While the Term Funding Scheme has been both a significant source of funding over the years and encouraged lending, the scheme came to an end in February, and banks now face higher interest costs as a result. In addition to that scheme, a further £31 billion was dished out under a similar Funding for Lending Scheme, which has also ended.
Moody’s warned in April that the loss of cheaper funding will mean UK banks will have to pay an additional £800 million in interest fees this year, equal to around three basis points in net interest margins. The £127 billion outstanding under the Term Funding Scheme is equal to about 8% of the sector’s eligible loan stock.
Banks are competing for customer deposits to plug funding gap
With access to cheaper funding now closed off, the sector is being tasked with finding other funding to plug the gap. The money that customers deposit with banks is already significant on their balance sheets, but the competition to attract deposits will heighten going forward.
The ratings agency believes of the total £158 billion lent out under the Term Funding Scheme and the Funding for Lending Scheme, 60% will be replaced with funds from deposits (particularly from households) with the other 40% to be plugged with secured funding. Virgin Money, OneSavings and Metro Bank have all said they will return to the securitisation market this year as a result.
Challenger banks are adjusting their businesses to gain access to as much funding as possible, demonstrated by the RBS fund. But does that demonstrate the need for funding, or the success of the programme in encouraging the banks to expand their services?
The funding that has helped challenger banks to rise is now drawing to a close and now they must flock the nest. They have the ability to stand on their own two feet but margins and profit will undoubtedly remain under pressure as costs rise going forward and, coupled with slower growth as Brexit rumbles on, will have to consider all their options to remain competitive.
Too big to fail or too small to succeed?
‘Big enough to matter, small enough to care,’ – CYBG.
As the financial crisis took its toll and the UK government tried to rescue the banking sector from complete collapse, a familiar message remerged that the big banks were simply ‘too big to fail’. Although efforts to step-up competition has seen more banks enter the market and expand their services, many challenger banks have been taken over by larger peers. There is widespread expectation that there will be a wave of consolidation among smaller banks in the UK, which prompts the question: big banks may be too big to fail, but are challenger banks too small to succeed?
Having split from Lloyds Banking Group, TSB Bank managed to remain an independent challenger bank for about a year before Spanish firm Banco Sabadell bought the newly-floated bank in 2015. Shawbrook was bought out for around £870 million by Pollen Street Capital and BC Partners earlier this year, and Aldermore looks set to be snapped up by South Africa’s FirstRand, after recently accepting a £1.1 billion offer. Taking on the big banks is proving a difficult task, and there is a trend that has seen smaller banks willing to accept offers from foreign bidders, as many are still struggling to steal customers from the larger banks.
CYBG makes takeover offer for Virgin Money
And the mergers and acquisition (M&A) are continuing after CYBG, the owner of the Clydesdale and Yorkshire Banks, launched an offer for Virgin Money to create the ‘UK’s leading challenger bank, offering both personal and SME customers a genuine alternative to the large incumbent banks,’ boasting six million customers with a strong digital and mobile platform.
Virgin Money shareholders would exchange each share for 1.1297 CYBG shares if the deal goes ahead, leaving Virgin Money shareholders with around 36.5% of the enlarged group. CYBG has until 4 June to make a firm offer or walk away, and Virgin Money is currently reviewing the bid. But some expect rival bidders to emerge, with Shawbrook’s owners thought to be possibly interested.
Challenger banks: acquire or be acquired?
Running parallel with the looming threat of becoming a takeover target, challenger banks are looking to bulk up by acquiring businesses themselves. For example, OneSavings Bank has said it aims to stay independent while acquiring other businesses, although it has said that strict rules on pricing and return on risk means it will only chase opportunities at a certain value.
As the big banks close even more high street branches, Metro Bank is seeing its customer base grow as it expands into new regions, and M&A will be more geared toward property. A further 12 stores will be added by the end of this year, but the bank is also organically growing its existing branches, which are taking more deposits from customers and delivering double digit like-for-like growth. Meanwhile, lending has been grown organically but also boosted by the purchase of a £600 million mortgage portfolio.
