The interest rate cycle has turned. On 1 August, the Bank of England cut the base rate from 5.25% to 5%. That should be good news for the banking sector, which is already up by 14% so far this year.
Yet taking a longer-term perspective – and comparing the banks today with how they were in 2006, before the financial crisis – we can see that there’s still a problem: growth. HSBC, the largest UK-listed international bank, has seen revenue shrink by 9% to $63 billion. Barclays has done slightly better-growing revenue to £25 billion, but that only equates to a compound annual growth rate of just 1% over 17 years, well below the rate of inflation. Remember that these were the well-managed banks, who avoided calamitous acquisitions and didn’t need to be rescued by the UK taxpayer. Lloyds/HBOS has seen revenue shrink by 44% to £19 billion, and NatWest’s reported revenue is down by 47%.
Software businesses such as Alphabet and Microsoft are classic examples of companies that need very little incremental capital to grow revenues. These firms have rewarded shareholders well over the long term. Banks have done the opposite. Revenue has been at best flat, if not shrinking, yet they have required substantially more equity funding just to tread water.
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The recipe for cross-border banking growth
To find growth, we need to look to the unlisted sector. Since 2019, Revolut has grown its top line 11-fold to £1.8 billion. Monzo is up by 13 times to £690 million, while Atom is up by 100 times, although from a much lower base. In Revolut’s case, it is also impressive that this expansion has run across borders.
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Before the financial crisis, bank chief executives and corporate financiers spent a huge amount of time working on mostly unconsummated cross-border banking marriages. From their perspective at the top of large organisations, these deals made sense, but no one ever bothered to think about how this might benefit the long-suffering customers. After Fred Goodwin met his nemesis when he led RBS in a disastrous deal to buy ABN Amro, cross-border deals fell out of favour and banking empires are in decline. RBS, which was once the world’s biggest bank by total assets, is a shadow of its former self, with the overall group renamed NatWest to shed that history. HSBC has spent the past decade disposing of non-core operations, including exiting Argentina, Canada and French retail banking. Barclays has also spent years slimming down, including the sale of its Italian retail mortgage book in April and its German consumer finance business in July.
Contrast that with Revolut, which has 45 million customers, of which just nine million are in the UK. Even before the UK regulator granted it a banking licence in July, its Lithuanian licence allowed it to take deposits across the 33 countries in the European Economic Area (EEA). It has also started taking deposits in Brazil and New Zealand and aims to expand aggressively in the US, where it already has nearly one million customers. Or for a different model, take Klarna, the Sweden-based buy-now pay-later fintech that wants to pivot into a payments platform and disrupt retail banking across 12 countries in Europe and the US.
How banks make higher returns
Ironically, unlike most start-ups that benefited from the easy-money era of low interest rates and central bank liquidity, fintechs didn’t. That’s because of a common misconception. Many people – including some professional fund managers – believe banks generate high returns from lending money. However, this assumption is demonstrably wrong.
Lending money is a commodity business: borrowers can easily shop around for the best interest rate. Getting the lowest interest rate on mortgages is particularly important, as a few basis points could save thousands of pounds, or even tens of thousands, in interest over the 30-year life of the loan. A host of banks, including Santander, Lloyds, HSBC and NatWest, are once again offering UK mortgages for less than 4%. This suits the government, as politicians believe cheap mortgages are popular with voters. So banks are unlikely to make returns above their cost of equity on UK mortgages.
Instead, banks make returns from the liability side of their balance sheet: customer deposits that provide cheap funding. Even now, with interest rates at 5%, around a third of NatWest’s customer deposits (£140 billion) are non-interest bearing. Having these accounts is a huge funding advantage relative to a non-bank lender such as Duke Capital, which lends to small businesses and pays sterling overnight index average (Sonia) plus 2% for its revolving credit facility. If Sonia ever fell back below 50 basis points, then the banks’ advantage of much lower funding costs would disappear again.
So in a 5% interest-rate environment, banks enjoy an advantage versus non-bank lenders. That said, certain non-bank platforms, such as Hargreaves Lansdown and Wise, also benefit. Neither has a banking licence, but both companies are in the business of looking after customers’ money, which is placed in interest-bearing bank accounts. In the 2023 financial year, Hargreaves Lansdown earned £269 million from customers’ balances, while Wise earned £118 million – amounting to 67% and 80% of group profits respectively. Clients started to notice this, and so in the current year, both firms have had to share more interest with their account holders.
Understanding how bank funding works explains why the easy-money era – in which companies such as Peloton, Zoom and the various flotsam and jetsam in Cathie Wood’s ARK Innovation fund briefly did very well – was not a great time to be a neo-bank. Many companies that promised profits in the distant future benefited from low interest rates, because investors discounted future profits at a very low discount rate, which made those future profits seem more valuable. On the other hand, banks and neo-banks struggled to make a profit in the low interest-rate environment, because every business had access to cheap funding.
