Digital Banks Hit Bump in the Road, But Pandemic Has Silver Lining

[Editor’s note: This is a guest post from Ryan Weeks, formerly with Dow Jones and AltFi, covering fintech. This is part two of a four part series (part one is here) he is writing for us on the UK fintech market in the run-up to LendIt Fintech Europe.]

Lockdowns in the UK and overseas have put a significant dent in their revenues, external investment suddenly looks far harder to come by, and, to top it all off, recent financial results painted an ugly picture of their financial position even before the pandemic.

To recap: in 2019 Starling lost £52m, Revolut lost £107.4m and Monzo lost £113.8m.

Yet optimism remains within the sector, with many hoping for a silver lining in the longer-term impact of the crisis on digitisation.

Take Zopa, for example. The UK’s oldest peer-to-peer lender officially became its newest bank in June, after finally being granted a full banking licence by regulators.

During times of uncertainty, the company tightens its lending criteria to focus only on borrowers with “a very high likelihood of being able to manage the debt and not suffer financial detriment”, and thus expects lower revenues, according to chief executive Jaidev Janardana.

“However, in the longer term we expect the events of 2020 to be an accelerator for Zopa as more customers embrace digital channels and providers,” he added.

This is typical of attitudes within the digital banking sector at present.

The long-term impact of the pandemic, however, is unclear; what is clear is that in the short-term it has wrought havoc on fintech firms.

“The difficult thing for all the neo banks is they monetise through transaction fees,” said Keith Grose, UK lead at the financial aggregator Plaid.

Digital banks primarily earn money on interchange fees, which are charged whenever people spend money, as well through foreign exchange services. But the pandemic has kept people from spending and certainly from travelling.

Other, more embryonic revenue streams include lending and premium accounts.

Starling Bank in particular has seen its lending skyrocket during the past six months, taking an active role in the distribution of the government’s emergency lending schemes. The start-up has lent out hundreds of millions of pounds under these taxpayer-guaranteed initiatives.

But Oliwia Berdak, an analyst at the research firm Forrester, said that such lending could come with “a sting the tail”, when defaults begin to materialise.

Starling also has a marketplace in which it tries to earn fees by referring customers to other financial products, but this again is in its infancy.

“For that to generate a lot of money, basically Starling customers would have to treat that marketplace as the main way in which they acquire other financial products,” said Berdak.

Yet Starling appears to have navigated the period with relative ease.

“I hesitate to use the phrase good crisis because it seems a bit hard-nosed, but I think it has been a good crisis,” said Declan Ferguson, chief strategy officer at the start-up.

“One thing that’s become remarkably different about us versus our peers is that our cards are about 85% domestic use. Even in the worst of lockdown, we only had a 15 or 20% reduction and that bounced back after two months.”

It also helps to have deep-pocketed backers. Starling’s existing investors, the Bahamas-based billionaire Harald McPike and Merian Global Investors, invested another £100m in the start-up across two rounds this year, according to reports.

Ferguson said that having “a very fragmented, smaller ticket size venture capital cap table” makes it tougher to secure follow-on investments in distressed situations.

Monzo appears to have been a victim of this.

The digital bank famed for its hot coral cards eventually got a £60m fundraising over the line in June, but not without stomaching a 40% hit to its valuation. Later reports confirmed that the start-up had been hit with tougher regulatory capital requirements while in the process of trying to court investment.

The down-round capped a trying few months for Monzo, in which it was forced to lay off hundreds of staff in the UK and US. Co-founder Tom Blomfield stepped down as chief executive in May, giving way to banking veteran TS Anil, who had been hired in December to lead the bank’s US push.

One digital bank that appeared to have no trouble courting external investors is Revolut, which hauled in $500m at a $5.5bn valuation in February, only to top up the round with another $80m in July.

But Revolut was not immune from the pressures of lockdown.

In April, the digital bank began offering staff the chance to swap part of their base salary for shares in the company, in an effort to stave off the need for layoffs. While some of its more than 2,000 staff took up the offer, it was not enough to prevent roughly 60 job cuts in May.

Yet in true Revolut fashion, the start-up continues to push towards its goal of hitting profitability by the end of this year, according to Financial News, and this has piled on the pressure for staff at the start-up.

Revolut has often been criticised for a cutthroat culture embodied by the slogan “get sh*t done”. One wonders, though, whether it may have helped the company batten down the hatches during this difficult period.

“Certainly being ruthless and slashing cost is going to matter,” said Forrester’s Berdak.

She added, however, that Forrester’s research suggests consumers will emerge from the crisis with a different set of values. This is underlined by a growth in “values-based purchasing”, which ranges from environmental responsibility to how companies treat their staff.

A Forrester survey conducted in May 2020 showed that 43% of UK consumers said they would go out of their way to buy from companies that can “prove that they treat their employees well” more so than they did pre-coronavirus.

“They will look at how companies dealt with employees, how they dealt with the crisis, and they will consider that going forward,” said Berdak.

Whatever their struggles, the crucial thing is that all the big-name digital banks in Europe – including the likes of Monese and N26 – have survived the first phase of the pandemic. Their challenge now is to push on towards profitability such that they are better insulated in the event of future crises.

Ian Connatty is managing director of British Patient Capital, a division of the British Business Bank which invests taxpayer money as a Limited partner in UK-focused venture capital funds and co-invests directly in tech firms – their portfolio companies include likes of Revolut and Thought Machine, the banking systems firm.

Connatty seems to think the past six months will ultimately prove little more than a bump in the road for digital banks.

“It’s not unusual for the market to kind of have these periods where consensus goes up and down around things like valuations and prospects,” he said.

“For us it’s a long-term programme… and short-term developments don’t detract from that tone way or the other.”

[This post has been updated to clarify the way British Patient Capital invests in fintech companies.]