The ultimate neobank battle will be about mortgages

Customers, customers, customers! Fintech enthusiasts will remember 2016 as the year in which many of so-called neo-banks, aka challenger banks, came to light with the promise of disrupting the core of banking. However, albeit very significant, being granted a banking license is a landmark that only represents the beginning of a journey, and that’s why many voices talk of 2017 as the barometer to measure how much of a ‘challenge’ do this neobanks really pose to traditional institutions. That being said, as time goes by, I am increasingly convinced that this battle for relevancy, apart from shifting to a customer-centric approach, in the end, will revolve around a very specific product: the mortgage.

The mortgage is ‘the king’ of retail banking

The customer base of traditional banks’ retail divisions (usually described as ‘high street banks’) are individuals and small business, and their core activities usually comprise deposit-taking, lending and providing payment services.

As you can see in the following graph, the retail business in the UK represents a very important share of banks’ total income (which varies depending on the importance of their other divisions as the commercial or the corporate ones).

So, if retail banking is the most important division for UK banks, what is its main source of profitability? Although we may find a variety of profitable products ranging from mortgages, consumer lending or credit cards to SME lending, it’s pretty clear that real-estate based loans, representing more than 56% of banks’ profits, are their fundamental pillar. Besides, there is no indication that this trend will change in the short term since the reliance of retail banks on net interest income has increased in the last years.

Neobanks have to enter the mortgage game if they want to become relevant

For the first time in decades, there is a wave of new financial institutions that have been granted banking licenses. These so-called neobanks or challenger banks, have caught much attention and are constantly described as one of the players putting more pressure to their much more traditional competitors.

However, many of these new only-digital banks are putting most of their efforts in disrupting the user experience and offering products that do not involve any sort of maturity transformation. Obviously, the good side of the story is that, since banks traditionally haven’t followed a very customer-centric approach, there is a lot of room for improvement in terms of UX -especially regarding the speed and convenience of many processes, e.g. onboarding, or the automation of document preparation. The bad news are that improving such user experience is easily replicable by the more traditional actors in the mid or long run.

Does this mean that neobanks won’t be able to build a business model around this and be successful? Of course they could, but coming to my previous point, if they really want to become game-changing players, they will definitely need to play and win the mortgage battle, or at least to get a relevance market share of the mortgage market. And I would defend this argument with two different but complementary reasons:

1. The major source of profits for retail banks comes from selling mortgages. So, if you want to be a relevant player in terms of size and market share, you have no other way but to be relevant in the mortgage game.
2. Mortgages are a key factor for people to switch from one bank to another, more than any other banking service. Banks always use mortgages as a leverage to “force” clients to bank with them. I mean, to bring their payroll, car loan, etc. They are often keen to negotiate a lower interest rate if the client bring more business. And given mortgages is a very sticky product, considering you are stuck for 20, 30, 40 or more years, once you have chosen your bank for your mortgage… you have in some way chosen your bank for most of your life.

This does not necessarily mean that neobanks will need to offer mortgages directly. As I described already almost two years ago, it is also possible that they partner with a third party that provides such services through the neobank marketplace.

"Imagine that you are a client of this 'marketplace bank' and that you need a loan. You do not really care if the loan is provided to you by Lending Club or Bank of America, what you look for is a quick and frictionless process to get your loan, and the lowest interest rate possible. So, through the API, the "marketplace bank" will consult all its third-party providers and offer you the loan that best suits you."

Atom Bank, the first mover

Apart from its two Fixed Saver accounts and SME lending product, Atom Bank, UK’s first digital-only bank backed by BBVA, started providing two-year fixed rate residential mortgages through selected independent advisers in December 2016.

According to the press release, Atom will offer a broad range of residential lending via independent mortgage advisers, including self-employed, contractors, lending into retirement, purchase, re-mortgage, shared ownership, first-time-buyers and new-build properties, with buy-to-let mortgages coming soon

Making the process of buying a house easier, quicker and more transparent, with real-time information and ensured by biometrics technology will for sure have an impact on the industry, and will put pressure on traditional banks to copy them. It will be interesting to see whether before that moment arrives, challengers have been able to seduce a relevant part of traditional banks’ customer base.

In conclusion, being able to convince other banks’ customers to try your app, opening a free checking and become new “users” is something that neobanks -especially their marketing departments- are doing pretty well -for example, last week Monzo announced it reached 100,000 users while still being in their beta phase-.

However, I’m becoming increasingly convinced that in today’s world -and until we arrive to a scenario in which people don’t purchase houses anymore-, any banking business model aiming at posing a challenge to traditional institutions will need to start winning the battle around mortgages.