A difficult era for fintechs
This meant, for instance, that Monzo struggled with bad debts before the pandemic and had to raise money from investors in 2020 at a 40% discount to its previous funding round, valuing it at just £1.25 billion. The decline in travel during the pandemic was devastating for Revolut’s core international payments business, while Wise also suffered losses due to unprecedented currency volatility in March 2020. Klarna also hit problems during the pandemic, and in 2022 it raised funds at a significantly reduced valuation of $6.5 billion, down from $45 billion in a previous funding round.
In technology investing, venture capital backers are happy to fund years of losses as long as unit cost economics stack up and they can see a path to profitability as customer numbers and revenues grow. By contrast, investors in banks are rightly cautious about rapid growth in loan books and don’t reward growth with high price/earnings multiples. Before the financial crisis, Societe Generale hosted a “high-growth banks conference” where the banks presenting needed a five-year record of double-digit earnings growth to participate. Names such as Anglo Irish, Dexia, Fortis, Kaupthing and Northern Rock. None of those banks survived the financial crisis.
Thus, one area where the traditional banks may yet win against the new entrants is credit quality and bad debts. Step back a couple of decades to when HBOS was aggressively growing its balance sheet and taking market share from more risk-averse banks, such as Lloyds. In meetings with investors, HBOS’s management were saying they planned to “wipe Lloyds off the face of the Earth”. The irony is that a few years later, they nearly achieved their aim – just not in the way they intended. Mere months after Lloyds took over HBOS in a reckless rescue deal agreed with the government, it had to be bailed out by the state after the assets it took on turned out to be even more toxic than expected.
Are neo-banks here to stay?
So how much are the neo-banks’ customers worth? In the UK, none of these firms has yet tested their private market valuations with a stock market listing. Starling is advertising for a head of investor relations, implying that it is looking to go public soon. Meanwhile, Revolut’s employees recently sold $500 million-worth of shares to existing investors at an implied valuation of $45 billion (£35 billion). That implies a similar market cap to Barclays and Lloyds, and 25% larger than NatWest. Valuations are wildly different. This would suggest a price-to-book multiple of 22, whereas listed UK banks have traded at discounts to book value since the financial crisis.
Revolut has grown customer numbers rapidly to 45 million and shows no signs of slowing. Average annual revenues per customer are just £40, around one-third that of Wise and a quarter of Lloyd’s retail bank. So even with no further customer growth (unlikely), if Revolut can persuade users to keep higher balances on deposit and become their core banking relationship, that valuation begins to look less delusional. Combine that with international expansion into the Americas, where Brazil’s Nubank has a market cap of $70 billion and 105 million customers, and it could even make sense.
On a market-cap-per-customer basis of £787, Revolut’s £35 billion valuation looks expensive, but not out of this world. Using a similar multiple would value Monzo at £7.6 billion and Starling at £3.3 billion. By comparison, Wise’s £6.5 billion market cap is £500 per customer, while the £5.4 billion buy-out of Hargreaves Lansdown by a private-equity consortium is at an implied value of £2,900 per customer, or 3.5 times higher. Still, a comparison with Hargreaves Lansdown shows that banking is not a licence to print money. Rather than lending, the neo-banks should be creating a platform to help customers with currencies, insurance and long-term savings to realise maximum value.
However, some caution will probably be in order when these businesses come to market. Funding Circle, CAB Payments and Metro Bank have all been disastrous investments, with their share prices falling by around 90% since they listed. That’s because the stock market has become a mechanism for wealthy individuals, private equity and insiders to exit at the expense of investors, rather than raise capital for growth. Fund managers, who invest other people’s money, appear not to have noticed, but retail investors, who are looking after their own money, have. Many now avoid initial public offerings (IPOs), joking that IPO actually stands for “it’s probably overpriced”.
Investors should also keep in mind a potential parallel with online UK fashion retailers. Firms such as Asos and Boohoo enjoyed considerable success in their early days, growing revenue and taking market share from high-street competitors such as French Connection, Ted Baker and Superdry. Yet Asos is now down from a peak valuation of £75 per share to below £4, and Boohoo has fallen 90% from its peak valuation. Much of that decline was caused by changes in customers’ behaviour (returning more clothes) and overseas competition, notably from Shein.
In the online world, it is possible to expand rapidly by offering better value than bricks-and-mortar incumbents and even scale internationally across borders. Yet those strengths can become a weakness, as they make it hard to create a durable competitive advantage with loyal customers, as users are inclined to jump on to the latest trend.
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