TSB Bank’s online issues
Similar to the conditions slapped on RBS that has forced the bank to slim down, Lloyds had to spin-off and rebrand the TSB branches as part of its own bailout during the financial crisis. TSB separated in 2013 and joined the London Stock Exchange (LSE) in 2014, before being bought by Banco Sabadell.
While TSB has been operating independently of Lloyds since the split, it was still relying on Lloyds’ IT systems until recently, when it finally migrated to its own system to an initial cheer. But it couldn’t have gone much worse for TSB, as its new online platform crumbled under the amount of users it had to handle, leaving many without access to their accounts for over two weeks. Its chief executive Paul Pester has forfeited a £2 million bonus, waived overdraft fees, raised interest rates on current accounts and promised that no one will be left out of pocket as a result of the ordeal.
The chair of the Treasury Select Committee, Nicky Morgan, grilling Pester on the bank’s failings, described TSB as a ‘broken bank’. TSB, which has been trying to woo customers with marketing that targets the ‘fat cats’ of the big banks, will now have to put extra effort in to retain customers as well as attract new ones.
The crisis at TSB does little to put challenger banks in a good light, and reinforces the strength of the big banks – but the problems to hit TSB do not represent a problem for all challenger banks, and their big rivals are anything but immune from technical failures. The issue shines more light on the difficulty of carving out a bank from an even larger one than it does on the ability of challenger banks to cope with online demand and security. Having said that, TSB has left one parent company for another and demonstrated the consequences of having someone to answer to.
Maintaining and improving their online offerings will remain key to challenger banks, and they will have to look to the fintech space for help. M&A will not be confined to banks consolidating themselves, and the gap between fintech and banking will grow closer over time. TSB already classes itself as a tech company that offers banking services rather than the other way around. The bank has a lot of work to do, but will hope it is over a bump that some of it peers could have to ride over in the future.
First there was challenger banks, then there was neobanks
Competition in the market has taken a new form. While the majority of challenger banks pride themselves on being predominantly online, there is a rise in the amount of providers focused solely on smartphone banking. Fintech companies look increasingly like competition to banks, flexing the digital muscle that has proven to a problem for the banking sector.
While the sector will continue to compete for customers through traditional means such as the rates it offers on deposits and loans, the fight is moving more toward making customer’s lives easier, making usability, security and (most importantly) reliability of their online systems the integral part of the business.
As more tech-savvy companies look for ways to monetise their developments, the more threats that emerge for challenger banks. Reports earlier this year suggested Amazon was working with JPMorgan Chase to open up bank accounts. Payment services giant PayPal already offers a debit card, loans and accounts, and is even rolling out new services such as allowing customers to deposit their wages directly into their PayPal account and an ATM-friendly card.
While both are based in the US, the threat they demonstrate very much lies here in the UK.
Read more about whether PayPal is moving toward traditional banking
Challenger banks are looking up at their larger peers and plotting their next move, but they should also look below at the smaller fintech firms that threaten to poach their customers, particularly the younger generations, from right underneath them.
How did UK challenger banks perform in 2017?
Virgin Money, OneSavings and Metro Bank all reported a rise in income in 2017, but saw margins come under pressure. All three are profitable after Metro Bank reported its first annual profit in 2017, having turned from a £17 million loss the year before, and the company delivered the most progress last year when compared to its peers.
Apart from experiencing a slight dip in net interest margin (NIM), which measures the amount of interest income generated from deposits versus the interest paid out to lenders, Metro Bank’s margins improved across the board to help deliver the huge turnaround. Meanwhile, Virgin Money saw NIM, cost to income ratio and its common equity tier one (CET1) ratio, which measures the bank’s financial strength, all deteriorate last year while OneSavings managed to keep margins relatively stable.
