The Great Filter for Digital Challengers

It seems like almost weekly I’m hearing something about a new challenger or digital-only bank brand. The velocity of news is substantial, but despite years of hype, it seems this class of institution is still largely treading water.

It reminds me of The Fermi Paradox.

The paradox was originally posed as a question by the physicist Enrico Fermi about the apparent contradiction between the probability of life in the universe and the complete lack of evidence to support it. With so many supposed earth-like planets, why haven’t we been able to find success stories?

One of the proposed theories is the idea of a Great Filter in the evolution of life. The theory goes that as life evolves it must overcome leaps in species advancement, one of which is a Great Filter that almost always stops its progress.

In the universe of banking there’s plenty of “new life,” specifically challenger banks looking to compete with traditional institutions (I won’t compare them to advanced species for obvious reasons). Despite major fanfare within the industry, however, these challengers have largely struggled to adapt and grow. Like life in the universe, could there be “great filter” keeping these new entrants from flourishing? I’d say there are a few contenders.

Technology

What old technology lacks in flexibility it makes up for in stability. It seems that for emerging providers, what’s made up for in flexibility is lost in stability. Simple, for example, has had its share of technical issues over the past couple of years. In late 2014, a systems upgrade lead to a number of glitches, including bill payment going down, online banking being inaccessible, and the safe-to-spend feature showing incorrect balances. Some accounts were locked for more than 24 hours. The transition process to BBVA also presented issues with integration. Systems had to be rebuilt, and customers had issues with using debit cards, not being US citizens, and just recently, losing their accounts (Simple said it wasn’t able to transfer everyone before its relationship with The Bancorp Bank ended).

Monzo (formerly Mondo) out of the UK had multiple issues inside of a week. It had outages with its third party card processor, and then a few days later customers reported not being able to properly view their balances or display transactions.

Traditional financial institutions have long known that trust is an asset, whether it’s trust to keep money safe or trust to keep data secure. Technology has been built around establishing reliability. Challenger banks and neobanks may be opening themselves up to risks associated with applying concepts of agility to the complexities of banking, and this may be a strong enough filter for reaching critical mass.

Revenue

In addition to trying to provide an amazing customer experience, almost all challenger banks share the same commitment to fee transparency. In recent years, many traditional banks have used fee income to supplant lower than usual net interest margins. Fees have been (often rightly) perceived as punitive and opaque.

The quest for fee relief is admirable, but ultimately emerging challengers need to make money to fuel new investments. For some that’s been an issue. The neobank Moven, after struggling to find a significant core audience in the US or overseas, decided to pivot and start selling its underlying front-end technology to traditional banks, most notably TD Bank. Customers Bancorp recently put BankMobile up for sale, citing profitability concerns stemming from limitations on debit interchange once the bank’s assets exceeded $10 billion. BBVA also recently reported a total of $89.5 million in goodwill impairment from the acquisition of Simple Bank in 2014.

Challenger banks are fully committed to reimagining financial services, but many haven’t yet reimagined the business model. Banks that are furthest along are the likes of Knab in the Netherlands and Fidor Bank in Germany (acquired by France’s BPCE Group) which have applied subscription-based pricing for consumers. Similar to Netflix or Pandora, the idea is that consumers will pay for value. What’s clear, however, is that the complexities of financial services require a scale of investment that presents a bigger barrier to entry than for other platform-based offerings (i.e. movies and music). If consumers are paying for value, then the question is whether a challenger can persuade consumers that they’re receiving enough value to validate a subscription before it begins to hurt its financial viability.

Acquisition

When confronted with barriers to organic growth, some challengers have found it easier to be acquired. When BBVA bought Simple, CEO Josh Reich said that BBVA would provide them with the resources to grow faster. Many took this as an admission that customer growth was slower than expected. When Fidor was purchased by the French banking group BPCE, the German bank said that the sale would “...allow Fidor to continue its international expansion…” as well as “…improving our overall financial sustainability.”

The question is: do challenger banks need traditional institutions? Well, they certainly need trust, and customers, and data, and with the pressure to grow and invest in innovation, it’s obvious that the financial incentives of joining a large organization can be attractive.

Challenger institutions have been an important part of the banking ecosystem. Most notably, they’ve moved the ball forward on what “good” looks like throughout the industry, better assimilating modern concepts of UX and UI design into their front-ends. At the more extreme end, however, these challengers were heralded as the white knights that would save consumers from pernicious traditional institutions with outdated technology. So far that hasn’t been the case.

In the explanation of Fermi’s Paradox, humanity (or a challenger bank) is left with three possibilities, depending on where the Great Filter occurs: we're rare, we’re first, or we’re in trouble. Rare is the challenger that’s made it through the Great Filter. First is the challenger within a pack of new institutions which has grown because of conditions that have only recently become favorable. In trouble is the challenger that hasn’t yet reached the Great Filter. There’s plenty of life in the banking universe, but it remains to be seen who will make first contact.