Challenger banks on the rise but hurdles await

Challenger banks are outpacing their larger rivals as profits boom but new legislation is threatening to put the brakes on their rise.

According to KPMG’s UK challenger bank report ‘A New Landscape’ total pre-tax profits for challengers increased by £194million in 2015 against a drop of £5.6billion for the so-called Big 5 such as Lloyds, HSBC and RBS.

Return on equity for the smaller challengers topped 17% and 9.5% for the larger challengers both outstripping the 4.6% achieved by their big high street rivals.

The report also found that smaller challengers were lending more with a 48.3% increase in lending assets compared with a 5% reduction by the Big 5.

Whilst the big five face mounting cost pressures challenger banks are enjoying reduced or consistent cost-to-income ratios (CTI). Smaller challengers enjoyed a 3 per cent CTI reduction to 49 per cent in 2015 and, according to the report, they are well placed to continue their cost cutting drive. Larger challenger banks saw a small year-on-year increase reporting an average CTI ratio of 59 per cent in 2015 compared with 58% in 2014. Ongoing conduct and litigation costs meant the big five UK banks had a CTI ratio of 81 per cent in 2015.

However, the report warned that the landscape for challengers was getting tougher and that although they will continue to win market share from the incumbents it will be an “increasingly difficult and fragmented journey”.

It said had an 8% bank surcharge to profits over £25million been applied in 2015 it would have added an extra £70million to the challenger banks’ tax bill.

It added that although recent buy-to-let changes are unlikely to be the Achilles heel of challenger banks it did “indicate that the tide is turning and goodwill towards challengers is waning”.

“Many challenger banks offer a high quality service while operating more efficiently than the big five, albeit in niche markets. This leaves them poised to take further market share in the year ahead. But, the challengers have grown up, and shouldn’t expect significant assistance from regulators or policymakers. Several will also begin to really realise both the benefits and difficulties that being a large listed company brings,” said Warren Mead, head of challenger banking at KPMG.

“I expect to see the divergence between large and small challengers widen. Several challenger banks have targeted profitable niches such as buy-to-let or specialist commercial lending but competition in these areas is reaching saturation so they will need to start widening their nets and working harder to compete with single-service fintech firms, such as payment companies or lending platforms.”