Rewind to 1989, the US and Russia were in talks to end the Cold War, the first version of Microsoft Office that bundled both the Word and Excel applications was released, the UK’s Prime Minister was Margaret Thatcher, the French President was François Mitterrand and the German Chancellor was Helmut Kohl. 1989 seems to be a distant past in terms of world-historic events, but you may be surprised to learn it was the same year a new type of bank was launched in the UK. Called First Direct, was this the first challenger bank in Europe?
First Direct was formed on 1 October 1989 by Midland Bank, one of the ‘Big 4’ high-street banks in the UK at the time. In 1992, it became part of HSBC when Midland Bank was acquired. First Direct is a telephone and internet-based retail bank in the UK with 1.35 million customers, that are served entirely online or via a customer call centre. There is no presence on the high street, no First Direct bank branches exist. In fact, any challenger bank recognises that a physical branch is a costly indulgence that only serves a dwindling number of customers. A challenger bank is a relatively small retail bank set up with the intention of competing for business with large, long-established national banks. A bank with 1.35 million customers is relatively small compared with, for example, Barclays’ 24 million customers.
Challenger banks or digital banks
Digital banks are built on new technology as opposed to the outdated infrastructure that is found in the legacy banks. The main touch point for the customer is usually the smartphone app and an internet banking interface. The back-end banking applications and product offering are commonly outsourced, bought using off-the-shelf solutions, or in some rare cases built from scratch. The focus of a challenger bank or digital bank is the customer experience and the different interactions that the customer receives from account opening through to customer servicing and transacting.
The goal of any digital bank is speed to market, they aim to capture customers with simple product offerings that are cheap or at least have transparent fees compared to incumbents. Digital banks include features such as instant payments and great customer service that provides real value for the customer. Offerings such as multi-currency travel cards, inexpensive cross-border payments, simple flat fee remittances, are provided via an app or a digital wallet. A current account, a prepaid card, a debit card or a no-frills credit card are commonly the first product offerings for many challenger digital banks. A true digital bank does not have a physical presence, unlike some ‘challenger banks’, such as Metro Bank or Virgin Money that have branches.
Revolut, a digital bank, originally had a go-to-market strategy that was to obtain an e-money license and target currency exchange with a simple multi-current prepaid card. Revolut provides instant notifications, free international money transfers and global fee-free spending. However, the scope of services that Revolut can offer without a banking license is limited. Each of Atom Bank, Tandem Bank, Monzo, Starling Bank, and N26 have obtained a full banking license, which delayed them in signing up their first customers. On the other hand, with a full banking license, a much wider range of financial services can be offered to customers.
Revolut launched a cryptocurrency exchange in November 2017 which helped them surpass the 1 million customer mark. As of February 2018, Revolut claims to have 1.5m customers, more than First Direct.
Monzo launched a prepaid card instead of a full current account product. This offered a quick to market approach with a product to help them learn quickly about their customer base. Monzo was going through a period of rapid growth, adding a reported sixty thousand users a month when the company was granted a banking license. In December 2017, they stopped adding new customers and announced plans to focus on transitioning the half a million existing customers from the prepaid card to Monzo’s own current accounts. Accounts are linked with a local bank account number and have a plastic debit card.
Tandem, has a credit card offering, whereas TransferWise, with a bank account linked to a debit card, allows the customer to send, receive, and spend money around the world much cheaper than a traditional bank. TransferWise claim that their new product is the first of its kind where the account is a multi-country bank account. There are obviously similarities between the TransferWise card offering and the one from Revolut. Customers may receive their income in different currencies which normally requires a local bank account, often a source of difficulty due to customer verification (they may be non-domicile relative to the bank’s home country) or high additional fees to exchange currencies. TransferWise aims to offer a borderless bank account, effectively letting customers receive money just like a local, including being given a local bank account number. Its debit card can be used around the world in the local currency.
There is something happening here and it is interesting to see that the plastic card is playing an important role. Digital banks will require something that allows customers to interact with the real world. The plastic card, whether it is using prepaid, debit or credit functionality, is usually the first point of interaction between the consumer and the real world. That is fantastic plastic! Plastic payment cards persist to be the main link to an ecosystem that is very well established and embedded within millions of standardised POS devices, ATMs, vending machines, ticketing kiosks around the world. This payment card acceptance infrastructure is not going to disappear in the next few decades.
