Introduction

This chapter will examine the possibilities for new entrants into retail banking in the United Kingdom, such as those representing ‘value brands’ (for example, Virgin Money), those whose origins lie in the traditional retail sector (for example, Tesco Bank), and new entrants with entrepreneurial backgrounds (for example, Metro Bank). The chapter will discuss what the possibilities are for these new entrants, from whatever their origins, to both enter and prosper in the financial services market, that is, whether they can offer a ‘real’ competitive threat to the more ‘established’ players who have traditionally dominated the market.

Chapter 1 discusses the impact of regulation on competition in commercial and investment banking. Deregulation facilitated the formation of ‘conglomerate’ financial institutions, where a broad range of services and products were made available to clients, through different arms of the same bank. Following the financial crisis, further legislative changes have been put in place to reverse some of these impacts of deregulation in an attempt to restore confidence in the financial services institutions, in part by changing the structures within those institutions and in part by restricting their marketing practices. Banks, for example, are being encouraged to disaggregate their various activities and construct walls between their various divisions, so that investors’ and depositors’ funds are not used irresponsibly.

In this context, there has been a growing pressure for retail banking activities to be made separate from investment banking activities by the so-called ‘ring fencing’ of the two activities from each other. In a speech in February 2013, the Chancellor of the Exchequer in the United Kingdom gave a speech on the future of banking in which he suggested that the proposed ‘ring fence’ should be ‘electrified’ with draconian sanctions if retail banking was not protected from riskier investment banking operations. The Chancellor said ‘My message to the banks is clear: if a bank flouts the rules, the regulator and the Treasury will have the power to break it up altogether – full separation, not just a ring fence’ (Financial Times 2013). He underlined his determination to open up the United Kingdom’s retail banking sector beyond its current domination by the large, well-established banks by facilitating the entry of ‘challenger banks’ to create a more competitive retail banking system, that would be more focussed on customers.

This situation where the market for banking services is dominated by a relatively few large ‘players’ is to be found in a number of countries; despite regulators and consumer groups calling for more competition, the challenges for new entrants are substantial. This chapter discusses those challenges beginning with the challenge of encouraging customers to move one of their key relationships (the personal current/cheque account) from one provider to another; the so-called ‘switching’ process. It then goes on to consider where new entrants might come from, to detail which ‘challenger banks’ have emerged so far in the United Kingdom and what their prospects might be.

Background to the situation

In the context of the United Kingdom (UK), the Office of Fair Trading (OFT) released a review of the personal current account (PCA) market in January 2013 (Office of Fair Trading 2013b). The PCA is equivalent to a check or transaction account in many other countries; it is a keystone product in the retail banking sector and often the starting point for the establishment and subsequent development of a relationship between the financial services provider and the customer (see Chapter 9 by Yu and Harrison). In 2013 the UK had 46 million PCA holders. However, according to a study by the Payments Council, the industry body in charge of managing the account switching system, less than three percent of these account holders switched their PCA provider in 2012, thus limiting the competitive impact of new entrants into this market.

The OFT review concluded that in the UK market, further significant changes were still required to tackle longstanding competition concerns and a lack of focus on customers’ needs. The OFT found that since it last looked at PCAs in 2008, the major banks had increased their share of the market, that entry by new competitors remained infrequent and that consumers still only rarely switched their PCA to an alternative provider. The conclusion was that overall a combination of a lack of competition, low levels of innovation, ongoing customer apathy/inertia in the face of unclear costs and a lack of diversity in the choices of PCAs available meant that this market was not working well for consumers or indeed the wider economy.

The OFT in January 2013 made new recommendations to make PCA costs more transparent, the switching process more reliable and to improve the way in which managed overdrafts are provided. It called upon all providers to make rapid progress in implementing these recommendations, as well as being more proactive in ensuring that their products and services are better aligned with the needs of their customers. The OFT Chief Executive commented:

Personal current accounts are critical to the efficient functioning of the UK economy. Despite some improvements, this market is still not serving consumers as well as it should. Customers still find it difficult to assess which account offers the best deal and lack confidence that they can switch accounts easily. This prevents them from driving effective competition between providers. Major changes are taking place in the personal current account market. For these changes to improve the effectiveness of competition in this market, banks and building societies need to act to improve the quality and value for money they provide their customers. The retail banking sector needs to become more competitive and customer-focussed to ensure that further action by the competition authorities is not required.

Office of Fair Trading 2013a

Since September 2013 banks in the UK have been required to reduce the amount of time it takes to switch PCAs from one month to just seven days, all at no cost to the customer.

