Are challenger banks now outperforming the Big Five?

Mobile banking
By Andrew Harbison, CA Today

10 May 2016

Challenger banks are living up to their namesake as they continue to put pressure on the Big Five banks, according to a new report.

KPMG’s challenger banking annual results report paints the picture of an evolving banking landscape, with small and large challengers steadily encroaching on the territories of the UK's largest retail banks: Barclays, HSBC, Lloyd’s Banking Group, Royal Bank of Scotland and Santander.

Last year the total profits of challengers increased by £194m, alongside a 31.5% growth in lending assets. As the challengers' bar is rising, the Big Five’s bar is falling, with a drop in profits of £5.6bn and a decline of lending assets by 4.9%.

How are challengers outperforming the Big Five?

The report states that a combination of regulatory changes, expensive real estate and disorganised legacy IT systems are hindering the performance of the Big Five.

In contrast, the challengers are progressing by providing customers with a smaller and more simplified product range than their incumbents. These products are often targeted at niche lending sectors within the UK banking market, which are proving to be both profitable and less costly to support.

When it comes to cost to income (CTI) ratio, the challengers are leading the way again, the report says. OneSavings Bank was at the forefront of this, reporting a CTI of 26% in 2015. Putting this result down to the fact that the company runs a low cost back office in India, the report goes on to claim that the potential benefit of offshoring for challengers is around 10% of CTI, assuming they offshore 50% of their full time equivalent (FTE).


What are challenger banks?

During the aftermath of the financial crisis of 2007/2008, there was something of a trust vacuum within the banking industry. Partly in response to this and in an effort to increase competition in the banking industry, the Bank of England revealed new and easier processes which introduced lower capital requirements in order to set up a new bank.

As a result of this change, several new banks began to appear which were dubbed 'challenger banks' as they were in direct competition with the Big Five. Challengers range from Close Brothers and Metro Bank to larger banks such as First Direct and TSB.

It is the digital only banks who are making the most out of the new banking landscape, with banks like Atom, which is the UK’s first bank designed for digital and optimised for mobile, raising around £135m in capital so far.

However, this run of success for the challengers may be threatened in the not too distant future, the KPMG report warns.


Will regulatory changes in buy-to-let spell the end of the challengers?

At the moment it’s hard to call either way. The buy-to-let market provides challengers with a substantial amount of business, making up around 15% of their balance sheets. The announcement in the 2015 summer budget that there will be a restriction on tax relief claims on rental properties, planned to be phased in between 2017 and 2020, will push some investors with a higher loan-to-value into a loss making position.

Others will face very high effective tax rates. In these situations, landlords may decide to accept the short term loss in exchange for the potential capital gain, something the challengers will be watching to ensure this doesn’t impact on arrear rates.

The report also points to a new 8% surcharge on banking profits over £25m introduced at the beginning of the year. It states that if the charge had applied last year, it would have added around £70m to the challengers' tax charge.

As the challengers continue to outperform banks in terms of return on equity (ROE), regulators may view them as no longer needing a helping hand.

The KPMG report states: “The message is clear, the landscape has changed, the challengers have grown up and they should expect no special treatment as they continue their journey.”

You can’t fool the children of the digital revolution

The report also focused on the movement in popularity to FinTech and digital banks. These 'agitators' have displayed clear efforts to differentiate themselves from their incumbents.

As customers continue to become increasingly immersed in the digital world, the next generation of banking customers are starting to lose interest in the traditional notion of retail banking. Mobile transactions have replaced trips to the local branch, and the Big Five are struggling to keep up with these new trends.

Digital banks are also displaying a shift in culture relating to transparency with their customers. The report says that “fees and interest rates clearly communicated alongside balances on mobile apps, and even informing customers when they would be better off with competitors, become the norm".

However, the report does identify a major challenge for the digital challengers.

“Customer inertia, particularly in current accounts, is a big issue in the UK.” Just over one million people switches banks last year, down 11% from 2014.

Warren Mead, global co-leader FinTech at KPMG, says that “if these new kids can successfully combat customer inertia at scale, they could blow the incumbents out of the water.”

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