Welcome to another issue of Net Interest, my newsletter on financial sector themes. This week, we’re looking at UK challenger banks, Starling and Monzo. They each published their annual reports recently and they’re worth digging into. Paid subscribers also have access to additional content on breaking themes in the weekly More Net Interest section.

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Battle of the Challengers

New Year’s Day, 2014, Anne Boden was on a cruise, skirting the coast of South Africa. She’d just left her job as chief operating officer of Allied Irish Banks and harboured a burning desire to create her own bank in the UK. “It’s going to be a new sort of bank,” she told a fellow passenger. “With a different approach. A digital bank.”

Boden’s idea was to start a new bank featuring a current account at its core. Other neo-banks had been launched over the years to market savings products or credit cards; none had been built around the simple current account. It was a hard market to crack: big established players managed 85% of the nation’s bank accounts, a position they’d clung to for years. On average, people held a current account for 16 years, famously longer than the average duration of a marriage which in the UK is 12 years. And, relatedly, the market wasn’t especially profitable. “You’ll never make any money out of a current account,” bankers warned Boden. “It’s a loss leader.” 

Boden thought otherwise. Her calculation was that a bank without any branches, using the latest digital technology, could keep costs very low. She anticipated that she would make money through interchange fees on card spending, and from net interest margin on the difference between what customers pay on overdraft lending and what they earn on deposits.

Eight years on, Boden’s bank – which she called Starling – is up and running. Over its first seven years of operations, it chalked up a cumulative £128 million of losses. But then in October 2020, it began to make money and this week it reported a £32 million pre-tax profit for its latest financial year through March 2022. 

Yet despite Boden’s intentions, it’s not current accounts making the money. Like many startups, Starling shapeshifted as it grew. It launched its current account in May 2017, picking up £1 million in deposits in its first month. As per its latest numbers, it now has 2.25 million consumer current accounts and holds £3.9 billion in retail deposits. But it didn’t stop there. In 2018, it tacked on business accounts and last year, it acquired a mortgage lending business to further its offering. It now has over 450,000 business accounts with £5.0 billion of deposits and a mortgage book that dwarfs its outstanding overdrafts. 

Along the way, the bank has responded to policy incentives. When the UK government set up a fund to help re-level the playing field for smaller banks after it nationalised Royal Bank of Scotland during the financial crisis, Starling was quick to apply. When the government launched a series of lending schemes to help businesses through the pandemic, Starling was there again.

Indeed, it’s these programmes that have propelled Starling to profitability. In April 2019, the bank won a £100 million share of the government’s £425 million ‘Capability and Innovation Fund’. The government body overseeing the process proclaimed that the “grant will enable Starling to radically transform business banking for customers in the UK, disrupting the stronghold of Big Four banks.” For Starling, this was more money than it had raised in its series C a few months earlier – a huge boost. 

Accounting standards require Starling to bleed the grant into its earnings as it incurs eligible expenditure. In the full year to March 2022, it booked income of £23.8 million from the grant. In addition, as a participant in the government’s ‘Incentivised Switching Scheme’, Starling also receives a “dowry” on every current account it woos from Royal Bank of Scotland or its sister bank, NatWest. At the end of June 2021, the scheme was wound up and what was left in the kitty was shared out among beneficiaries. Starling booked £9.2 million in its most recent financial year, bringing its total grant income for the year up to £33 million. 

The government’s pandemic relief programmes were no less generous. The Bounce Back Loan Scheme (BBLS) offered small businesses loans of up to £50,000 via a streamlined application process. The loans have a fixed interest rate of 2.5% although the government picks up the tab for the first year. The benefit to providers like Starling is that the loans are 100% guaranteed by the government so originators get all the income yet take none of the risk. Starling ended its financial year to March 2021 with 53,276 bounce back loans on its balance sheet, totalling £1.6 billion; by the end of March 2022, it had 55,028 loans on its balance sheet, totalling £1.4 billion. ¹

Taking the 2.5% interest income on the bounce back loans and assuming a funding cost of 0.05% – reflecting the bank’s overall funding cost – the portfolio earned Starling £36.2 million last year, around a third of its overall net interest income. It’s fair to say that without the grant or the opportunity to participate as a conduit for government loans, last year would have been another loss-making year for Starling. ² ³

Yet while these profits are not recurring, they do represent real money that Starling has been able to raise without suffering dilution associated with going to the market. As we discussed last week in the context of Klarna, banks are capital-intensive businesses and these non-recurring income streams enable Starling to fund more recurring growth. Only recently has Starling ramped up its external fundraising, bringing in a £322 million series D round last year and a further £130.5 million in April this year (at a valuation of £2.525 billion).

They also reflect a significant regulatory endorsement. Getting approved for these programmes is no easy task. But from the very beginning, Starling set itself up to be regulator-friendly. As a result, it was the first fintech to be accredited to offer pandemic relief loans in April 2020 and it was the largest overall beneficiary of the banking competition remedies programme. 

It’s a position others have struggled with. Boden highlights the tensions bank founders are subject to in her memoir as they negotiate between regulators and investors:

I couldn’t help reflecting that there was a fine balance between the stringent requirements of the regulator and what our potential investors would like to see. For the PRA [Prudential Regulation Authority] we needed to be people who had done it all before, who knew how the committees and governance processes worked, and who were fully aware of our responsibilities to look after our customers’ money. On the other hand, for the private equity (PE) world we needed to appear as hard-headed business people who were going to sweat the assets and run a traditional high-return banking business. Meanwhile, any potential venture-capital investors would be on the lookout for a bunch of smart people who wanted to change the world. We just needed to fulfil each and every role somehow! Or rather, some people on the team would have to be all three people on the same day, while others picked a side and stuck with it.

