The U.K. banking sector has undergone significant changes, and incumbent banks have responded with large investments to meet the continuously evolving customer preferences for digital banking over traditional in-branch service. S&P Global Ratings thinks the incumbent banks have done this successfully so far, but they still face work to fend off competition. This is particularly important given the U.K.'s global lead in the fintech space, demonstrated by the £5.1 billion of invested capital in 2023--more than the rest of Europe combined. With strong access to capital markets, a large talent pool, and a supportive regulatory framework, the U.K. banking sector remains attractive to prospective entrants.

The growth in the use of "Open Banking," a set of regulatory reforms enabling the sharing of customers' financial data, has been substantial. We think this is partially responsible for a structural increase in competition, particularly in the deposit market, whereby the most popular digital banks have seen significant growth in deposit bases over the past few years. This has challenged smaller incumbents and led to further industry consolidation. Nevertheless, digital banks pose only a small threat to the major banks, which have deployed windfall earnings to achieve sufficient scale and operational efficiency. Digital banks are unlikely to gain any material market share within our two-year outlook horizon, given their lack of presence in the credit markets.

TRIP Analysis Shows That U.K. Banks Face Elevated Risks

We base our views of disruption risk for U.K. banks on our four-factor analysis of the banking system's technology, regulation, industry, and preferences (TRIP).

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Technology: Disruption Risk | High 

A global leading technology ecosystem underpins heavy competition in U.K. retail banking

We think highly sophisticated technology will continue being deployed through new and improved products and services, further enhancing the U.K. retail banking system as the leading hub for tech talent and capital investment in Europe. The U.K.'s open and innovative technology sector continues to attract investment, with fintechs at the center of this ecosystem. Even as fintech investment decelerated globally in 2023, the U.K. led the way in Europe, attracting $5.1 billion of fresh capital across 409 deals, which was topped only by the U.S. globally. We see fintechs as major players behind innovation in the U.K. retail banking sector, providing new services that force incumbent banks to improve their own offerings. We expect this strong cadence of investment and innovation to continue, supported by sectorwide initiatives like the Fintech Growth Fund or Capability and Innovation Fund. The Fintech Growth Fund is the latest in a string of these initiatives and is backed by Barclays, Mastercard, and London Stock Exchange Group. It has the aim of investing in domestic fintechs, with ticket sizes ranging from £10 million-£100 million.

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Central to the U.K.'s success as a European technological innovation hub has been its role as a trendsetter in and active adopter of innovative data sciences, a broad term incorporating a host of disciplines from advanced data analytics to machine learning and artificial intelligence (AI). Indeed, we think the rapid adoption in the U.K. of innovative technologies like machine learning and large language models has been a catalyst for product innovation and research for both established financial institutions and disruptors, visible across a host of traditional banking activities--including intermediation, lending, and market making. To this end, the U.K. government published a decade-long National Strategy Artificial Intelligence plan with the aim to bolster the country's already-strong international position in this space. The proceeding toolkit that will assist in expanding the AI ecosystem will integrate services for U.K. consumers and facilitate developments for financial services companies as they seek to incorporate software such as generative AI into their business plans. Of note, we think this advanced technology will enhance, and not replace, banks' operating models.

Fully operational and widespread 5G coverage in the U.K. has accompanied the pace of digital transformation, in our view. Reflecting the U.K. government's proactive stance is its updated telecoms strategy, which seeks to install stand-alone 5G coverage for all areas by 2030. We see this infrastructural strength as supporting and disseminating broader technological innovation. However, despite being one of the first countries to implement 5G commercially in 2019, sluggish investment and tightening government policy on key technologies within 5G infrastructure have slowed expansion, with the U.K. falling behind peers. As of April 2023, 10.1% of consumers in the U.K. had 5G coverage, while it was 14.7% on average in Europe.

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Regulation: Disruption Risk | High 

U.K. regulators foster innovation and competition

The U.K. regulatory environment is constantly evolving, and the regulator proactively seeks new opportunities to promote change and improve the industry for consumers.

Since our most recent evaluation of the regulatory space and its impact on financial innovation, the U.K. government has continued to place significant importance on enabling technological innovation in the financial sector. Indeed, the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have been a significant factor behind the success of the U.K.'s fintech sector, in our view. The threefold innovation project, established by the FCA in 2014, included a regulatory sandbox, an innovation hub, and a global financial innovation network. It has also entered a second phase of its digital sandbox in collaboration with the City of London. 

Open Banking has been a central plank in the government's attempts to stimulate competition in the retail banking sector. Established in 2017, the Open Banking system provides third-party access to consumers' financial data, with the aim of enabling bank customers to make more informed decisions on their financial position, and to move their financial resources around freely and securely. Since its inception, there has been a flurry of new products and services, a considerable proportion coming from fintechs. The system has proven successful, and countries like Germany, Sweden, and Poland are modelling their approaches on the U.K.'s. 

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In June 2023, the U.K. government's Financial Services and Markets Bill received royal assent. The bill aims to provide the platform for the government to systematically revoke previously retained EU financial services regulations and replace them with U.K. specific provisions. The wide-ranging scope encompasses everything from payments to consumer credit to Markets in Financial Instruments Regulation (MiFiR). This legislation also promotes additional sandboxes to facilitate innovative technologies such as the use of blockchain in central clearing, and proposes new regulation of crypto assets. Notably, a secondary objective of the bill is to impose a responsibility on the FCA and PRA to ensure regulatory decisions consider the implications of those measures on the U.K.'s competitiveness and growth. Overall, we see the bill as laying a foundation for the government to respond quickly to fast-evolving innovations in U.K. financial services--although it has yet to generate any significant and broad-reaching legislative changes.