The issue of switching between providers is a vital one for new entrants, as according to the OFT (Office of Fair Trading 2009), the PCA market is the cornerstone of the UK’s retail finance system and an essential service for 90 percent of the adult population. Thus, new entrants cannot rely on an ‘unbanked’ target market from which to gain customers. They must instead hope to win new customers by luring them away from their existing providers; hence customers’ perceptions of the difficulty of switching providers will impact strongly on their willingness to switch to a new entrant.

Research conducted by the OFT (Office of Fair Trading 2013b) showed that perceptions of switching among consumers who have never switched PCAs before had not changed significantly since 2008, when only 26 percent had considered switching; by 2012 the percentage who had considered switching had actually reduced to 25 percent. Similarly, for those who have never switched, there has also been no real change in the level of confidence in the switching process running smoothly; in 2008, 52 percent were ‘very’ or ‘fairly confident’ about the process, but by 2012 this percentage had also fallen, to 50 percent.

This could be partially explained by changes in perceptions requiring time to occur, particularly if they are not based on the individual’s own experience. However, even when individuals have had experience of switching their PCAs between providers, the perceptions of the switching process did not change significantly between 2008 and 2012: in 2008, 75 percent of those who had switched their PCA in the previous 12 months said that it was a relatively ‘easy’ process, but by 2012 this figure had only grown to 81 percent. Also, in terms of referrals/advocacy, there has been no real change in the likelihood of those who have already switched recommending others who have not switched to change their PCA provider. Thus the overall message arising from the OFT’s research, is that switching levels remain low and are either constant or displaying a very gradual increase over time. The findings also suggest that although actual switching of PCAs from one provider to another has gradually increased, it still remains low in terms of the overall proportion of account holders.

The new entrants

How significant are the effects of the global financial crisis on the future structure of the banking sector? Clearly, the ramifications of the financial crisis have led to major changes in the capital, liquidity and accounting regimes for banks. But might the crisis also open up the sector to new competitors on a scale not seen before? Is the distrust of mainstream banks now so deep that ambitious companies in other sectors have an unparalleled opportunity to become major providers of banking services? Chapter 30 discusses the challenges ahead in re-building trust for traditional banks. Many of the potential new entrants to banking are however already well-placed in terms of established consumer trust.

Opportunities for ‘non-banks’ to enter the market have been discussed many times before. It has been said that ‘Banking is essential to a modern economy. Banks are not. If some other entity performs the functions of banking faster, smarter or cheaper, it will replace banks’ (Furash 1993: 20). Commentators forecasted that companies from outside banking would use their stronger grasp of information technology and customer service to shake-up financial services, taking lucrative business away from cautious and insular banks (see Worthington and Welch 2011).

In many markets, retailers have been perceived as the biggest threat. Their strong brands, marketing know-how, existing retail networks and store and loyalty cards offered a potential entry platform. In the UK, leading retailers took up the challenge and have been offering financial services for many years. For example, Marks & Spencer (M&S), a leading clothing, food and household goods retailer, entered the market as far back as the late 1980s and Tesco and Sainsbury’s, then the two largest UK supermarket chains, launched banking services in the mid-1990s. In the US, Walmart has shown interest in entering the financial services market and made a bid in 2007 to acquire a banking licence; a bid that was subsequently abandoned under fierce opposition from some American lawmakers and community banks that were wary of Walmart’s power as a retailer. This has not stopped Walmart from entering the market for financial services and it now has MoneyCenters in-store and offers both credit cards and a checking and debit card service called Bluebird, in partnership with American Express. Bluebird is directly aimed at Walmart customers (140 million visit Walmart every week) who are disillusioned with or excluded from traditional banking services. In China banking regulators are also inviting retailers to apply for banking licenses and their desire to enter this market is understandable as there are large margins to be made in Chinese banking.

Disruptive value brands, such as Virgin, that operate across structurally diverse consumer sectors (air travel, music retailing and mobile telephony) have also identified opportunities in financial services. Virgin Money launched in 1995 with an index tracking unit trust (mutual fund) and has since considerably expanded its range of services. However, prior to the crisis, the ‘non-banks’ concentrated on a select range of financial services and often operated through partnerships with existing banks. For example, the UK retailers concentrated principally on credit cards and other forms of consumer credit, simple savings accounts and insurance policies that could be sold directly. Tesco and Sainsbury’s operated through joint ventures with Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS) respectively, while M&S, after initially operating on its own, moved into a partnership agreement with the Hong Kong and Shanghai Banking Corporation (HSBC).

