Challenger banks’ challenge and path to success

As a fintech enthusiast, I am excited to see all the digital / challenger banks trying to disrupt the industry by offering better products through their cheaper operating model. However, I am concerned as challenger banks are not offering enough value above of incumbents nor differentiation from one another. In this articles we will look at:

1. Challenges faced by challenger banks
2. Basic foundation of a good bank
3. How to succeed as a challenger bank

Challenges faced by challenger banks

The number one problem with challenger banks in the US is that most of the people, even millennial, are staying with incumbent banks. In a survey by Cornerstone only 6–9% would consider a digital bank.

I think what’s happening here is that having a clean, simple, and even cool interface is not enough to make the customers “switch”. What customers want is better products as pointed out in more recent survey on why consumers open account with a digital bank:

Q2 2019 survey of 2,506 US consumers

The top three reasons were better financial tools, debit cards, and saving rates.

In addition, the challenger bank space is getting really crowded with roughly 30 home grown, and more coming from Europe. So what should challenger banks do? I believe that the challenger banks need to apply the 10x rule (10 times better) because offering a slightly better solution is just not enough.

Basic foundation of a good bank

To achieve 10x, one must apply the first principle design approach. If we were to totally redesign a bank, what would it be? Well, let’s start by looking at the basic utility of a bank:

1. Store something of value
2. Transfer
3. Credit

Store:

Safe & secure and easy access are the basics. For storing money, banks should combine the best of both check and saving account into 1 account. Why 2 accounts when we can do it all in one? Banks need to make finance simple. In this hybrid account, it needs to offer one of the highest interest for saving with the payment functionality of checking account. In fact, Betterment, Sofi, Radius, and Zero have already begun to offer the hybrid account.

Note that even without the payment function, we have already seen the success of high yield saving account as an attraction. Marcus by Goldman Sachs is one of the fastest growing online saving account in the US and UK recently logging in at $46 billion in asset. The main reason for its success were attributed to high interest saving accounts, easy access and usage, the Goldman brand, and marketing. I argue while all factors pointed out are important, the most important is the high interest yield.

The world’s largest saving account, Alipay’s money market account (yue-er-bao), exhibits such feature of combining the best of saving and checking account. It currently has $300 billion in asset. It provided 3–4% interest with a click of button, and can cancel anytime (easy access) while banks only offer fixed term CD with that kind of return. Now, technically it’s not a hybrid account. But Alipay made it so easy that it’s seamless to the user. Again, the key here is take the best of saving (yields) and checking account (flexibility in payment), to give consumers good reason to “store” their money with your institution.

Transfer:

The basic rules to transfer are: easy, fast, free, and acceptability. There has already been a number of improvements in this area in US with Zelle, Venmo, and RTP. Taking from the above of simplifying finance, I think a value-add product is one that combines the best of credit and debit card for consumer to use in payment, which is transfer of money. Basically, users get the benefits and rewards of credit card, and bound by the spend limit of debit card. Users should be able to set spend limit, such as debit or credit card limit, and link to loan product (next section on credit) when not able to make full payment.

Another area of transfer is international money transfer. This is one area where inbumbents are still charging sizable fees, giving the challenger a chance to offer value. In fact, a number of successful European challenger bank started with international money transfer differentiation (cheaper, faster, and easier) such as Revolut, N26, and Monzo. I believe that the value in “transfer” depends on the specific user target strategy. For example, if the challenger bank were targeting a specific ethnic group or expats, having cheap, fast and easy to use international money transfer function will be key.

Credit:

The basic rules to credits or loans are fast, cheap, and easy. Fast means the loan approval should be instant. Easy means consumers shouldn’t have to fill out a book to apply for a loan. In fast, most of the work should be done behind the scene. Consumers should just need to enter basic information and perhaps grant access to his/her data as additional steps. There are several ways bank can offer value from providing access to unbanked / underbanked to offering the most competitive interest. Webank, the most successful digital bank in the world with 180 million users, which is more than JP Morgan Chase, started by offering small sized loans to the unbanked / underbanked in China.

In addition, a value-add product can focus on providing credits / loans at “when” users need them. For example, when users don’t have enough to make full payment on its credit card balance, an “AI adviser” would kick in to find a cheaper option to pay back the balance specifying the saving amount, and provide a 1-click button to use the option.

Above are the basic utility of a bank, while I do give some examples of “value-add” for each of the category, it’s not meant to be a blueprint. In order for a challenger bank to start look like a 10x compared to the incumbent, it should try to think of value-add in each of the category that’s specific to its customer target. Also note that the area listed above is not exhaustive as the actual focus of a challenger bank may be different based on its strategy. Now, I don’t imagine any challenger bank will be able to do it all off the gate. It’s a stepped process as I will outline in the next section, the “how”.

How to succeed as a challenger bank

phase 1: set target users and create specific products and services

The above provides differentiation for challenger bank on the basis of product, but that’s not enough to stand out from incumbent in the US. The challenger will need to further stand out by targeting a specific segment that is under-served by the incumbent. By targeting and providing specific solution to the group, it helps the challenger to further achieve 10x.

One of the leading US challenger bank Chime is a successful example. It targets the pay check by pay check and unbanked millenials as it’s a sector that has typically been ignored or even penalized most with fees by incumbent banks. For this specific group, Chime offers access to pay 2 days early, 0 account maintenance fee, and cover overdraft up to $100 without fee. All these features are specific to the group of users they are targeting. 2 days early access to pay check may not be useful to those that are well-off, but is probably world of difference to those who depends on it. The strategy is apparently working at least for investors as news just broke out that Chime closed another round of funding with $500 million and valuing the company at $5.8 billion.

It’s widely suspected that Chime will start to build out more services, and I bet it will offer some type of small sized loan before offering investment products.

phase 2: start to build out its platform

After the challenger has set the specific target users, built differentiating product for the users, and gained initial mass through word of mouth or good old fashioned marketing, it can now start to build out its platform. The goal here is 2 fold:

1. As the challenger build out its services, its goal is to make its as the primary account for users.
2. Create further differentiation with other challenger banks who might have the resources to do so. For example, offer more free services such as free trading account.

No surprise here, as the challenger grow, it aims to be the financial hub, or Amazon of finance. I see it play out in a number of fintech start-ups such as wealthfront, robinhood, betterment, SoFi, and Revolut.

Basically, challenger bank will typically start out with a targeted function to attract / entice the specific group into using the challenger. Then, enrich its platform with more features to provide more user value and value to its company. As for the overall banking landscape, I think we will have a mixture of incumbent and pure digital players. Those who have a clear strategy, and are able to execute, innovate, and bring value-add products to market will be key

Conclusion

We started by pointing out problems challenger banks face, outlining the foundation of a sound bank, suggesting how to start and grow. Having been in the trenches founding my own start-up, I know it’s not easy. Honestly, if it were, then you probably wouldn’t get a chance to solve it. I look forward to more and better products to come from the challenger banks. In the next article, I will dig deeper by looking closely at the product offering of a challenger bank.