Challenger Banks and Venture Capital

The challenger bank phenomenon is one of the most important in the fintech world. Today, many challenger banks operate in most Western countries and seek to define firmly in the banking sector, precisely by “challenging” traditional banks.

After the 2008 financial crisis the banking sector lacked competition and from that time on (especially in the UK) Challenger Banks started to emerge as an alternative to traditional banks exploiting technological services and covering the rising demand for a faster, more transparent, and reliable banking service.

What are they? Even if we can define several types of challengers banks the common denominator is that they provide technology-driven services accessed by customers through immediate and intuitive platforms, such as apps, through which they can execute transactions, monitor expenses and in many cases also directly access investment opportunities, all this done quickly and often with zero commission.

Challenger banks allow customers to have the classic services provided by traditional “high street” banks but with lower costs and commissions and through immediate platforms that simplify the typical way of dealing with your bank.

In addition, many challenger banks target groups of people that may be underserved by traditional banks, such as consumers with lower incomes or those with no credit history.

Still, the path to success in a system like banking is not easy. Banks are age-old institutions that enjoy the support and the trust of billions of people, companies, and government; despite this, Challenger banks have over the years attracted the attention of numerous investors, including Venture Capitalists, in the audacious attempt to establish themselves as a new, sustainable, and competitive business.

Data on the industry (Europe)

Considering the data regarding Europe provided by the CB Insights database, since 2009 there have been 504 deals for a value of $11 billion dollars of total funding in the sector of banking and automation in banking.

Even if not all the deals are exclusively related to challenger banks, these figures give an idea about the expansion and status of the sector.

Source: CB Insights

As the graph shows, since 2013 the trend has been of consistent growth in both the number of deals and the amount of money invested with the peak reached in 2020 in terms of both number of deals (93) and funding amount ($3.01 bn).

About 40% of the deals are Seeds/Angel with an average deal size of $2.8 million, followed by Series A/B/C with 24%, 16%, and 9% and an average deal size ranging from $12 million in Series A to $53.2 in Series C passing through $30 in Series B.

The average deal size grows exponentially to $105 million with Series D (5% of the total) to 130 million with Series E+ that accounts for 2.57% of the total.

In which countries is the industry most active? Home of the main challenger banks and the most important deals are the UK and Germany. The UK has accounts for 56% of the total deals in Europe since 2009 with an average value of $27.5m, followed by Germany which accounts for 10% with a higher average deal value of $33.6m.

The UK in particular has seen more challenger bank activity than other countries, as a result of progressive regulations enacted to promote competition and break up monopolies.

Considering the big names in the challenger banks scenario we can point to 5 names of which 4 were founded in the UK: Revolut (London-based, Russian-led), Monzo bank, Atom bank and Starling Bank and the German N26.

Italy is a “bit” behind when compared to Germany and the UK, in fact deals in Italy only accounts for the 2.18% of the total. Still, also in Italy there are some interesting phenomena in the field of challenger banks or innovation in the banking sector.

For example, Hype is the leading Italian challenger bank supported by Illimity and Banca Sella; it offers a wide range of services used by more than one million Italians.

It is also worth to keep an eye on Aidexa founded in 2020 and seed-funded for $53m by Banca Sella, Generali Group and Banca Ifis. Aidexa is a fintech company offering an Artificial Intelligence-powered, data-driven challenger bank. The company aims to make life easier for those doing business by leveraging the technologies and opportunities offered by open banking.

Let's go back now to the “big challenger banks” on the European scene i. e. Revolut, Starling Bank, N26, Atom Bank and Monzo.