The crisis may have extended the opportunities for ‘non-banks’. Tesco and Virgin Money in particular aspire to move from being niche players in financial services to full-service providers of retail banking. Both have sought to expand their offerings and the introduction of current accounts (PCAs) and mortgages are planned or in progress. Tesco bought out RBS’s stake in its financial services joint venture in 2008 and re-branded Tesco Personal Finance as Tesco Bank. Virgin Money purchased a small regional UK bank (Church House Trust) in 2010 to expedite its acquisition of a banking licence and provide a platform for launching a retail banking business. In early 2012 Virgin bought, from the UK Government, the viable assets of the ailing Northern Rock bank, taking over the healthy loan and depositor base of Northern Rock and converted its existing 75 bank branches into Virgin Money outlets. Since taking over in 2012, Virgin has added 1.7 million new saving and mortgage accounts to its business and it is preparing to enter the PCA market, following Tesco and M&S.

Furthermore, these ‘challenger banks’ are ambitious in their visions for retail banking. Virgin Money talks of an ambition ‘to offer a new kind of bank in the UK – one where everyone benefits’. Tesco says it will focus on ‘being simple, straightforward and rewarding loyalty’. Moreover, Tesco and Virgin are not alone. In 2010 it was announced that another new entrant, Metro Bank had received a banking licence from the Financial Services Authority. The activities of each of these three new entrants are now analysed below.

Virgin Money

Virgin moved into financial services in the mid-1990s and originally operated as a niche player in personal financial services, with many of the services actually supplied by third parties but carrying the well-known Virgin brand. Virgin Money was initially founded as Virgin Direct in 1995 as a joint venture between a member of the Virgin group of companies and the insurance group Norwich Union, with the aim of offering equity savings products directly to the UK retail consumer market. It was one of the pioneers of index-tracking funds which carried low fees compared with actively managed funds, and it attracted £42 million invested funds alone in its first month of operation. In 1997, Virgin launched the One Account in a joint venture between Virgin Direct Personal Financial Services and the Royal Bank of Scotland. The One Account was the UK’s first current account mortgage direct to the retail market. However, in 2001, RBS bought out Virgin Direct Personal Financial Service Limited’s stake in the joint venture and the management team transferred to RBS.

In 2002, Virgin Direct subsequently re-branded as Virgin Money and increased its product offering, adding a credit card offered in partnership with Bank of America and additional savings, personal loans and insurance products. In 2003, Virgin Money welcomed its millionth customer and launched the Virgin Credit Card in Australia, which was followed in 2006 by the launch of a Virgin Money Credit Card in South Africa. In April 2004, Virgin Group Investments Limited acquired full ownership of Virgin Money with Sir Richard Branson investing £90 million to buy out the existing shareholders. In January 2010, Virgin Money announced a recommended offer for Church House Trust, a small regional bank offering deposits and mortgages. The acquisition of Church House Trust gave Virgin Money a banking licence in the UK, which allowed it to offer its own banking products without the need to partner with established financial institutions.

In January 2012, Virgin Money acquired Northern Rock, the Newcastle-based ex-Building Society which had been nationalised by the British Government following a run on the funds as a consequence of the credit crisis. The earlier purchase of Church House Trust in 2010 had been expected to trigger Virgin’s launch into mortgages and current accounts. However, this was repeatedly delayed as Virgin struggled to find a business model that would allow it to compete with the biggest UK banks. Virgin acknowledges that without the purchase of Northern Rock, it would have been difficult for Virgin Money to build a strong foothold in the UK market. Northern Rock had 75 branches and these were rebranded as Virgin Money stores in 2012.

Virgin Money aimed to offer PCAs with ‘free banking’ (i.e. no monthly or annual fees), however Richard Branson cautioned that free banking should have quotation marks around it, as customers would pay by accepting a small upfront fee, rather than the ‘hidden charges’ levied by the major banks. Following the acquisition of Northern Rock, Virgin Money had 4 million customers and 2,100 employees and aspirations to grow to 8 million customers and 200 branches. As a step in that direction, the first new Virgin Money Store opened in July 2012, which gave customers their first taste of the Virgin Money branch of the future.