OneSavings Bank: the over-delivering lender
OneSavings Bank is leaning on its core buy-to-let operation, where it is continuing to deliver growth, but has conceded that its margins will be tested by the withdrawal of cheap funding and higher regulatory costs. The bank is trying to circumnavigate the slowdown in the buy-to-let market, following the changes in stamp duty, by focusing on professional landlords and lending grew in the first three months of this year, with the loan book up 5%.
Shares found support when its annual results for 2017 beat expectations and its first quarter (Q1) update also pushed shares higher. The bank remains on course and has promised ‘at least mid-teens net loan book growth’ this year.
Metro Bank: the ambitious outlier
Metro Bank is expanding its branch network as the big rivals continue to close their own. RBS has said it will close another 162 branches and Lloyds 49. For perspective, Metro Bank is opening up branch number 56 (based in Watford) in May, and aims to have a 100-strong network by 2020. Similar to the big retailers that are plagued by large property portfolios, the big banks understand the move online means they need a much smaller, more evenly spread network of branches to gain maximise exposure on both fronts.
While the big banks continue to trim down, Metro Bank is building up, and has the ability to create a more effective, cost-efficient high street presence than its larger peers. Metro Bank’s existing branches are seeing strong like-for-like growth, so growing the portfolio should help push the bank on the path to consistent profit after escaping the red for the first time last year.
However, Metro Bank cannot neglect its online presence because of its high street network, and the bank aims for ‘simple and secure’. Eight out of ten customers use online banking and customers on average log-in around 22 times a month, demonstrating that its strategy seems to be working.
Metro Bank has clear targets set out for 2020, and has more recently outlined its goal for 2023:
Chief executive Craig Donaldson reaffirmed his commitment to wait until next year, but investors were swayed by the drop in its CET1 ratio, judging by its financial strength, to 13.6% from 15.3% at the start of 2017 and 18.1% at the start of 2016, as rapid growth has led to dilution.
The question being posed now is whether Metro Bank tests its mettle, holds its nerve and waits until next year to raise more cash as promised, or whether it should have a rethink and raise capital now while in a stronger position rather than stretch itself and wait till next year, when the need will be greater.
Metro Bank’s management recently survived a potential revolt at its annual general meeting (AGM) after some shareholders being led by advisers Glass Lewis complained about its chairman making substantial payments to his wife’s architecture firm and a pay rise awarded to Donaldson. While shareholders could not have been clearer with their vote in support of the board, the woes about capital will give those unhappy shareholders something more to grumble about.
Read more about activist investors and how they work
Virgin Money: shares climbing to two-year highs
Virgin Money shares had already found momentum after releasing strong Q1 results, before spiking to their highest level in two years following the takeover offer from CYBG. Concerns that its credit card business was growing at an unsustainable rate have been allayed after impressing with the quality of its credit with lower-than-expected arrears and impairments, leading to higher-than-expected profits.
The jump in Virgin shares after the CYBG offer was so large that it drew the attention of the Financial Conduct Authority (FCA), the outcome of which is yet to be known.
The bank is looking to create a ‘data-driven, customer-centric digital bank’ for its retail customers and to launch new business products, with a business current account to be launched this year to build on the SME deposit product it launched in January. Virgin is very focused on the technology and hopes to move into current accounts and linked primary savings markets as it progresses.
Conclusion: the challenge will only get greater
The environment for challenger banks will get tough over the coming years. More competition will enter and margins will be tested, and as the financial help they have become accustomed to draws to a close they will have to prove they have the mettle to survive beyond state aid.
Consolidation and tie-ups will continue, spilling over from banks to the fintech space that represents a new wave of rivals for challenger banks to consider. Challenger banks had been able to make headway while the big four deal with legacy issues, but they have now started looking to the future having dealt with the past.
Technology once again is proving to be the fundamental resource needed to get ahead in this sector and the need for challenger banks to differentiate themselves and find their niche has never been greater.
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