By Michael Tattersall, Financial Services Research Analyst

    Michael Tattersall

    In their near decade of existence, digital challenger banks have disrupted the face of the banking world forever, making a convenient digital experience table stake customer expectations. And investors responded to their rapid customer growth and Lean digital-only business models by providing them with the funding war chests to fuel their growth: Revolut, Monzo, and Starling have each raised in excess of $1 billion across several funding rounds.

    Yet the economic downturn last year has taken the wind out of digital challenger banks’ sails. Investors pulled back from digital challenger bank funding more than any other fintech funding category in 2022, with global funding nosediving by 63% year over year to $9.4 billion in 2022. This signals that digital challenger banks’ “customer growth at all costs” mentality isn’t as appealing to investors in the current economic climate.

    The harsher fintech funding environment has heaped pressure on digital challenger banks to chart their paths to sustainable growth to investors. This blog explores four possible routes they might take to boost their profitability in 2023.

    But before we focus on the profitable growth strategies, let's explore the causes of the challenge to this digital challenger banking sector.

    Why aren't digital challenger banks profitable?

    Digital challenger banks have lured in customers in their tens of millions in the UK alone by disrupting the banking user experience with faster onboarding and easy-to-use mobile apps. Yet the majority have failed to effectively monetise their customer bases illustrated by their low revenues per customer.

    Customers rarely use digital challenger banks as their primary account, which results in lower fees from smaller payments volumes and transaction amounts. Digital challenger banks are heavily reliant on low-margin debit card interchange fees. And they typically also have small lending portfolios.

    However, the success stories of Starling and Nubank demonstrate that profitability is within reach for digital challenger banks that can pivot towards profit-generating strategies.

    So why has digital challenger bank funding dried up?

    As well as overall fintech funding volumes declining after a record 2021, it seems that investors are shunning fintechs with a “growth at all costs” mentality, in favour of those with more sustainable growth models. And profitability has so far proved elusive for digital challenger banks: Less than 5% of global digital challenger banks were estimated to be breaking even in 2021.

    Now we know the issues, let’s take a look at my top four strategies for digital challenger banks to turn their scale into profits.

    Consumer Lending

    Consumer lending products will generate increased revenues for licensed digital challenger banks. UK banks with large lending businesses enjoyed a boost to their profits in 2022 from improved net interest margins amid the interest rate hikes. Higher net interest incomes will continue for UK banks in 2023, underlining the case for digital challenger banks to prioritise lending products.

    Brazil-based Nubank clocked net profits of $7.8 million in Q3 2022, largely driven by the rapid growth of its loan portfolio. While UK-based Zopa doubled its revenues in 2021 thanks to its consumer lending products.

    The caveat is that the risk of delinquencies and defaults will grow with the worsening economic outlook – and large UK banks set aside vast sums to prepare for bad loans in Q3 2022. Digital challenger banks that push into lending will need to invest in their machine learning capabilities to build robust credit models to power more accurate risk decisioning. Digital challenger banks will also need to find ways to increase deposits volumes to cheaply finance lending.

    SME Banking

    Business banking services to SMEs will be a key revenue growth driver for digital challenger banks. SMEs are more willing to pay fees for banking services and represent larger wallets to capture than their retail counterparts due to their higher cash flows and deposit volumes. What’s more, around a quarter of UK SMEs are considering switching to a challenger bank or fintech in 2023.

    SMEs have long been neglected by incumbent banks as they are not as profitable to serve as larger commercial clients. Resultingly, SMEs want lower fees, more flexible products, and better digital servicing. An SME can range from a one-man band to 200-strong organisation – and the different types of businesses require tailored offerings.

    Digital challenger banks can leverage their operational Agility and easy-to-use mobile apps to meet SMEs’ demands for greater flexibility and an enhanced digital experience.

    Already profitable Starling Bank has benefited from its strategy of targeting SMEs and says it will quadruple its profits this year thanks to the growth of its small business accounts. Given that the majority (80%) of UK SMEs use a high street bank, SMEs represent a relatively untapped opportunity for challenger banks to steal market share from incumbents.

    Monthly Subscriptions

    Subscription fees from a “freemium” model will bring in recurring monthly revenues and help digital challenger banks change course from offering largely fee-free products. Basic account services can remain free for customers and value-add services can be moved over the paid tiers of subscription.

    Monzo quadrupled its subscription revenues to £11 million year over year in FY 2022. Additional features deemed worth paying for by its customers include phone and worldwide travel insurance and fee-free withdrawals abroad.

    Turn existing customers into primary customers

    Digital challenger banks will focus on building trust and enhancing their mobile app experience to convert their customers into primary customers. Primary customers hold multiple products with their bank, are more loyal, and also more likely to recommend their bank. Incumbent banks hold a trust advantage over their digital challenger counterparts which partially explains why UK banking customers opt to conduct primary banking activities with the more established names.

    Digital challenger banks can kill two birds with one stone by supporting highly in-demand security-related features. According to Insider Intelligence’s 2022 UK mobile banking study, the ability to hold a debit card and receive alerts for unusual account activity are two of the most valued features among UK customers. Supporting security-related features will give customers peace of mind that their money and financial data is well-protected.

    Digital challenger banks must prove to investors that they can achieve profitable growth to still raise capital. Inflation is also driving up the cost of doing business, making it all the more pressing for digital challenger banks to compete for the smaller pie of available funding. We expect the digital challenger bank sector to contract. Yet surviving players will thrive and emerge as more credible competitors to incumbent banks.

    Digital challenger banks will pivot towards more profitable strategies, such as lending, taking SME market share, earning repeat fees from subscriptions, and converting customers into primary customers.

    Want to know more?

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