How will challenger banks fare as the cost of living crisis hits?

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Challenger banks broke into the mainstream in the UK in the late 2010s, offering consumers more innovative services and, often, better savings rates than the high street giants were willing to offer. to offer.

But they have had a tougher time since 2020, first as the Covid recession has restricted their sources of income and now as the Bank of England continues to raise its base rate to control inflation, thus curbing the economy.

The next 18 months could be particularly hectic for them. How they fare will depend on their level of capitalization, the quality of their offerings and their exposure to weakening customer affordability as the cost of living crisis drags on.

Several challengers have yet to make a profit and are still relying on venture capital backers whose confidence in the sector is dwindling. Yet they continue to experience explosive growth. More than a quarter of adults in the UK – around 14 million people – have an account with a digital neobank such as Atom, Monzo, OakNorth, Revolut or Starling.

In theory, a period of rising interest rates should benefit challenger banks as yields on their mortgages and other loans should, after more than a decade of ultra-loose monetary policy by the Bank of England, finally rise. . The Bank has raised its base rate five times since December 2021 in a bid to curb inflation, which hit a 40-year high of 9.4% through June 2022. Some economists believe the base rate could go from 1.25% to 3% next year.

Which banks are likely to benefit from interest rate hikes?

Despite this favorable trend, “not all lenders will benefit equally, given their different funding profiles,” according to Fitch.

In a research note published in June, the rating agency observed: “Large high-street banks tend to benefit the most from rising interest rates, given their large market share in deposits. in current account. medium-sized banks, [non-bank] mortgage lenders and challenger banks will find it harder to expand their margins. They are more dependent on savings deposits, for which savers will demand higher interest rates.

Regulators have told banks on all sides to put more money aside to prepare for possible shocks, which will squeeze margins further. More worrying for neobanks, experts warn that the mortgage market could slow and defaults will increase as more consumers feel the effects of rising prices.

We don’t really know how high interest rates can go before the bubbles burst

Simon Youel is head of policy and advocacy at Positive Money, a non-profit group that campaigns for banking reform. He says that while a period of higher interest rates “can be good for bank profitability, it also presents dangers. It is likely that more than a decade of low interest rates encouraged them to engage in all sorts of risky loans in search of yield. We don’t really know how high interest rates can go before the bubbles burst. There are already worrying signs coming from housing markets in countries like Canada, for example.

Monzo still growing

But the challengers seem confident they can handle such risks. Take Monzo, for example. In its July annual report, the bank said it had shown “extraordinary resilience” during the pandemic and continued to “grow at pace”.

During the year from March 2021 to February 2022, Monzo added one million new customers and its deposits increased by 42% to reach £4.4 billion, which enabled it to generate a turnover of record business of £150m. But it also posted a loss of £119million, after similar results in the previous two years.

TS Anil, CEO of the bank, wrote in the report: “While rising interest rates tend to benefit our business model, given the heavily deposit-centric balance sheet we have, we must remain vigilant. the impact of cost-of-living increases on our customers. We have not yet seen a direct impact on our customers’ deposit balances, their spending behavior or their ability to repay us.”

We must remain mindful of the impact of the rising cost of living on customers

Another risk challengers face is that investors, concerned about the faltering economy, lose confidence in the fintech sector in general. For example, Klarna, the Swedish finance giant buy now, pay later, saw its valuation plummet from $46bn (£38bn) to less than $7bn in July. And UK mobile payments company SumUp was valued at €8bn (£6.7bn) when it raised money in June – a 60% discount on the price it was targeting at the start of the year. ‘year.

Potential for failure of some fintechs

The indications are that many fintech companies will go bankrupt in the next 18 months and some may even fail. Starling thinks smaller “non-bank” operators might have a hard time, but points out that he and his fellow fired actors are in a much stronger position. The bank, which has about 2.1 million customers, says it is “very well capitalized” and is not looking to raise more funds.

“We have established a stable and sustainable business model that allows us to generate our own capital organically and expand into new markets,” said a spokeswoman for Starling, which announced its first full year of profitability in July.

Although there has been no indication that a licensed UK challenger is in dire straits, Volt, Australia’s first-ever online-only bank, has gone out of business. In July it surrendered its license and returned around A$100m (£58m) in deposits to customers. It came after he failed to raise enough capital to back his mortgage plans.

If a British challenger were to run into serious trouble, Westminster would likely step in to help, according to Youel. He points out that some operators are highly exposed to government-backed Covid commercial loans, which would be canceled in “implicit bailouts”.

Despite the risks, the neobanking sector should be able to weather the UK cost of living crisis even if it takes a few bruises along the way.

According to Rich Wagner, founder and CEO of digital bank Cashplus, the best-run challengers “should be in a strong position to cope and even thrive” if things get as tough as experts predict.

They are “sustainable, well-run businesses built on good economics,” says Wagner. “They will fare better than those who have pursued explosive growth or sky-high valuations at the expense of solid foundations.”


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