Nevertheless, we consider the biggest technological threat to the retail banking sector as arising from operational resilience shortfalls, whether they are based on cyberattacks or weak internal controls. Over the past decade, regulators have made significant changes to the breadth and depth of their supervision of institutions' operational resilience--with the greatest scrutiny, unsurprisingly, applied to domestically important banking groups. Lately, attention has turned to the supervisory approach towards third-party service providers, including key outsourcing partners such as cloud service providers that form the bedrock of much of the banking system's push for innovation.

Industry: Disruption Risk | Moderate 

Incumbent banks embrace technology to weather the increased risk from digital banks

The U.K. banking sector continues to be dominated by the six major banks: Barclays, HSBC, Lloyds, Nationwide Building Society, NatWest, and Santander UK. With banking system digitalization well underway, it is unlikely that any new innovation will harm these main players given their demonstrated ability to navigate and adapt as the industry changes.

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Fueling the emergence of digital banks is an influx of funding, with 236 equity deals totalling £11 billion since 2011, according to Beauhurst's "Top UK Challenger Banks 2023" report. The digital banking revolution in the U.K. has been driven by the "big three": Monzo, Revolut, and Starling. From 2021-2023, they have increased their share of deposits over 100%, to £10 billion. In our view, this also partly reflects the effect of the Open Banking reforms, which favors these data-driven banks as they seek novel routes to improve customer experience and satisfaction.    

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Notwithstanding this significant growth, challenger banks remain a relatively small part of the financial ecosystem. For example, the deposit base of Nationwide–-the smallest of the six largest banks–-is about 10x that of the three largest digital banks combined. In addition, most digital banks compete solely in the deposit space, with very insignificant, if any, lending products. Those that do have a narrow selection of offerings, which is limited mostly to overdrafts and small-scale personal loans. Some digital banks have recently entered the wealth segment by starting to offer services in investments–-for example, Monzo providing access to three ready-made BlackRock funds--but we think incumbent banks are well-positioned to at least match this through similar propositions that are already well-established.    

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Incumbent U.K. banks have invested consistently and heavily in digital transformation programs. These sit at the core of their strategies as they target improved efficiency through lower operating expense–-primarily via reducing staff costs and branch density. In 2023 alone, Barclays closed over 170 branches and HSBC announced the closure of 113. Alongside this, there has been a focus on developing digital products and services such as HSBC's recently launched foreign exchange app, Zing, in addition to streamlining and enhancing current digital offerings. Furthermore, management teams have moved cyber risk higher on their agendas and we foresee greater investment in technology to fortify their defenses against these emerging risks. 

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Outside of core banking services, the U.K. has seen sharp growth in niche financial pockets as smaller institutions bid to gain market share in areas where incumbent banks are either nonexistent or underweight. One area, Banking-as-a-Service, or embedded finance, has become an increasingly popular concept, enabling nonbanking businesses to provide white-labelled banking products and services without a banking license. Subsequently, a number of specialist providers have emerged to facilitate these products through their application programing interface, which provides users (typically fintechs) direct access to a bank's platform. Some providers of embedded banking, like ClearBank, hold banking licenses, while others need a sponsor bank. This remains a niche area, though, and we think it is highly unlikely that banks operating in this domain will disrupt the dominant players solely through this proposition.

Preferences: Disruption Risk | High 

U.K. banks have altered operating models to accommodate changing customer preferences

Although most banks are well-positioned to facilitate the continued shift in preferences, risks remain as the U.K. edges closer to a fully cashless and digital banking system.

The U.K. is one of the world's most cash-light economies, with just 14% of all payments made by cash in 2022, as per the "UK Payments Market 2023" report by UK Finance. This is down from 61% in 2007 and 34% in 2017, one of the fastest declines in Europe. The payments landscape in the U.K. has evolved dramatically, but incumbent banks, particularly the main players, have developed advanced digital infrastructure to accommodate changing client habits and preferences. 

The use of debit cards accounted for half of all payments in 2022, while contactless payments increased to 37% of all payments–-up from just 7% in 2016. The COVID-19 pandemic acted as a further catalyst for the shift, as in many other countries, accelerating the move towards noncontact payments. This is especially true among certain demographics, like older adults, which were previously unfamiliar with the concept--87% of those 65 and older used contactless payments at least once a month in 2022.  

U.K. banks easily adapted to this shift in preference, though, following early investment to replace old cards with contactless ones. By end-2022, there were 147 million contactless cards in circulation, with debit and credit card contactless functionality of 91% and 88%, respectively.

The U.K. population is generally tech-savvy and continue to adapt to increasing digitalization. For instance, approximately 98% of U.K. adults owned a smartphone in 2023, according to USwitch. This led to the increased use of mobile wallets, in turn supporting the growth of contactless payments and reducing the need for physical cards.

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Despite the population's clear shift in preferences, there remains some demand for traditional products, such as physical branches or cash payments. However, we expect this to weaken as digital services increase their domination.

U.K. banks have been proactive in their approach to digitalization, identifying emerging trends and deploying capital to develop the necessary capabilities. The largest banks have some of the most advanced technological ecosystems globally, which aligns with a population that now heavily favors digital offerings. This has enabled incumbent banks to successfully compete with neobanks and fintechs, and, in our view, the banks are well-positioned to nullify the threat from the competition. But as opposed to this being a credit strength, we view the banks' digital advancements as essential to just remain competitive in the U.K. retail banking market.