Wednesday 4 May 2016 2:30 am

Britain's challenger banks had a bumper 2015 – but now they're facing the challenges of scale

Amid the misery and bad news associated with UK banks since the crisis, one of the positive rays of light has been the challenger banks. They have grown quickly, with several listing last year as the sector continues to attract both customer and investor interest. The challengers have also long been feted by politicians as injecting much-needed further competition into the UK banking sector.

In KPMG’s annual review of the challenger sector, we have found good news in terms of growth but also identified some real headwinds that lie ahead. 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 many of the challenger banks are no longer budding businesses: they are sizeable establishments and some are realising both the benefits and difficulties that being a large listed company brings.

After the excitement of last year’s initial public offerings, the 2015 reporting season has seen balance sheets continue to expand, with lending assets for challengers increasing by 31.5 per cent compared to a decline of 4.9 per cent for the Big Five UK retail banks: Barclays, HSBC, Lloyds Banking Group, Royal Bank of Scotland and Santander. This helped total pre-tax profits for challengers to increase by 17.8 per cent to £194m against a drop of £5.6bn for the Big Five. For investors, return on equity for the smaller challengers topped 17 per cent and 9.5 per cent for the larger challengers, against 4.6 per cent for the big high street banks.

The challengers also outperformed the Big Five on costs, despite being significantly smaller. The former have an average cost to income (CTI) ratio of 59.6 per cent (excluding Clydesdale) compared to the latter’s 80.6 per cent. However much of that is due to conduct-related costs the big banks have had to face. Not having that legacy is another strength of the challengers, of course.

The challengers have based their business models on targeting profitable lending niches within the UK banking market. But competition within these niches is beginning to intensify. Small challengers and digital-only banks are building personalised systems that rely on detailed and marketable data, completely free from the restrictions of legacy systems and culture. Banks like Atom, Fidor Bank and Starling are promising digital-led personalised banking. The question for them is whether, in a market where customer inertia is one of the most powerful forces, they will be different enough to reach scale. But this also shows that today’s challengers cannot stand still.

Watch: Warren Mead explains his findings here.

A second problem is the new 8 per cent surcharge on the profits of banking companies with profits in excess of £25m. We estimate that the surcharge would have added approximately £70m to the challenger banks’ tax charge for 2015 (excluding Williams & Glyn). This symbolic perceived shift in support from politicians will worry the sector. However with the challengers outperforming the Big Five in terms of return on equity, it is little wonder that support for the “underdog” has started to wane. The message is clear: the landscape has changed and they should expect no special treatment as they continue their journey.

I’d expect to see the divergence between large and small challengers to widen. They will all have to work harder to compete with single-service fintech firms, such as payment companies or lending platforms. If 2015 was the year of the IPO, I wouldn’t be surprised to see 2016 as the year of M&A as the larger challengers need real scale to take on the Big Five banks.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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