Challenger banks are unable to capitalise on Open Banking

The much-heralded arrival of Open Banking has proved a disappointment. Neither the second iteration of the Payment Services Directive (PSD II), nor the concomitant efforts of the Competition and Markets Authority (CMA) to use digital technology to widen consumer choice and improve customer experience in retail banking, have had much effect.

In 2000 the top six banks accounted for 80 per cent of personal current accounts, according to the Financial Conduct Authority (FCA). By 2017, the figure had risen to 87 per cent. So while there is a lot of noise about the number of customers and accounts the challengers are securing, the facts about market share in retail banking tell a different story.

Research shows one in ten British consumers have switched their banking services to digital. Less than one in eight (12 per cent) of that tenth have switched to a digital-only bank. Nearly half (47 per cent) of those using any form of digital banking keep less than £1,000 in the account. It seems few customers are making the leap to app-only banks, almost certainly because of continuing mistrust – although apathy and so-called “shoeboxing,” in which consumers compartmentalise their finances, will have played a part.

It is not known how many of the two million digital-only bank accounts are primary, secondary, tertiary or “test” accounts. Consumers might be using digital accounts to pay for coffees and other everyday transactions, or to use the apps to analyse their day-to-day spending, and to be able to use a mobile telephone or smart card for the convenience of contactless payment. But the data suggests they keep this activity separate from their salary, their pension and their utility bills.

This is not the outcome challenger banks, other new entrants, start-ups and FinTechs were supposed to deliver. They were supposed to break the dominance of the established Big Four retail banks, revitalise the banking market in the United Kingdom, cut costs, improve efficiency and widen consumer choice. Instead, they seem either to be struggling with familiar funding and accounting problems (see Metro Bank) or failing to establish a viable business model.
It is tempting to blame over-cautious regulation. Certainly, regulation is always challenging for providers of retail financial services. The “Dear CEO” letter the director of the Prudential Regulation Authority (PRA) sent to challenger banks in June 2019 regarding their approach to risk quantification, control and management raised some interesting questions.

The PRA indicated firms were being overly optimistic about the potential impact of the various Bank of England stress scenarios on their businesses. In particular, assumptions that they would be able to raise capital, dispose of assets or widen margins in times of market-wide stress were thought to be unrealistic. The concentration of lending in particular segments- notably small and medium sized enterprise (SME) and buy-to-let landlords -might well make the challengers more vulnerable to stress, and the PRA clearly takes the view they underestimate the potential losses they could incur.

After all, the challenger bank business model inevitably steers the newcomers to taking on higher risk business, simply because the incumbent lenders have already taken the low-hanging fruit. Metro Bank, for example, has recently completed deals with three FinTechs designed specifically to boost its SME offering. So it is not surprising the PRA insists the higher risks are priced in, and that risk controls are tightened up.

That means challenger banks need effective governance (a senior management team which can make informed judgements, take appropriate action, and remain mindful of their Senior Managers and Certification Regime (SMCR responsibilities); better risk management (ensuring the business has sufficient resources and expertise to identify, quantify and mitigate the full range of risks); more up-to-date management information (accurate and timely information about assets and liabilities, delivered promptly to the right people, and especially the senior management); and operational effectiveness (making sure the loan underwriting and collections sides of the business are in order, both in terms of resourcing, and in terms of their adherence to regulatory requirements).
These are not the only regulatory challenges faced by the eponymous challenger banks. While the PRA has a focus on prudential requirements, and the overall stability of the financial markets, the FCA expects firms to pay due regard to the potential conduct risks of their treatment of end-customers.
The FCA have made it clear that they would take action against individuals at challenger banks under the SMCR regime. So, challenger banks have to be mindful that, even in the worst kind of market stress scenario envisioned by the Bank of England, the FCA will still expect business to be conducted with due regard for fair customer outcomes.

And that discipline will apply to unregulated as well as regulated business. It is telling that the scope of the Financial Ombudsman Service has been extended to include many more SMEs, even when they are engaged in unregulated activities with challenger banks.
So regulation is becoming more onerous but the lack of progress by the challenger banks might reflect another factor. This is that genuinely Open Banking is simply too difficult to achieve technologically. Basic Application Programme Interfaces (APIs) are not proving good enough to make it easy to change banks and generate revenues for newcomers. So-called “premium” APIs are unlikely to solve that problem.

As for improving banking services for small and medium-sized businesses (SMEs), the September deadline for PSD II with “strong customer authentication” (SCA) – a form of two factor authentication designed to increase security when consumers pay for goods and services on-line – came and went, with plans deferred for 18 months as most of the market was unprepared.

Most testing of all, challenger banks must comply with these regulatory and technological issues at a time when their financial performance and funding are being tested. The travails of Metro Bank have been well documented in the press. But in September there was a profit warning from Clydesdale and Yorkshire Banking Group (CYBG), which re-branded last autumn as Virgin Money after buying the brand in June 2018 and promising to create a contender capable of taking on the Big Six. Its shares have fallen by two thirds since then.

Written by Peter Smith – Non-Executive Director at Senecaim

Advisory Board Member of Future of Finance

March 2020