The sceptical have for years been repeating the mantra that the wave of fintech companies, especially online or app-only challenger banks and peer-2-peer lending platforms, will only be truly tested in a recession or financial crisis. It looks like that moment has arrived.

We may not, at least not yet, be in a financial crisis thanks to the liquidity that central banks have poured into the financial system. But a recession, an international one, has now started. Its unique nature, catalysed by a global pandemic whose final outcome is not yet known, means it is also uniquely difficult to predict how long or deep the resulting recession will be.

But the harsh reality of being a challenger bank focused on scaling customer numbers more than profitability in recent years is already apparent in the most recent financial results of the UK’s 3 leading fintech challenger banks – Monzo, Revolut and Starling.

Those results have laid bare that for all their progress and relative success in attracting new account holders, fintech challenger banks still have a long way to go before genuinely challenging traditional rivals.

A large and growing percentage of millennials may have opened accounts with one or more of the online-only banks. But the accounts of all three demonstrate that they make most of their revenue from card transactions, and not holding deposits, which have proven difficult to attract.

Between them, the fintech challenger banks of Starling, Revolut and Monzo hold just £4.8 billion in account holder deposits. That compares poorly to even the more traditional challenger banks of Metro Bank and Virgin Money, which hold £14.5 billion and £64 billion in deposits respectively.

Despite being popular with millennials, especially for spending money abroad thanks to offering highly attractive exchange rates, international transfers and online shopping and transactions, online-only fintech challengers are struggling to win the trust necessary to become the ‘main bank’ of account holders – that which they assign for salary payment.

Deposits are not necessarily hugely important in themselves when it comes to fintech banks achieving profitability, especially with interest rates as low as they are currently. But they are an important indicator of trust and a foundation from which to offer more profitable financial services, such as lending.

The Problem With Lending For The Fintech Challengers

It is only relatively recently that the fintech challengers starting offering loans and their lending books are relatively small. But lending represents a challenge when you only have at most a few years of history with account holders, sometimes just months, and they don’t have all their money with you. You can’t know borrowers as well as a bank that has access to years of financial history and is the ‘main’ account salaries are paid into.

That’s translating into loan books that aren’t performing very well for the fintech challengers. Their latest accounts show that the level of bad loans is higher for the online-only challengers compared to their traditional rivals. In fact, across the three banks, their bad loans losses have basically cancelled out interest revenues from performing loans, bringing them back to where they started – a long way from profitability.

Starling has made the most progress of the three in terms of lending and may be on the right track having been approved to offer the UK government-backed Bounce Back loan scheme. The scheme offers loans to small businesses that have seen their income dry up as a result of the Covid-19 pandemic. The loans are backed by the Treasury so represent no risk to the lending banks.

Starling started offering Bounce Back loans after details of its last accounts were published but it has issued around £700 million in loans so far, which will give it a major boost over coming years. Of the three, it appears to have made most progress towards establishing a sustainable business model through lending and account holders trusting it with more of their money.

The situation is less rosy for Monzo, with 23% of its loans now classified in accounting terms as ‘stage two’, which means the represent a medium risk level of turning into bad loans. Having not raised cash ahead of the Covid-19 pandemic, and funding markets having dried up since, Monzo is in trouble.

Co-founder Tom Blomfield has openly admitted concern over whether the fintech bank can keep going as an independent business after losses doubled over the coronavirus crisis as card transactions, especially those involving currency exchange, dropped significantly.

Revolut is somewhere in the middle. It does very well on travel-related transactions, which have unsurprisingly fallen off a cliff in recent months. But it also services a lot of small businesses and freelancers who work in different currencies and receive international payments. Its overall numbers are good, even if its lack of profitability does mean its management and investors will not be without their concerns if the current economic situation extends beyond 2020.

The Online-Online Challenger Banks Have Done A Lot Of Things Well

Online-only challenger banks and their investors have never been under any illusion that their route to profitability would be a long and winding one. Retail banking is a small margin business outside of lending, which is higher risk, especially for small banks.

But the fintech challengers have done a lot of things well and set a standard that traditional banks must now aspire to if they are not to continue to lose market share to the young pretenders over coming years. They have slashed the costs of many traditionally expensive services, such as foreign currency exchange and international bank transfers. And they’ve raised the standard of banking apps and value-added functionalities such as budget tracking and savings pots.

Customer service standards are also well regarded and generally considered far superior to those of traditional banks. A recent Ipsos Mori survey commissioned by the Competition and Markets Authority, showed customers of Monzo and Starling were most likely of any UK bank to recommend their current account to friends and family.

Monzo chief executive TS Anil said:

“Our customers love the convenience of changing or cancelling their overdraft anytime in the Monzo app, as well as transparency around exactly what they’ll pay.”

Will The Fintech Challenger Banks Survive Or Even Thrive?

The reality is that the survival of the online-only fintech challengers will ultimately come down to whether they are able to attract new investment over coming months. That’s especially the case for Monzo.

But all three have built up big enough account holder bases, and are popular enough with their customers, to be an attractive acquisition prospect if they do find themselves in trouble. That could either be in the form of M&A activity, or traditional banks buying up a fintech challenger.

In the favour of the fintechs is the amount of liquidity injected into financial markets in recent months, with more stimulus set to follow. It was cheap cash that fuelled the rise of the fintech sector in the decade that followed the 2008/09 financial crisis. It could well be the case that it will be more cheap cash that will fuel the investment needed to get the fintech challengers over their current hurdle.

It is probably overly optimistic to hope all the online-only fintech banks will survive in their current format. Some will merge or be bought out and others thrive. But it is unlikely that the sector will succumb to this crisis and give up its challenge to the traditional banking sector. And that, ultimately, is in the best interests of consumers.