
Charging for the service could take the form of a commission from the service provider, or a service fee charged to the user. If that’s a model that takes off, businesses like Monzo may necessarily be a threat to more traditional financial services providers, but could be another revenue stream if they are willing to work with third-party apps.
