KPMG: Challenger banks outpacing Big5 banking giants

The UK banking landscape is changing, with challenger banks seeking to capture terrain owned for centuries by the Big Five banks. Recent research from KPMG highlights that small and nimble challengers are doing well, picking up with high RoE and low cost profiles. Although larger challengers encounter higher cost to income ratios, investors remain confident in the long term position of these challengers, with share prices of listed large challengers far outperforming the market.

While the UK’s major banks have had their doors open for centuries, it has only been with recent changes to the wider financial landscape, in part through the FCA looking to stoke competition, that new challengers are seeking to pick off the customers from the established HSBC, Barclays Bank, Lloyds Bank, and the Royal Bank of Scotland.

In a recent report from KPMG, titled ‘The Game Changers’, the consulting firm explores how the different challengers are faring in the current economic and regulatory environment. KPMG looks at the current state of the field, the various factors that are contributing to the success of new entrants and what continues to inhibit their ability to secure market share from the most dominant players.

The report highlights that the challenger landscape is more complex than one simple grouping, with a divide between new entrant start-ups and more established challengers that – while inheriting loan books – are working under new brands from new operators. The new entrants group contains large challengers, including TSB, NAB and Virgin. The smaller challengers include Handelsbanken, Metro, and Onesavings. While retailers – were they able to fully leverage their financial offerings – make up a third set of new challengers.

Financial advantage
Particularly the small challengers are doing well, with the Return on Equity (RoE) for the smaller challengers running at 18.2% in 2014 compared to 5% in 2012. This is massive compared to even top tech companies, where the RoE for Google stood at just under 15% in March 2015 and Facebook’s under 11%. Larger challengers and the Big Five traditional players had relatively similar RoE in 2014, although the increase in RoE of the larger challengers is significantly bigger than the increase in RoE of the Big Five.

Rapid growth
In total the new competition grew with a compound annual growth rate (CAGR) of 8.2% between 2012 and 2014 on their loan-books. The smaller challengers were however the forerunners, growing at 32.3% compared to the larger challengers at 3.2%. The Big Five in contrary met with a modest shrinkage, of -2.9% on their loan-books. The effectiveness of small challengers, the report highlights, stems particularly from their niche market presence bringing in specialised financial products for those markets. 

Cost to income
One way in which challengers are able to differentiate themselves is through their ability to keep costs down while charging market rates for their products – thus improving their returns. Particularly the smaller challengers have been able to reap higher net interest margins (NIMs) through their use of the Funding for Lending Scheme (FLS), which provided the opportunity to re-price their deposits and diversify their deposit products.

Large challengers have, with the inheritance of higher cost bases, found themselves with relatively high cost to income (CTI) ratios, with the average running at more than 80%. The smaller challengers have managed to reduce their cost footprint with, among others, digital efficiencies and the economies of scale as they grow, thereby reducing their CTI from 65% in 2012 to 53% in 2014. The Big Five have remained relatively stable in their CTI, with it growing slightly from 60% in 2012 to 63% last year.

Challenges and opportunities
The long term picture looks relatively rosy for the new challengers, with investors continuing to be confident about the expected RoE that these new entrants will deliver. This is seen back in the share value of new entrants that have gone public, with challenger banks’ value generally far outperforming the FTSE 250. The book value multiple of new entrants is also performing well, with particularly the smaller challengers showing envious multiples compared to traditional banks.

The authors conclude: “But for all Challengers, 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.”