Challenger banks surged into the mainstream in the UK during the late 2010s by offering consumers more innovative services and, often, better savings rates than the high-street giants were prepared to give.
But they have had a tougher time since 2020, first as the Covid recession constricted their revenue streams and now as the Bank of England keeps increasing its base rate to control inflation, putting a brake on the economy in the process.
The next 18 months could be particularly bumpy for them. How they fare will depend on how well capitalised they are, the quality of their offerings and their exposure to weakening customer affordability as the cost-of-living crisis wears on.
Several challengers have yet to post a profit and still rely on venture capital backers whose faith in the sector is waning. Yet they continue to enjoy explosive growth. More than a quarter of adults in the UK – about 14 million people – hold an account with a digital-first neobank such as Atom, Monzo, OakNorth, Revolut or Starling.
In theory, a period of rising interest rates ought to benefit challenger banks, because yields on their mortgages and other loans should, after more than a decade of ultra-loose monetary policy from the Bank of England, be increasing at last. The Bank has put up its base rate five times since December 2021 in a bid to curb inflation, which hit a 40-year-high of 9.4% in the year to June 2022. Some economists believe that the base rate could rise from 1.25% to 3% next year.
Which banks stand to benefit from interest rate rises?
Despite this favourable trend, “not all lenders will benefit equally, given their different funding profiles”, according to Fitch.
In a research note published in June, the ratings agency observed: “Larger high-street banks tend to benefit the most from rising interest rates, given their large market share in current account deposits. Mid-sized banks, [non-bank] mortgage lenders and challenger banks will find it more difficult to widen their margins. They rely more on savings deposits, for which savers will demand higher interest rates.”
Regulators have told banks of every stripe to put more money aside to prepare for potential shocks, which will further squeeze margins. More worryingly for neobanks, experts warn the mortgage market could slow down and loan defaults rise as more consumers feel the pinch from rising prices.
Simon Youel is head of policy and advocacy at Positive Money, a not-for-profit group campaigning to reform the banking system. He says that, while a period of higher interest rates “might be good for banks’ profitability, it also poses dangers. It is likely that more than a decade of low interest rates encouraged them to engage in all manner of risky lending in the search for yield. We don’t really know how much higher interest rates can go before bubbles start bursting. There are already worrying signs coming from housing markets in countries such as Canada, for instance.”
Monzo still showing growth
But the challengers seem confident that they can cope with such risks. Take Monzo, for instance. In its annual report in July, the bank declared that it had shown “extraordinary resilience” during the pandemic and was continuing to “grow at pace”.
In the year from March 2021 to February 2022, Monzo took on a million new customers and its deposits grew by 42% to £4.4bn, enabling it to pull in a record revenue of £150m. But it also posted a loss of £119m, following similar results in the preceding two years.
T S Anil, the bank’s CEO, wrote in the report: “While rising interest rates tend to benefit our business model, given the highly deposit-centric balance sheet we have, we need to remain watchful for the impact of cost-of-living increases on our customers. We’re yet to see a direct impact on our customers’ deposit balances, their spending behaviour or ability to repay us.”
Another risk facing the challengers is that investors, concerned about the faltering economy, are losing confidence in the fintech sector generally. For instance, Klarna, the Swedish giant of buy-now-pay-later finance, saw its valuation plunge from $46bn (£38bn) to below $7bn in July. And British mobile payments firm SumUp was valued at €8bn (£6.7bn) at its June fundraising round – a 60% discount on the price it had been aiming for at the start of the year.
Potential for some fintechs to fail
The indications are that numerous fintech firms will over the next 18 months and some may even fail. Starling believes that smaller “non-bank” operators could find life hard, but stresses that it and its fellow licensed players are in a much stronger position. The bank, which has about 2.1 million customers, reports that it is “very well capitalised” and not looking to raise more funds.
“We have established a settled and sustainable business model that allows us to generate our own capital organically and expand into new markets,” says a spokeswoman for Starling, which reported its first full year of profitability in July.
While there has been no hint that any licensed UK challenger is in dire straits, Australia’s first ever online-only bank, Volt, has ceased trading. In July, it surrendered its licence and returned about A$100m (£58m) in deposits to customers. That came after it failed to raise enough capital to support its mortgage-lending plans.
If a British challenger were to get into serious difficulties, Westminster would probably step in to help, according to Youel. He points out that some operators are highly exposed to government-backed Covid business loans, which would be written off in “implicit bailouts”.
Despite the risks, the neobank sector should be able to weather the UK’s cost-of-living crisis even if it sustains a few bruises along the way.
According to Rich Wagner, founder and CEO of the digital bank Cashplus, the best-run challengers “should be in a strong position to cope and even thrive” if the going gets as tough as the experts are forecasting.
These are “well-managed, sustainable businesses built on good economics”, Wagner says. “They will fare better than those that have chased explosive growth or dizzying valuations at the expense of solid foundations.”