Europe’s Digital Banking Industry Enters Its First Restructuring Wave

In recent years, Europe has witnessed a frantic arms race between its new generation of digital challenger banks. The number of platforms offering mobile-native banking services has proliferated into the dozens, with their high-growth business models driving an inflow of investor capital. This rising tide of private financing activity has propelled UK fintechs Revolut and Monzo, and Germany’s N26, to unicorn status and driven the adoption of their services, as well as those of their peers, by tens of millions of customers.

But Covid-19 presented these challenger banks, who were already operating in an ultra-competitive market environment, with a new set of potentially existential challenges. In response, the European market has begun to consolidate and restructure in a way that will continue in various forms over the coming years.

The pandemic has pressured challenger banks in a variety of different ways. The incumbent bricks-and-mortar high-street banks they are seeking to displace have had a good crisis, relatively speaking. Lockdown accelerated the closure of loss-making physical branches and fostered greater familiarity among core customers with online and mobile banking. The extraordinary circumstances of the pandemic helped expedite the roll-out of new digital products in timeframes previously considered unrealistic. Unlike in the global financial crisis, their reputation has benefited from the role they have played in administering mortgage holidays and small business loans.

In addition, the surge in technology adoption prompted by Covid-19 has built on the progress already being made by traditional banks in the context of Open Banking (with regulations such as the UK Open Banking Directive and the EU’s Payment Services Directive 2), and is driving further innovation and lowering barriers to entry. Financial institutions are partnering with technology providers such as Tink, Fabrick, Token and Plaid to gain better customer insights, offer more customised products and deliver greater accessibility, transparency, speed and convenience of both banking services and payments.

Meanwhile, the digital-native challengers have found that periods of economic turbulence deter customers from switching to new providers of sensitive financial services. Travel restrictions have also reduced demand for the zero-fee foreign exchange rates that act as a key draw for several of Europe’s leading ‘neobanks’. The sector has therefore experienced a drop-off in customer acquisition rates, while still grappling with the same long-standing problem as before: how do you convert scale into profit when your business model centers on free-of-charge current accounts, which traditional banks typically offer as a loss leader for their other services?

This more difficult operating environment has been reflected in the changing attitude of venture capital backers towards the challenger banks they have funded. While Revolut’s pre-pandemic $500m financing round in February 2020 tripled its valuation to $5.5bn, by May N26 announced a $100m extension to its latest funding round that kept its valuation flat at $3.5bn. Later that month, Monzo raised capital at a 40% discount to its prior valuation, while recent media speculation has suggested that Atom Bank’s GBP40m fundraise this February took place at a still larger discount. (Starling Bank did, however, buck the trend, attaining unicorn status via its GBP270m fundraise this March.)

This somewhat subdued fundraising market exemplifies a slight but discernible shift in investor sentiment: less appetite for subsidizing losses in the name of customer growth, and a greater willingness to ration capital unless there is a clear path to profitability. Regulators have mirrored this thought process, pushing challenger banks towards a more sustainable commercial footing, with the Bank of England setting punitively high ‘minimum requirement for own funds and eligible liabilities’ (or MREL) standards. Responding to these pressures, Starling and Revolut announced the landmarks of profitable and breakeven months respectively in late 2020.

Troublingly for Europe’s other players, these are the headwinds facing the best-funded and most well-scaled players in the market. Amid macroeconomic uncertainty, investors are only likely to channel a greater proportion of capital towards those considered most capable of achieving pan-European or even global leadership. New funding may be scarcer still for smaller, more localized and regional neobanks. The prospects of making up ground on the likes of Monzo, Revolut and N26 through organic growth alone have become even more distant.

The industry is responding accordingly. Consolidation through mergers and acquisitions is a logical alternative for growing market share domestically. Similarly, with investors likely to favour challenger banks with international presence, foreign acquisitions and combinations can provide a beachhead for entering new markets – rather than registering for banking licenses in each new jurisdiction, as Starling Bank and Revolut are reportedly doing in Ireland and the US.

The other way in which smaller challenger banks can use M&A to emulate and gain ground on the industry leaders is by expanding along the value chain. Revolut and Monzo have both launched paid premium retail banking services. Starling reportedly now holds a more than one-fortieth share of the banking market for the UK’s small and medium-sized enterprises (SMEs).

Tacking on new, higher-margin services, such as mortgage or SME lending, has always been part of challenger banks’ long-term playbook for achieving profitability. However, with Covid increasing the time pressure on product diversification, acquiring or partnering with a small ‘legacy’ bank with a pre-existing bulk of business will offer an attractive shortcut to gaining critical mass in these areas. Starling’s CEO and founder Anne Boden announced in January that they were actively seeking “lending businesses to buy”.

The formation last year of a joint venture between Fabrick, the open banking subsidiary of Italy’s Sella Group, and illimity Bank epitomized a number of these dynamics. The transaction created a new leading Italian national fintech platform that combines HYPE, a challenger bank with 1.3 million customers, with a range of other banking activities, such as SME lending.

Going forward, the US market will likely emerge as a focus for European challenger banks seeking transformative deals. Unlike China and the south-east Asian markets, which lead the world in terms of adoption of digital banking services, the US has been slower to move away from cash, offering a lucrative and comparatively untapped market. In addition, America’s community banks, with their established presence in local mortgage and SME markets but less sophisticated digital offerings, offer a rich selection of potential partners or legacy acquisition targets.

The prospect of Europe’s challenger banks investing in American assets is a stark inversion of one of the key trends in technology investment in the past five years. This reversal of the usual transatlantic flow of capital would be testament to how the combination of fierce competition and extraordinary economic circumstances is transforming the still-nascent landscape of European digital banking.

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