UK Challenger Banks and Their Effect on the Big Four

June 7, 2022

Fintech adoption has reached a mass scale in the UK. The average UK consumer manages 67% of their finances online and on average uses 2.8 fintech products and services. About 76% of UK users feel confident about using open banking technology, citing that it helps them save time and money, while also reducing stress.

The rise in popularity of digital banking and payments accelerated during the pandemic. Challenger banks capitalised on this opportunity. Regulatory reforms in the EU, like the Payments Services Directive (PSD2) and the UK’s Open Banking Standards, made it easier for new entities to establish themselves in the market. The key priorities for the regulators have been enabling increased competition in the banking sector and reducing the market power of the big 4 banking groups: HSBC, Barclays, Lloyds Banking Group and NatWest.

There are currently almost 20 challenger banks in the UK, with the 3 most powerful bring Monzo, Revolut and Starling Bank. Competitions among these companies has been escalating over the last couple of years, with increased investments being secured, rising customer registrations and news of personal feuds between the founders.

Have they been able to shake up the market and dethrone the incumbents? Let’s find out.

Challenger Banks vs. The Big 4

Challenger banks have been focused on digital services from the start. Super apps are allowing consumers convenient ways of banking. Brands like Monzo and Revolut have changed the banking experience for millennial and Gen Z consumers, with both innately digital innate generations preferring easy account opening facilities being offered online. They like the personal and more efficient banking services on mobile apps, with real-time payment notifications.

Challenger banks also offer improved customer support. This has led to a huge migration of customers to challenger banks in recent years. Over 14 million people in the UK have opened an account with a digital-only bank, as of January 2022, which equates to 27% of the nation’s population. This is 3x more customers than in 2019.

As a result, incumbent banks have been pressured to improve their digital offerings to stay competitive. An example of this is the short-lived attempt of the RBS to launch its digital-only banking app, Bo. In 2021, JPMorgan launched its digital bank, Chase.

So far, the incumbents have failed to keep pace with the modern digital era. They don’t have centralised data-lakes on consumers and their financial behaviours, to improve their income streams and services. The more agile challengers can, on other hand, innovate offerings with emerging technologies and new software. Legacy systems in big banks have led to huge catch-up costs, which they will have to bear to service the young UK workforce. As of 2020, Gen Z comprised 25% of the UK workforce and were fast surpassing millennials in spending power.

The Incumbents Still Rule

Despite the rise in popularity of challenger banks, the Big 4 still hold the lion’s share of the market. Challenger banks are seen more as secondary banking providers, typically for lower-value, day-to-day transactions. An average UK customer uses a traditional high-street bank 83% of the time and uses a challenger bank 17% of the time. Customers of challenger banks have been found not to be “sticky,” being eager to switch to cheaper alternatives given the opportunity.

With Brexit restructurings behind them, the incumbent banks are investing in niche technologies and re-focusing on core business lines. They don’t face immense cost pressures like challenger banks, many of which have struggled to remain profitable through the pandemic.

However, the long-term potential of challenger banks is clear, and investors are not shying away from them. From Q1 to Q3 2021, 9 equity rounds worth £1.06 billion were announced, making the year a record one for investments in UK challenger banks. This includes Revolut’s Series E funding round, where it raised $800 million to reach a $33 billion valuation.

Future Outlook for UK Challenger Banks

Overall, there is scope for higher net interest income for the UK banking industry, with marginal increases in bank rates. The Bank of England raised its key bank rate for the third time in March 2022 by 25 bps to 0.75%. This took interest rates back to the pre-Covid levels.

Challenger banks are expected to face competition from both high-street banks and major tech companies. These tech companies are investing hugely in payments infrastructure, data and combined services. Banks that can leverage data available to them to offer customised services to users will remain competitive.

In the past, it has been possible for them to thrive with low-income models, but they will need to find new ways to win new customers now. They will have to steer them towards more profitable products, at the risk of not chasing them away. All of this has to be done within regulatory constraints. They will face fee caps in some jurisdictions.

Strategic acquirers will possibly acquire digital entities to expand their income streams and capabilities. Consolidation among smaller and specialist companies can lead to challenger banks obtaining scale and penetrating new markets.

The Top UK Challenger Banks and Their Lack of Dividends

The Bank of England allowed UK banks to resume and increase dividends in 2021. This reflects the resilience of the banking sector and its capitalisation, despite the pandemic and global economic uncertainties.

However, the top UK challenger banks, like Revolut, Monzo and Starling, don’t pay dividends yet. Starling, which posted a 400% YoY increase in revenues in March 2021, said it will use the money to grow and expand its operations in the UK and Europe. Some challenger banks that pay dividends include:

Virgin Money

In November 2021, Virgin Money stated that it will restructure its costs and business model to return to full-year profit. A dividend of £0.25 per share on May 5th (ex-div date May 19th), with pay date 21st June - and we are forecasting £0.05 per share with ex-date 9th Feb 2023.

Paragon Banking Group Plc.

Restructuring and diversification of its business have led this UK-based specialist banking group to post higher revenues. It is expected to pay out a dividend of £0.08, ex-div date June 30, 2022, before a final pay-out of £0.18 in December 2022, ex-div date January 26, 2023.

Predicting Dividends the Woodseer Way

Challenger banks are operating in a continuously evolving market. They are making waves and changing consumers’ relationship with money. The banking sector in the UK is heavily regulated, which leads to huge implementation and remediation costs for new companies like these. Many of them are in the start-up phase. However, they have the technical upper hand, while the incumbents have regulatory approvals. We can see a possible amalgamation of both these branches in the future. Will that impact, or increase, the dividend-paying capacities of these banks?

Woodseer, with its analyst+AI approach, offers accurate and reliable dividend projections about UK challenger banks. Contact us to learn more.