Most consumers carry more than one piece of plastic in their wallet. It’s common to have a debit card, typically your main bank account where your salary is paid into, and one or two (or more) credit cards. But the one that receives the largest share of a consumer’s purchases is referred to as the ‘top-of-wallet’ card, and every card provider wants to make sure their card is the first choice. Influencing someone’s decision to select a specific card from their wallet or purse for any given transaction is a thing which is eagerly pursued and sought after by all types of banks and non-banks. Mobile wallets such as Apple Pay, PayPal and Samsung Pay are complicating the payments landscape and financial institutions are battling to be the top-of-digital-wallet in the virtual world. What is not surprising is that when a customer makes the decision to select their payment type it largely depends on the time and place and the type of purchase. A decision that is usually out of the control of the card issuer. For larger transactions, such as an airline ticket, car rental, a new washing machine, consumers will be most likely to take out their credit card. For everyday purchases such as groceries, incidental items at a local convenience store, they prefer a debit card. Cash is still king when paying individuals, or small businesses. The only time I use cash is for a haircut or to pay for my dry cleaning. Buying a takeaway lunch, or getting a latte at Pret, my preference is Apple Pay because it is convenient and fast.
Too many choices make customers fickle
Digital banks and Fintech providers appreciate the importance of the humble plastic payment card to be that vital link to the customer’s real world. However, there will be more choices of payment methods that the customer needs to make.
Customers make their payment choices based in part on personal preferences but they are influenced by a number of factors. These include cost, technology, regulation and merchant acceptance. These will influence the consumers’ choices of how to pay. A small independent convenience store can sometimes insist on having minimum transaction value for a customer to use their debit or credit card. Prior to European regulation that came into force in January 2018, some merchants and small restaurants used to surcharge customers using a credit or debit card. Technological innovations in payments have expanded the choice for customers and increased the convenience and speed of the transaction. Your mobile phone is more likely to be accessible than your payment card that may be buried in a wallet, purse or handbag. It only takes a second or two to complete a transaction using NFC technology in a smartphone.
Merchants can also successfully steer consumers to the payment method that merchants prefer the most. Some years ago, an experiment was conducted by the Swedish furniture store IKEA, where consumers in the UK were surcharged for credit card payments, while consumers in the US were given a discount for debit card payments. Both experiments led to changes in consumer behaviour, with a larger shift away from credit cards in the UK, and a smaller shift toward debit cards in the US. The surcharge and discount results generally support the notion that consumers respond more to surcharges than to discounts. Now the European rules under the second Payment Services Directive are in force, surcharging consumer cards, such as Visa and Mastercard, is banned across all 28 countries in the EU. As these rules have been written into UK law they will continue after the UK leaves the EU in 2019.
Furthermore, in the US, there have been a number of fascinating research studies that found that age, education, and income are strongly correlated with both adoption and use of most payment methods, while race was strongly correlated with use. Cash was used most heavily by young, black, least-educated and lowest-income consumers, while credit cards were used mostly by older, wealthier, and more-educated individuals. Many of the Fintech and digital banks will not be too knowledgeable of the customer segmentation techniques that the traditional card issuers have been using for the last 40+ years of card issuing. Customer segmentation techniques include categorising their credit cardholders into ‘transactors’, ‘revolvers’ or ‘subprime’. Some credit card issuers will offer a sign-up bonus when incentivising new customers to switch providers. There are usually three categories in which customers can receive the sign-up bonus: miles, points or cash. Deal chasers will seek out these and swap from one provider to another. The more mature financial institutions are much more sophisticated at building a richer, deeper view of the different customer segments. This allows them to sharpen their customer value proposition, integrate their card offering into other lending propositions, reduce channel confusion and clarify positioning and promotions. This approach helps to break down silos that can exist within large financial institutions which have built a plethora of products over several years. The relationship between a mortgage offering, credit card, savings account, investment account and current account can be confusing for the consumer. For the financial institution, there needs to be a common goal and a single company-wide view of the customer.
What needs to be done?
The plastic payment card will remain to be the key physical interaction with your financial institution in the near future. The card is a vital link to the customer’s real world. The number of consumer advice portals for payment cards seems to be growing – just look at Nerdwallet, Comparethemarket, moneysupermarket or uSwitch. There are more choices and advice on which payment cards are the best for your specific circumstances. Whether it is money transfers, using your card aboard, the best rewards, the best cashback, the best interest rates, the list is endless.
For an issuer, there are five strategic, yet fundamental questions that need to be addressed:
1. What regulatory authority will you issue a card under?
Issuing a card with prepaid, debit or credit functionality will influence the way you need to be regulated as a business. For example, an e-money license will permit the issuance of prepaid cards. Offering a line of consumer credit via a credit card is a whole different ballgame. The conduct of business rules and regulations, safeguards and risk management processes are very different. Everything you do, from how you sign-up customers to how you process their transactions is highly regulated.
2. What do your cardholders need?
However good your payment card is, the simple truth is that no-one will use it if they don't want it or believe they don't need it. You will not persuade anyone that they want or need to use your card unless you clearly understand what it is your customers really want. This is where customer segmentation techniques come into their own. Different segments will want different features and functionality from their cards. Customer needs will vary according to where they are in their own life cycle. Customers will undergo a journey with their financial service firms. To maximize the lifetime value of a customer, financial institutions need to continuously monitor and understand how their products are used, continuously review how digital services are used and test how best to cross-sell and up-sell other offers and services. As we saw with the cryptocurrency feature which helped Revolut acquire new customers, new features can bring new opportunities. Another example is Starling bank using TransferWise to provide its customers with cheap foreign currency transfers to bank accounts in over 30 currencies. Other partnerships have provided additional benefits and allowed for first-mover advantage to capture new customer segments or even define new service offerings previously unavailable.