As of 2014 Virgin Money was offering a range of financial services encompassing payment cards (credit, prepaid and travel cards), savings and investment products, general insurance products (motor, home, travel and pets), pensions, financial planning and mortgages. Work was continuing on developing a range of Virgin Money PCAs. In terms of product strategy, Virgin Money claims that it aims to bring simplicity to the UK banking market, which has traditionally been a complex sector, and that Virgin Money’s focus will be on a strong retail deposit base with an approach to banking that is founded on developing a sustainable, savings based business.

Tesco Bank

Tesco, like Virgin, has been providing financial services for nearly two decades. The supermarket group began offering financial services in 1996 when it launched the Tesco Clubcard Plus, an in-house debit card, which paid interest on the funds deposited in it and rewarded its users with Clubcard loyalty points. In February 1997, Tesco announced the creation of Tesco Personal Finance (TPF) as a joint venture with the Royal Bank of Scotland (RBS). Tesco PLC and the Royal Bank of Scotland Group PLC held an equal number of shares in the holding company, Tesco Personal Finance Group Ltd. However, one of the shares held by Tesco was a non-voting share and, as a consequence, RBS was the ultimate holding company. In December 2008, Tesco completed its acquisition of RBS’s stake in TPF for approximately £950 million, with TPF becoming a wholly-owned subsidiary of Tesco PLC and in October 2009, TPF was re-branded as Tesco Bank.

At the time of the acquisition of the RBS stake in TPF the UK financial services profit pool was estimated to be worth at least £20 billion per annum. The Tesco Personal Finance product offering at that time had material market positions in two of the core categories of financial services products: credit cards (6.9 percent of the market) and car insurance (4.3 percent of the market). Less meaningful market positions were held in home insurance (2.0 percent) and savings (0.8 percent), hence it was claimed that there was considerable opportunity to exploit Tesco’s innovative capabilities and customer service skills, to both build share in existing categories and to enter new product segments successfully.

By 2013 Tesco Bank had become the UK’s largest supermarket bank with 6.5 million customer accounts across a range of financial products and services. Its principal activities are credit cards, savings, personal loans, mortgages and general insurance, including car, home, pet and travel. Tesco Bank also operates a network of automated teller machines (ATMs) and customers can purchase products in-store, online or by telephone. In mid-2012 Tesco Bank also launched a range of mortgages, both at fixed rates and a base rate tracker. By 2013 it had over 3000 employees and according to the Tesco Annual Report 2012–13, for that financial year Tesco Bank generated £1.02 billion of revenue and a trading profit of £191 million (4 percent of the Tesco Group total), with a trading margin of 18.7 percent.

The 2012–13 Tesco Annual Report also describes Tesco Bank as having been in a period of transition since its creation in 2008. It now has a completely new infrastructure and is poised to move towards offering a full-service retail bank experience to Tesco’s customers. As of 2014, Tesco Bank has 7 million customer accounts and is preparing to launch its first current account product (PCA) this year.

Tesco Bank also welcomed the initiatives being taken in the UK to make it easier for customers to switch their PCA between providers. Tesco Bank’s ambition is to be Tesco customers’ core provider of banking services. With regards to PCAs, Tesco intends to be its customers’ main banking relationship and wants its customers to say ‘I bank with Tesco’.

Metro Bank

Metro Bank was the UK’s first new ‘high street’ bank in over 100 years when it was launched in July 2010, having been granted a banking licence by the Financial Services Authority (FSA). It promised to revolutionise the retail banking market. By the end of 2013, Metro Bank had opened twenty bank branches and planned to have a total of 200 by 2020. It had also attracted over 140,000 customers and businesses, based primarily on its customer service ethos. The bank operated typical retail store opening hours with extended evening opening. By May 2013, 136,000 customers held a PCA with Metro Bank, which, after only three years in operation, demonstrates just how difficult it is for new entrants to gain new customers in this key PCA market.

Metro offers PCAs, savings products, personal loans, credit cards and mortgages and various extra ‘services’ such as safe deposit boxes and free coin counting machines. Metro Bank has free online banking, instant in-branch issuance of bank cards and assistance with switching accounts from other providers. Its customer service focus is summed up by its tag line ‘No stupid bank rules’ and it encourages its customers to ‘Love your bank at last’. Metro Bank’s key point of differentiation is its focus on its customers, by offering them very high levels of service and convenience.

Metro Bank’s business banking offers working capital, commercial mortgages or expansion funding for both start-ups and established businesses, clubs, societies and charities, with a dedicated business banker in each branch. Notwithstanding, Metro Bank has found attracting new customers problematic: in the four months following its initial inception it had only provided about 100 mortgage loans. The bank’s lending capacity is limited by its reliance on retail deposits to fund the loans. These retail deposits often follow the opening up of a PCA by a new customer. Metro Bank acknowledges that there is a lack of public confidence in the switching process and that this is preventing customers from changing to the new providers.

