The Undeniable Rise of Challenger Banks in the United Kingdom: What Should the Big Four Do?
Posted March 18, 2018| Lenore Scanlon , Ken Sawka
How to evaluate, plan and execute a competitive counter-strategy against swift new entrants, the challenger banks.
To say that the UK banking industry has weathered significant turmoil since the 2008-2009 financial crisis would be a gross understatement. After ten years marked by government bailouts, a string of annual losses, and customer defections, the big four UK banks – Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland (RBS) – are just now starting to re-gain their footing. All four banks last year reported increases in operating profits, with RBS realizing its first full year attributable profit in ten years. Most of the big four – with the notable exception of RBS – have returned to private ownership or are close to doing so, having emerged from under the government bailouts provided in the wake of the financial crisis. Capital ratios are stronger, and customer defections seem to be stabilizing.
However, a confluence of trends, including liberalized regulatory policies, the rapid emergence of digital innovation from FinTech companies, and shifting consumer preferences, has accelerated a competitive risk over the past several years – the rise of challenger banks in the UK. Challenger banks– also known as “neo-banks” – are small, newly formed retail banks that compete with the Big Four, often by specializing in areas underserved by the those larger, established firms. These upstarts distinguish themselves from the traditional banks by deploying cutting edge information technology practices, such as on-line only operations, that avoid the costs and complexities of traditional banking. And, these technology innovations not only serve to keep costs in check, they also appeal to the increasingly tech-enabled and mobile segments of younger consumers, who liken banking at a high street financial services institution to using a dial up modem to access the internet.
New Entrants Competing in the Banking Space
According to a review earlier this year of challenger banks by Banking Technology, there are some 76 viable alternatives to the traditional high street banks currently operating, or planning to commence operations this year, in the UK. To be sure, many of these are extremely limited in scope – Coconut, for example, which launched in January 2018, is a “banking service” targeted at freelancers rather than a full-fledged bank – but many offer virtually all the consumer banking services of a walk-in RBS or Barclays branch anywhere in London.
At the heart of the proliferation of challenger banks is a loosening of regulations that favors the upstarts. According to the Financial Times, the Bank of England has promised to change the capital requirements for challenger banks so that they can offer a more competitive mortgage service. Furthermore, the Second Payments Services Directive (PSD2) this year requires banks to open their payments infrastructure and customer data assets to third parties that can then develop payments and information services for customers, according to an analysis of the new regulations by audit, tax and consulting firm PwC. The new regulation aims to level the playing field for all payments providers while ensuring enhanced security and stronger consumer protections.
And, they are well funded and well managed. Many challenger banks have incredibly innovative talent behind them, mostly from outside the financial services sector, according to an article in the Financial Times. Challenger bank founders include American entrepreneur and venture capitalist Eileen Burbidge, Indian steel magnate Sanjeev Gupta, and the billionaire Pears family, one of the largest and most private landlords in London and the Southeast. To assume that these upstart competitors are fly-by-night, shoestring operations would be a grave mistake.
Understanding and Responding to the Threat of Challenger Banks
What then, should the large established banks, or any incumbent financial services company threatened by these new entrants, do? The first step is to acknowledge that the knee-jerk counter-competitive responses that established banks may have deployed against each other probably will not work against this new breed of competitors. Why?
- Profit expectations are undoubtedly different for the challenger banks. Profits that would disappoint the established banks may be a boon to the new guys, especially as many FinTech organizations suffer multiple quarterly losses before turning their first profit. Don’t expect profitability to be a core objective of the challenger banks, at least in the short run, and don’t assume that poor financial performance makes these upstarts any less of a competitive threat.
- Challenger banks’ understanding of consumer preferences. Especially among young and tech-savvy consumers who may be opening their first bank account, service expectations are more sophisticated. Having lived through the financial crisis as children and now entering their professional lives, these consumers are not easily drawn to teaser interest rates. These are financially weary, risk-averse individuals for whom rapid accumulation of capital is not a primary driver of happiness.
- Trying to compete with challenger banks on their own terms may not be feasible. While large banks may be compelled to launch their own challenger brands, they are likely to be burdened by inflexible legacy infrastructure and an adherence to old business models. Collaboration and partnerships with the FinTechs may be a better course of action than direct competition.
Establishing a Competitive Strategy
A better approach undoubtedly is to take a measured and disciplined route to developing a unique competitive strategy that is intended especially for the challenger banks. The first step is to simply get smart about the new rivals. Basic competitive intelligence gathering and market analysis that can uncover challenger banks’ strategic intentions, goals and objectives, and basic assumptions about the market is critical. Remember, to assume that these competitors are operating to achieve the same goals and objectives of established banks—or even of each other—is a mistake. Any established firm being challenged by a new entrant cannot hope to compete without in-depth knowledge of the intentions and capabilities of the new competitor.
Stress-Testing Your Strategy
With facts about the new competitors in hand, the next step is to stress-test your current business strategy to ensure it is resilient against the challenge posed by the new group of competitors. This stress test should encompass two critical aspects of strategy:
- The first is to test for differentiation. At the very essence of strategy is the notion of differentiation. Strategy, according to Michael Porter, is performing different activities from your rivals or performing similar activities in different ways. Established banks should determine whether their strategy fits either of these two requirements when considered against the challenger banks’ intentions and capabilities.
- The second is for the established banks to re-examine their market segmentation. Not every challenger bank is going to appeal to every segment of the market; counter-competitive strategy to take on the challenger banks should focus on 1) identifying and protecting those segments that may be at risk from the challenger banks, and 2) identifying those segments that challenger banks are unlikely to target, and avoiding any shifts in strategy that could weaken the established banks’ appeal to these segments.
Prioritizing and Devising a Counter-Strategy
After re-examining differentiation and customer segmentation strategies, the incumbent banks should then be able to prioritize where the threat from the challenger banks is most severe and explore different strategic options to counter the threat. In this situation, tools like scenario analysis and competitive war-gaming can help generate strategic options that have been tested against various market conditions and forces in ways that facilitate internal alignment and a sense of urgency to act. It’s always better to test and rehearse strategic options in a safe and controlled environment rather than deploying them in competitive markets blindly.
Just when the large and established UK banks are solidifying their footing ten years after the global financial crisis, a batch of start-ups, taking advantage of rapid technological advances, lower cost structure, and loosening regulations, is posing new challenges. Established banks must first acknowledge that competitive response to the challenger banks requires new ways of thinking about the competition, and then take a measured and disciplined approach to develop and deploy a targeted and workable counter competitive strategy.