Large challenger banks are no longer mere challengers, says KPMG

The UK challenger banking sector is outperforming the ‘Big Five’ UK high street banks, according to a new KPMG report.

The new annual report, The Game Changers, has analysed the full-year results of some of the largest UK challenger banks, grouped in three categories – the ‘Large Challengers’, ‘Small Challengers’ and ‘Retailer-owned’ banks.

The report reveals that while Small Challenger banks are securing stellar returns, key financial indicators of the Large Challengers such as the return on equity, are becoming very similar to the ‘Big Five’ – Barclays, HSBC, Lloyds, RBS and Santander.

This leads KPMG to ask for how long the ‘Large Challenger’ banks can continue to be considered as still only “challenging”.

The report reveals that as Small Challengers have grown, they have benefitted in a reduction in their cost to income ratio (CTI), from 65 to 53 per cent between 2012 and 2014.

Larger challengers, meanwhile, reported a higher CTI of 64 per cent in 2014 as many have inherited a higher cost base, which has yet to be optimised.

The figures are remarkably similar to the ‘Big Five’, who reported an increase in their CTI from 60 to 63 per cent in the same period.

Warren Mead, head of challenger banking and alternative finance at KPMG, said: “Although the overall challenger banking sector is growing rapidly and securing greater returns, it is the Small Challengers who are driving its growth.

“Small Challengers are securing high returns and have better cost optimisation. If this trend were to continue, as the challengers grow and benefit from economies of scale, it poses an interesting question for the Big Five as to whether too big to fail, becomes too big to compete?

“Financially, the Large Challengers are looking very similar to those of the traditional banks. To ensure they remain differentiated, they must review their brand, distribution, products, culture and customer service.

“Digital banking is a great example. Our report found that the mobile functionality of the challengers is at best equal to, but often worse than, the ‘Big Five’. For those challengers focusing on customer service or cost as a differentiator, this could be a major hurdle for the future.”

The report also revealed that the challenger banks are strengthening their balance sheets and embarking on a lending spree, while traditional banks reduce the size of their operations as a result of regulation. In 2014, lending assets grew 16 per cent, compared with a decline of 2.1 per cent for the ‘Big Five’.

This translated into an average annual 8.2 per cent growth in loans and advances to customers between 2012 and 2014, compared with a decline of 2.9 per cent from the ‘Big Five’.

For Large Challengers, this was 3.2 per cent growth, while Small Challengers significantly grew their loan books by 32.3 per cent. However it should be noted that the combined loans of the five largest challengers are still just five per cent of the Big Five’s loan books, and therefore it is easier achieving higher levels of growth.

These figures paint a picture of the challenger banks picking-up the whitespace left behind following the financial crisis. This includes areas such as small business lending, second charge mortgages, invoice financing and unsecured lending.

However challenger banks face key challenges. Although regulatory rules apply equally to all banks, in practice however, they do not. Challengers have to hold more capital in comparison to established banks.

Depending on the results of the Competition and Markets Authority’s current review into the banking sector, there may also be a significant impact on the fortunes of the challenger banks and their willingness to push further into the small business banking and current account markets.

Mr Mead added: “For the next few years at least, we expect the challengers to continue to outperform the market in terms of pure financial results.

“However Small Challengers may have to start making trade-offs as maintaining high rates of growth will be difficult to maintain. For Large Challengers and the Retail-owned banks, there is plenty to go for if they accelerate their differentiation journey.

“But for all challenger banks, the main point of difference is their culture. Being largely free of the legacy problems of the past contributes to a sense of social purpose that puts fire in the bellies of their executives and frontline staff alike. Only time will tell whether the big banks will combat that fire with fire of their own. Creating a ‘bank within a bank’ – a new challenger brand free from legacy conduct, technology and culture – might be the best start.”