Metro Bank views itself as a retailer of financial services and as a retailer it is open 7 days a week. The physical presence is important; Metro Bank claims that 93 percent of all its new accounts are opened in its bank branches. Metro believes that what matters most is the customer experience and hence its goal is to reclaim the banking values of the past by focussing on a more retail-orientated structure, hence the longer branch opening hours.

Analysis of ‘challenger bank’ competitiveness

An obvious way of structuring the analysis of the ‘challenger bank’ prospects is through a conventional Strengths, Weaknesses, Opportunities and Threats (SWOT) framework. The analysis looks first at the opportunities and threats facing the challenger banks in the financial services market environment. It then considers the new entrants’ own strengths and weaknesses. How well the challenger banks fare will depend on their ability to minimise the effects of any external threats or internal weaknesses and use their strengths to capitalise on opportunities.

Conclusions

Before the financial crisis, both Tesco and Virgin had provided financial services for more than a decade. However, both were happy to operate as niche providers and they concentrated on a select range of products, operating through partnerships with existing banks and insurance companies. Neither showed an appetite for directly competing as full-service providers in retail banking. In the wake of the financial crisis, both now harbour ambitions to become full-service retail banks. But are the changes flowing from the financial crisis sufficient to justify such an expansion? Existing banks may be more unpopular, making non-banks more attractive, but there is a debit as well as credit side to the post-crisis investment case. Banking is set to be less profitable, making the market less attractive.

The biggest challenge for Metro Bank, Tesco Bank and Virgin Money, as full-service retail banks may be to grow quickly and profitably, while at the same time doing banking in a way that is markedly different from the mainstream. Tesco admits that one of the challenges it faces is the industry’s ‘standard economic model’. The hurdles to overcome for both PCAs and mortgages are high. The pricing of retail banking products in the UK has in some ways been analogous to the famous description of the art of taxation of Jean Baptiste Colbert, French economist and Minister of Finance under King Louis XIV of France ‘The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing’.

The traditional banks remain reliant on opaque means of generating revenue from their PCAs, namely high overdraft charges and little or no interest paid on credit balances. Existing pricing structures are reinforced by the attachment of UK consumers to ‘free’ current account banking, ‘free’ credit cards and ‘free’ ATM withdrawals. In practice, this attachment to notionally ‘free’ banking services acts as a significant barrier to innovation and competition in pricing and it has resulted in significant cross-subsidies between different groups of banking customers.

Metro, Tesco and Virgin, therefore face the challenge of offering PCAs profitably without themselves relying on the same revenue models as existing providers. They also face the challenge of acquiring deposits without either offering unprofitable rates or tempting introductory rates that are then reduced over time. In light of their stated ‘visions’ for banking, high standards will be expected. Their services will be closely scrutinised by consumer and personal finance journalists, and ranked in the many comparison sites on the internet. Reputationally, Metro, Tesco and Virgin, are likely to face tougher customer standards than their existing bank competitors.

Notwithstanding, one of the key challenges for the existing ‘players’ in the retail banking market is that they have collectively lost the trust of their customers and indeed the wider community. Financial intermediation which occurs when those lending money to the banks (savers) implicitly agree with it then being lent out to borrowers, relies on the trust that their money will be available when they want it back. The great debate in banking thus needs to be how to restore the communities’ trust in banks. The regulators have demanded more capital and liquidity and less leverage. This means that for customers, banking will become more (rather than less) expensive, there will be higher interest rates on loans and less availability of credit. Increased levels of financial literacy will be essential if financial services consumers are to be empowered to choose between the traditional providers and the new entrants.

There has been research into both irresponsible borrowing by consumers and irresponsible lending by providers (see Worthington and Durkin 2012), which have combined to produce co-destruction of value in retail banking. Banking regulators have stressed that these ‘irresponsible’ behaviours from both consumers and providers are no longer acceptable.

Looking forward, changes to the ‘macro’ environment of retail banking outlined may help to restore trust in the banks, but they will combine with existing structural forces to make it even more difficult for new entrants to make an impact in the market. Switching providers continues to be fraught with suspicion by customers, capital requirements make new entry expensive, credit is being rationed making lending less profitable and the housing market remains flat, perhaps because of fears of another financial crisis. New entrants, from whatever origins they emerge, will need both patience and luck if they are initially to survive and then prosper!