The Threat of Challenger Banks: Community Banks’ Strategies to Overcome
The topic of financial institutions’ mergers and acquisitions has been a hot subject in 2019 due to a mixed bag of M&As, from the creation of a $45-billion-asset Midwest powerhouse at Chemical Financial to credit unions buying banks at an accelerated rate. However, as bank executives scramble to gain a grasp on what the rest of the year holds in store, there might be another looming threat that community banks and credit unions should be on the lookout for: challenger banks.
Often referred to as “neobanks” or tech-first banks, there has been confusion around what a challenger bank is. The term challenger bank has traditionally been used to describe financial institutions in the United Kingdom; however, because their impact is felt across the banking sector, the term has since been commonly referenced in the United States. Challenger banks are non-traditional financial institutions that often offer more advanced digital banking services than traditional banks. These digital-first financial startups often only offer one service, or a limited amount of services. This enables challenger banks to specialize and fine-tune specific products, as well as function in a less strict regulatory environment than their traditional banking peers. This is why challenger banks have caught the eyes of private investors, attracting several million in venture capital series funding due to all the increased buzz. The number of digitally-savvy players in the financial services industry continues to increase, and today’s community financial institutions must innovate in order to keep up with customer demand and new, unique pain points that challenger banks remedy.
Challenge #1 – Establishing a baseline of digital capabilities
According to The Financial Brand, there are over 40 challenger banks in the U.S. today that pose a threat to traditional banks’ dominance due to fresh, digital offerings that most banks simply do not offer. A few of these products include:
- Online bill payment systems
- Person-to-person mobile payment/transfer systems
- Budgeting education/tracking tools
- Online loan refinancing options
- Mobile and direct deposit options
- Mobile check-sending functionality
- In-app customer service/assistance
- High APY online savings accounts
- High APY online deposit accounts and more
No community bank or credit union should expect to adopt all of these products at once; however, financial institutions who offer less digital products than their peers might soon be eclipsed by them. According to a Salesforce report, 70 percent of customers say technology has made it easier than ever before to take their business elsewhere. This is especially alarming when, in some cases, the largest barrier to adopting digital lending offerings is simply the overwhelming amount of financial technology options or knowing where to start. To address the upheaval in banking customer expectations, community financial institutions must establish a baseline of digital offerings to offer, whether it’s a mobile online loan application system or simply building a digital branch. For several community institutions, it’s offering a digital loan origination channel. Today, half of banks with assets above $1 billion and just 38 percent of small banks offer a digital lending solution for clients, which represents a significant opportunity for community financial institutions to hop on the digital lending train and innovate.
Challenge #2 – The competition for deposits
To onboard loans, banks and credit unions must first have sufficient funds. Retail deposits – such as checking and savings accounts – are often viewed as a primary method to fund loans. Smaller financial institutions are losing the battle for deposits to big banks, but community banks and credit unions might find themselves battling with challenger banks as well. One offering that challenger banks are focused on is deposit products. Online-only banks, like Goldman Sachs’ Marcus, have taken the financial world by storm, attracting young, digital-first customers. While some might argue that Goldman Sachs is an established brand, its internal product, Marcus, is viewed by many as one of the largest challenger bank threats. Marcus is an online-only bank offering high-yield savings accounts and certificate of deposits as well as short-term consumer loans at nearly half the interest rate of national average.
Everybody loves a deal, and that mantra extends to banking customers. Challenger banks have the luxury of offering high-interest savings accounts and low-interest loan packages with little unease about funding issues down the road. For example, Marcus deposit products boast a high annual percentage yield (APY) of 2.25 percent, while the national average is just .09 percent, and offer loan packages with an annual APR as low as 5.99 percent with no-fee structure. Community financial institutions, however, often have less funds and resources to offer similar rates and benefits. In cases like these, it is especially important for community banks to seek our technological solution. For many community financial institutions whose rates hinder staff from booking loans, technology can speed up loan decisioning and make up for other limitations. The automation of manual spreading and booking processes has been able to drive loan growth without having to add to the payroll or sacrifice interest rates.
Challenge #3 – Young entrepreneurs = Debt + thin credit
Millennials have been dubbed as the entrepreneurial generation, often trading in a traditional nine to five for a startup lifestyle. The millennial generation is also riddled with debt, averaging $42,000 of total debt according the Northwestern Mutual’s 2018 Planning Progress Study. The majority of that debt has accrued from credit card debt.
For an entrepreneur, credit card debt can be a major hindrance. Unless venture capital is on the table, young entrepreneurs must turn towards small business loans. A mass amount of credit card debt and lack of traditional employment means three things for entrepreneurial millennials:
- For the average millennial who earns the salary of $35,592 and owes an average of $42,000, his debt-to-income (DTI) ratio is 118 percent, which is considered poor compared to the ideal 28 percent.
- Millennials’ credit utilization, which is considered one of the most important factors lenders use to assess creditworthiness, is incredibly high.
- For freelance workers, and some startup employees, a W-2 is not available, which makes it much more difficult to verify income.
All of these factors put the goal of starting a business out of reach for most millennials, and challenger banks are taking advantage of this trend. An added benefit of specializing in particular financial products is that challenger banks and providers often don’t adhere to the same compliance restrictions that community banks must endure. For that reason, they can onboard loans that might be considered too risky for a community bank or credit union and reap the financial benefits of those loan packages. Take challenger bank Oxygen for example. Oxygen offers lines of credit to freelancers who are often denied access to credit lines simply due to poor credit history. They do this by taking a look at borrowers’ broader financial picture by pulling cash flow information and performing cash flow forecasting. It also accounts for external bank data to get a full understanding of discretionary income versus debt.
Community banks and financial institutions have the opportunity to level the playing field by implementing solutions that cater to specific pain points such as these. For example, Plaid, an API used with Abrigo’s Loan Application can collect real-time asset account data from more than 9,000 financial institutions. This additional information can be advantageous for credit analysis, as it adds another layer of support during loan decisioning. For community banks that want to tap the young market of small business borrowers, the key is finding the specific barriers to entry that young entrepreneurs face and optimizing internal systems to cater to those pain points.
Digital lending is predicted to account for 10 percent of the U.S. lending market by next year and is a total addressable market of $1 trillion in the U.S., which means there is a wealth of opportunity for community financial institutions that have invested in technology. But due to their digital-first mentality, challenger banks pose a major threat to community banks and credit unions that want to gain market share of the digital lending industry. Smaller financial institutions must have a plan of attack in place through digital solutions of their own, so the question is – what’s your strategy for 2019?