John Yakas examines the key issues supporting the rise of the challenger banks.

    Challenger banks offer an opportunity for investors as they continue to take market share from the much larger incumbents. The 5 key issues helping them include:

    1) Large banks are shrinking

    The new capital requirements focus management attention on delivering a reasonable return on capital coupled with an aversion to taking on additional and more complicated credit risk following the financial crisis. This has opened up opportunities for smaller, nimbler players, in particular in SME lending and asset finance. Beneficiaries have included banks such as Close Brothers and Shawbrook in the UK to Banca Ifis in Italy. Although in some markets large banks are beginning to grow their balance sheets, the rates of growth remain low when compared to smaller players.


    Source: Polar Capital analysis and company reports.

    2) Technology

    With no incumbent systems, many of the challenger banks have been able to gain a considerable advantage over their larger competitors since they can implement the latest technology with relative ease. Also, there is much less imperative to add branch networks since transactions are shifting to the mobile phone and internet.

    “New banks may well have to spend more on marketing costs to gain customers and this is often the ‘Achilles heel’ in the potential returns from new technology-driven entrants.”

    Atom is in the process of creating the UK’s first digital bank and is looking to differentiate on the customer experience through an intuitive and personalised app. Being branchless, Atom is targeting a cost/income ratio of under 30% to support an ROE of over 20%. The distribution could broaden as evidenced in the US, where lending platforms such as Lending Club have agreements with small community banks for them to place their surplus savings through these platforms.

    New banks may well have to spend more on marketing costs to gain customers and this is often the ‘Achilles heel’ in the potential returns from new technology-driven entrants. This may help to explain why some of the more successful challenger banks have been in specialist lending segments such as SME asset finance and buy-to-let mortgage lending, rather than the broad mass market, since better spreads and less focus by the larger banks help to offset the lower economies of scale. It does however add to the risks over the cycle.


    Source: Polar Capital analysis and company reports.

    3) Simpler business models

    Banking business models have been under pressure, whether it is the global network bank espoused by the likes of HSBC and Standard Chartered, or the wholesale banking approach popular amongst investment banks. These models make it difficult to analyse externally and difficult to manage internally as past management failings have shown and investors are exposed to the fines and litigations which have occurred. These issues are less relevant when looking at new challenger banks although they do have concentration risk compared to a large diversified bank.

    4) Credit cycle

    One key short-term advantage these new players have is that they are growing at a point in the credit cycle which is benign.  The best time to add credit risk is coming out of a macro downturn since the availability of credit is limited and so banks can pick the best credits at highly profitable levels. However, the new banks’ credit skills remain untested until we have been through a subsequent downturn and it remains too early to assess their credit writing skills.  Should interest rates rise, some of these players could be impacted, although the impact on loan book quality will take a number of years to be felt.

    5) Capital and funding

    One strength of the smaller banks is their stronger capital and they have not had the need to spend years trying to rebuild their capital positions post crisis. Often this also reflects their recent IPOs or other opportunities to raise capital to fund their growth. Ultimately the high loan growth rates will dilute their capital ratios unless their profitability is sufficient to replenish these internally, and so investors should expect further capital raisings ahead. One key weakness is usually in terms of their funding. They often lack the branch network to raise retail deposits and are reliant on price sensitive time deposits or wholesale funding. However, current environment is highly favourable in view of the access to ample and cheap funding in the current market conditions. Having said this, it is important these banks have a strategy of funding over the cycle and, in particular, the means to raise cheaper and stickier retail deposits.

    Overall, the attractive environment is resulting in a number of new players being launched and concerns are growing that some of these returns will be competed away very quickly. However, investors need to note how small many of these players actually are compared to leading incumbents and so could continue to grow for many years to come.  Finally, though growth will be better amongst the smaller players, investors should not lose sight of the fact that large banks still offer very attractive value and dividend growth opportunities on their path.

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