Challenger Banks. What Are They and How to Start One?

Avatar placeholderMateusz Raczyński

July 28, 2022

15
 min read
Challenger Banks. What Are They and How to Start One?

The world of finance, with all the resources and cash, has been lagging behind the tech revolution for some time. Looking at banks, they still often have mobile apps with outdated or too complicated interfaces, they still promote doing business with them over the phone and require physical interaction in their facilities.

That’s okay and older people are used to such standards, but for millennials and younger generations? It’s not what they’re used to. That created a space where innovation could thrive and take banking onto the next level of user-friendliness – either provided by the old and known institutions, as well as… challengers.

And here we are, talking about challenger banks that want to break the status quo. If they seem to be all around, and you’ve started to research whether there’s a business opportunity in launching one–look no further. We’ve gathered all the relevant information about what are challenger banks, what it takes to start one, and shared some ideas on what can they offer.

Let’s dive in.

What Are Challenger Banks?

In the world of finance, trust is one of the most valuable assets. For banks, one of the main factors for trust is how long the bank is on the market. Since we hand them over our life savings, we wouldn’t like them to go bankrupt one day, sinking with all our hard-earned money. A positive track record going through decades and market cycles is an indicator that this institution is likely to withstand the test of time.

However, with bank guarantees and the urge to manage all our lives from smartphones with great UX, challenger banks can thrive even without the long track record. Today, it’s more and more about the actual offer rather than the name.

This sets up the environment in which challenger banks arose. They are simply those banks that came to the market in recent years and want to take their market share from the long-established institutions. The term is most often used in the UK.

Why now?

Imagine that when Metro Bank received its banking license in 2010, it was the first high street bank in the UK in 100 years. The market has been dominated by The Big Four–Barclays, HSBC, Lloyds Banking Group, and NatWest Group. However, in the wake of 2008 financial crisis, the government opened up to new banks and introduced Finanacial Services Act 2012. The regulations came into force on 1 April 2013.

In 2018, a PSD2–Payment Services Directive–has been introduced across Europe. It requires banks to give third-party providers direct access to information related to payment accounts, with the user’s consent. The UK’s Open Banking initiative was designed to boost market competition, requiring the largest banks to open their APIs and grant certified third-parties access to customer’s data.

Part of the Bank of England, PRA, set up their New Bank Start-up Unit to guide firms through the process of setting up a new bank, from the initial interest through application and authorization with restrictions until obtaining a full banking license. The aim was to also publish clear requirements for setting up banks and identifying barriers.

Among the identified barriers to set up a new bank, there were:

  • difficulties in attracting new customers, 
  • encouraging customers to switch from their existing bank, 
  • the lack of a wide branch network as a barrier to capturing customers, 
  • the convenience customers may find by buying a number of products from the organisation with which they have (historically) chosen to deposit their money.

Effectively, both PSD2 and Open Banking Initiative enable challenger banks to obtain data about the customers of larger banks and propose innovative solutions.

Challenger Banks vs Neobanks – What’s the Difference?

While there’s a thin line between challenger banks and neobanks, the latter are considered to be more focused on serving clients in a mobile-first, internet-first environment. Some of them could have obtained licenses specific to challenger banks in the UK, while others are likely to have relationships with traditional banks to service their customers. There are also neobanks ran by traditional banks just to apply to a certain demographic–a sound approach would be to introduce another brand that’s more appealing to younger users.

In a direct comparison, most challenger banks are already more than a decade old as they’ve been set up after the 2008 financial crisis. 

Outside UK, the terms are rather interchangeable and this is the approach we’ll take.
What’s worth mentioning is that in the US, a group of people can form a bank relatively easy–provided that they have enough cash and time as it can take anything from $10M to $130M. They are often created from different motivations than challenger banks and neobanks in other parts of the world. For example, a common practice is to set up banks to serve underserved communities, continue the work of a bank facility, etc. 

Why Start a Bank?

There’s an interesting chart on dealroom.co that shows the challenger bank’s value based on their launch date. It seems that the trend is picking up and the banks that were started the most recently are consistently taking share from the older ones. There’s a market opportunity in that.

Source: dealroom.co

The same list guides us to the UK as the home of challenger banks. Over $7.9 billion has been poured into that space so far in funding there, and while Germany is the second largest home of challenger banks with $1.9 billion in combined funding, the rest of the world is behind with combined market funding ranging from $3.8 million in Latvia to $650 million in France.

Looking beyond pure data, there are plenty of problems to solve, improvements to be made, and innovations to be made to offer the best possible experiences and products, at the best possible rates. The good thing is that challenger banks can have access to data that can help them solve those problems. 

Another framework in favor of breaking the status quo is the European Economic Area (EEA) passport handed to licensed firms. The companies that are registered in one of 27 EU member states can provide financial services across the remaining states without any additional authorization.

And is it worth it? Looking at the data from the United States, it seems so. Edward J. Carpenter–owner of a consulting company handling 40% of US new bank applications–said in an interview that once start-up banks go through the regulatory process, it’s a very safe investment with 10-15% annual return on the equity the startup group has invested in.

How to Start a Challenger Bank?

Setting up a new bank is similar to introducing other ventures, however the regulatory process and requirements order founders to act in a certain way. This is to ensure that the end users are protected from frauds and their funds are safe up, at least up to the standard bank guarantees.

The business side of things is just as anywhere else–the steps are simple, but the real work is harder than it seems:

  • you research the market
  • analyze competitors, looking for an edge
  • craft the offering and services
  • build a bank MVP to validate the concept and/or start sooner with the core product

The most time-consuming processes are around the legal part, though. Obtaining a license and bank insurance requires much paperwork, but it’s not impossible to get one.

How to obtain a challenger bank license?

It differs among countries, but in the UK, there’s a clear process of obtaining a challenger bank license. First, the institutions register with UK’s Financial Conduct Authority (FCA)–the charter process can take up to two years. The process is not too cheap, either–for example, Atom spent over $18 million pursuing charters.

In the background, you should secure additional funding, while not doing so can again generate costs. Tandem–another UK challenger bank–had its charter revoked after failing to get enough funds from investors. Every situation has a way out, though–they bought a banking division of Harrods to restore their charter.

On the other hand, Revolut obtained a different type of license–eMoney. It was easier to acquire and with the EEA passport, Revolut could quickly onboard new customers while competitors were still waiting for charter approvals.

A similar set of licensing frameworks is being prepared in the Middle East and Australia.

According to PwC, while obtaining a challenger bank license, you need to prepare for a rigorous process that is quite clear but is designed to test whether the aspiring bank is capable of succeeding in the market–with whatever it takes to test your idea

Summary

The FinTech revolution is happening in the banking sector not only through innovative technology but also because of the regulatory framework that encourages challenging the legacy institutions. Looking at the most successful challenger banks, it seems that the idea is working well so far. Old institutions are challenged, pushing them to offer better services and products. The newcomers are still compelling enough to find their customers and grow even faster than the legacy firms.

If you’re researching how to build a challenger bank or neobank and combine the open banking APIs to offer a new product–don’t hesitate to contact us. We’re capable of building it with you!

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Mateusz RaczyńskiAvatar placeholder
Mateusz Raczyński
Marketing Manager

Mateusz spent over a decade on launching and marketing tech products. Crypto enthusiast. Always on the lookout for the next growth opportunity.

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