While Starling prioritised the regulatory path, competitor Monzo prioritised the venture-capital route. ⁴

Monzo: A Different Path

Starling and Monzo actually have a shared history. Before going on to establish Monzo, its founder, Tom Blomfield, worked alongside Boden at Starling. The two had met back in 2012 and when Blomfield heard Boden’s plan to launch a new bank, he was keen to join.

Tom… was a start-up expert. We’d ticked the boxes on regulatory matters but now we needed to tick some boxes in the start-up world too. Having founded a number of businesses, Tom was very experienced in working with the venture-capital community, and that previous experience would get a big tick from the VCs. 

A partnership between a banker and start-up expert should have made for a formidable team, but tension festered and Blomfield resigned in 2015 together with several colleagues. With the backing of Passion Capital, they went off to launch their own bank. “It’s a big market out there, and we feel that there would be more than enough room for another player,” Blomfield wrote to Boden in an email in February. 

For Boden it was a major setback but she pressed on in her application for a bank licence. Blomfield did likewise. Eighteen months later, in mid 2016, each received good news: they were in business. From then on, their paths diverged. 

Leaning on the venture capital playbook for platforms, Monzo went all-out for growth. It launched products more quickly than Starling and by October 2018 had a million customers, compared with Starling’s third of a million. Over the course of 2019, customer acquisition accelerated as Monzo emerged as a breakthrough brand. That year alone, it picked up over 2 million new customers. 

But customer quality wasn’t the best, reflected in low balances that customers were bringing over. Although they’ve edged up, average deposits per customer at Monzo are £766 as at end March, compared with £1,737 among Starling’s retail customers. In addition, Starling seems to be winning more primary accounts. In the full year 2021, it opened a net 57,224 new accounts actively switched over from other banks, according to official data, compared with only 23,017 at Monzo despite its larger customer base. ⁵

Such growth came at a cost. Monzo generated £350 million of operating losses over the period that Starling generated £130 million. And this past year, according to financials it released last week, it added another £119 million of losses.

Monzo’s growth has been financed by £965 million of venture funding, including £450 million raised in December 2021 at a valuation of $4.5 billion. The influence of venture capital permeates the organisation. To a greater degree than Starling, staff are incentivised via equity – 18% of personnel costs comprise share-based payments which compares with only 5% at Starling. They also get paid more – £69,000 per head on average last year, compared with £57,000 at Starling.

And, in similar homage to the tech community as that paid by Klarna, Monzo highlights revenue as a key performance indicator. On its calculations, revenues were running at an annualised £270 million in May this year, but that excludes fee and commission expenses (£22.5 million last year) which banks usually book as a contra-revenue item and it excludes credit losses which are the cost of doing business as a bank.

Rapid growth also came with other costs:

• Last year the UK regulator commenced an investigation into Monzo’s compliance with anti-money laundering rules between October 2018 and April 2021. The ongoing investigation is looking into both civil and criminal liability. 

• More accounts means a greater surface area for fraud. “Frustratingly, UK customers have continued to suffer as criminals have found new ways to defraud them,” the company writes in its annual report. “We’ve continued to compensate customers who’ve fallen victim to financial crime. In FY2022 this cost us £16.0m, up 32% from FY2021.”

• Monzo also slipped up on credit. Last year, it was forced to write off £6.7 million of bad debts, equivalent to 5.4% of average loans. So-called stage 2 and stage 3 loans – where the asset has experienced a significant increase in credit risk since being originated or where it is altogether credit impaired – grew to 43% of the total loan book (compared to 9% at Starling at the same time). Since then, the book has been cleaned up somewhat. Stage 2 and stage 3 loans now make up 27% of the loan portfolio and write-offs last year were down to 4.2% of average loans.  

Going forward, lending is a key focus for both Monzo and Starling as they look to provide additional customer services and earn a superior return on customer deposits. Monzo writes in its annual report: “we’ve continued to invest in our lending capabilities, technology platform and collections and recoveries process so we can safely grow our lending business.” In the most recent year, customers borrowed £259 million, up from £105 million the prior year, although lending still only accounts for 5% of deposits. 

Starling has ramped up its loan book more aggressively, first via the government schemes and more recently in mortgages. Its loan/deposit ratio is 35%, with £1.2 billion of mortgage loans being added in the past year, partly via acquisition. Since the end of the financial year, it has grown its mortgage book further, taking it to over £2 billion.

Starling’s larger loan book skews its income statement more towards interest income compared with Monzo’s. Last year, 65% of Starling’s revenue came from net interest income, with 30% coming from card transactions. In Monzo’s case, only 27% comes from net interest income, with 51% coming from card transactions and a further 9% from subscriptions. 

For both, benefits may come via higher interest rates. Both banks were born in an era of exceptionally low interest rates. When Boden was contemplating her bank on the deck of her cruise ship in the Indian Ocean, UK base rates were just 0.5%. Since the end of 2021, they have risen from 0.1% to 1.25%. We’ve talked about why banks like higher rates here before. And given their large deposit bases, these challenger banks like higher rates a lot. According to their financial disclosures, a further 200 basis points of hikes would more than double their net interest income. Monzo’s balance sheet is more exposed – such a rate hike would add £64 million to its £34 million of net interest income. But given its greater reliance on net interest income, Starling would receive a bigger overall bump to earnings. 

Starling and Monzo have each struggled to make money but a common path to profitability may now be available.