  • Revolut was founded in 2015 and its currently valued at $5.5bn, the bank operates in 33 countries and has more than 10 million users making it the largest challenger bank in Europe. Revolut offers a personal money cloud, reducing banking fees to zero. It allows users to exchange currencies at perfect interbank rates, send money through social networks and spend it with a multi-currency card wherever MasterCard is accepted. All this is done at the touch of a button, in a mobile application. The company's goal is to completely eliminate all hidden banking costs. (Investors: Index Ventures, Ribbit Capital, Balderton Capital, DST Global)

  • Starling Bank was founded in 2014 and it’s now valued $1.954 bn, it offers personal, joint, and business accounts to its clients helping them visualize and manage their finances in real-time, all from one app. Starling Bank was also one of the first challenger banks to become profitable and claims to have an average balance in its bank accounts of £1,625 (well in excess of the £250 for Revolut, and £359 for Monzo). (Investors: GS Growth, Fidelity Investments, Qatar Investment Authority, JTC Group).

  • N26 was founded in 2013 and has now reached a valuation of 2.7 billion with more than 3.5 million users globally; N26 said its goal is to have between 30 and 70 million customers (which would make it bigger than Deutsche Bank, RBS, or Barclays). N26 offers a mobile banking platform that offers customers a solution to control their finances trough an account that customers can directly open from their phone or computer in an easy, paperless, 5-minute registration process. (Investors: Tencent, Insight Partners, Allianz X, Earlybird Venture Capital).

  • Atom bank was founded in 2014 and has raised $643.49m so far; the bank offers customers the ability to open accounts using a mobile app, giving them access to their financial information and the ability to take advantage of a wide range of tools. (Investors: BBVA, Toscafund Asset Management, Anthemis, Woodford Investments).

  • Monzo was founded in 2015 and has raised $640m so far; the bank on par with its competitors offers banking services through a mobile app. (Investors: Accel, Y Combinator, General Catalyst, Thrive Capital, Stripe).

The challenger bank sector is not only made up of unicorns but especially in recent years there have been numerous deals and financings backed by Venture Capital firms and angel investors around the world and in Europe. Considering the top investors by number of deals in the last year, on the podium we have Accel, Crowdcube and Y combinator.

  1. Accel is a venture capital company ($8.8 bn under management) that invests in people and their companies from the early days to all stages of a private company's growth.

  2. Crowdcube is a particular case since it is an investment platform for funding start-ups and business expansion through equity crowdfunding, giving entrepreneurs a platform to connect with people and raise venture capital. By attracting investors who invest small amounts of money in a person, company, product or idea, users can bypass traditional ways of raising venture funding.

  3. Y-Combinator is a seed stage venture firm. Y Combinator specialises in funding early-stage start-ups, mainly in the software and web services arena.

Where challenger banks have been successful and where they can and should improve

Challenger banks entered the established retail banking market with a simple business model - basically free banking with no hidden fees. These companies have been able to exploit technological advances and benefit from decisive changes in customer demand. The phenomenon of challenger banks exemplifies that new start-up can be quite innovative even in established industries with large and reliable players. In particular, leveraging technology to offer existing services in a more convenient and cost-effective way can provide an advantage in competing with incumbents.

At the same time, as mentioned earlier, challenger banks find themselves operating in one of the most difficult areas to establish as a new competitor. The issue of trust is crucial, as challengers need to be 100% trustworthy in order to truly “challenge” traditional banks.

This is not an easy process, especially given the nature of many challengers which are in stark contrast to traditional banks. The non-banking attitude of some challenger banks has a negative effect on the confidence of their clients, who seem to prefer at the moment to transfer most of their assets to traditional banks. Indeed, one of the main criticisms levelled at challenger banks such as Monzo and Revolut is that they have not yet succeeded in capturing the full trust of customers, which is a key attribute in the banking world.

Still, not all challengers are the same: Starling Bank, for example, has always focused on acquiring a good reputation among its customers and this has a positive effect on the average balance of its current accounts and on its profitability (first challenger bank to become profitable). In addition, the pandemic has put challenger banks under strain: in June Monzo completed a funding round at a 40% discount to its previous valuation as the coronavirus hit its growth prospects.

The risk for challenger banks, therefore, is that they will not be able to reach the level of trust that can make them as profitable and good as traditional banks, as VC investments may not last forever.