3. Do you outsource or build in-house?
The ability to issue and process cards has been commoditised over the last 50+ years that cards have been issued. What has become more complicated is the digitalisation of the card proposition, the need to support digital wallets, faster or immediate payments, and support multiple accounts and currencies is becoming a customer expectation. Customer friendly features and functions that the traditional banks have found hard to offer because of the legacy systems that their card issuing and processing platforms have been built upon. The new entrants have had the luxury of starting with a blank sheet of paper and built a digital bank and digital card offering that is rich in features and functions, TransferWise and Revolut are just two examples where the card proposition is streets-ahead of the traditional legacy bank offerings. Outsource your card processing to a third party may help to address your need for ‘speed to market’ but how your proposition can differentiate in a competitive market could be challenging. Building in-house can be costly but a good way to spend the millions currently being poured into Fintech.
4. How to make your card compelling?
In Western Europe and North America, payment cards are readily available and it is easy for customers to apply and sign-up for. The difficulty that many card issuers find is to convince their cardholders to transact. One or two transactions a month is just not enough for a viable card program. An average debit card is used 12 times a month according to the UK Card Association and this is very similar in many of the debit card markets across Europe, especially in Germany and the Netherlands. A credit card may be as low as four transactions per month. Contactless acceptance on the public transit networks has helped to drive up transactions and drive the average value of transactions down. The card becomes a utility, allowing the customer to easily navigate the public transit networks. Other use cases must be developed to differentiate and encourage the card to be top-of-wallet, especially, when that card is a credit card. In a highly competitive credit card environment, rewards, cashback and miles are some of the options available to help encourage cardholders to use their card. A trend from the US filtering into Europe is the growing prevalence of metal-based payment cards which have proved popular with the affluent customer base keen to stand out from the crowd. The digital banks are looking to differentiate through service and transparent pricing.
5. How can open banking bring further benefits?
As we have seen the European regulators have taken action to encourage competition in the financial services sector. A key provision of PSD2 and the Open Banking framework aims to foster competition and innovation for payment service providers in the European Union. The future will be increasingly varied and modular, resulting in a very different banking experience for customers. HSBC, for example, has taken a step into the Open Banking era with the launch of its Connected Money app, enabling customers to see account information from all their providers in one place. Open Banking will give rise to new business models, with some providers choosing to specialise with niche offerings rather than providing a traditional range of products and services that the traditional financial institutions have provided in the past. Some new entrants will attempt to manage the customer’s end-to-end experience. Larger tech organisations such as Google, Amazon, Apple and Facebook are expected to play a role in the Open Banking environment.
By facilitating financial services like payments directly into websites, AmazonBuy button is a good example of open API technology, and by inserting themselves between the customer and the underlying bank, Fintechs will continue to downgrade the traditional banks to the role of providing the back-office ‘plumbing’. This will become a commoditised area and difficult to add value. Open banking and PSD2 standards enable a huge opportunity for more non-banks and technology providers to plug into traditional banks and build new service propositions for customers.
The new era of banking
The financial services industry is only just starting to wake up to Open Banking and Open APIs. The PSD2, with the help of the European Banking Authority (EBA), is expected to set the standards for the banking industry to allow Payment Initiation Service Providers (PISPs) and Account Information Service Providers (AISPs) to gain access to data held within banks. Crédit Agricole, BBVA, Fidor, Banco Sabadell, ING, BNP Paribas and Garanti are experimenting with open APIs by either opening up specific segments of consumer data, hosting their own App Stores, or facilitating hackathons for API software developers to innovate. This is only the tip of the iceberg. In the future, we will see the ‘API-isation’ of banks, which will effectively turn a closed ecosystem into an open game that can be played on a level playing field – this is what I prefer to call ‘Lego-isation’ of the financial services industry. Like Lego, there will be a standard set of building blocks that banks and third-party providers will use to work together, to give consumers greater choice and build the next generation of products and services. By 2025, we will see more from the financial services and payments sectors as a result of Lego-isation and Open Banking. There will not be the notion of a challenger bank.
In the future, your mortgage could be provided by Amazon, your groceries delivered by Walmart and paid via a bank transfer facilitated by Apple Pay, whilst Zurich Insurance provide your life insurance based on your health measurements from wearable technology device, such as Fitbit. Your credit card could be provided by Facebook.
This is an exciting time for open banking and the enriched usage of consumer data. The future winners of Lego-isation are unlikely to be the traditional banks but new entrants; technology disruptors, digital innovators and non-banks with an open mind to open data, innovators that are unhindered with legacy systems are expected to be the new financial service providers to the millennial generation.