close
Share with your friends
Challenger Banks: Opportunities & Challenges

Challenger Banks: Opportunities & Challenges

Challenger Banks: Opportunities & Challenges

The so-called “Challenger Banks”, the collective term used to describe the new banking players that emerged since the Global Financial Crisis, have made a significant impact in the market.

A word on definitions…

The new market entrants have historically been referred to as a single, homogeneous group known as the “Challenger Banks”. Although the shortfalls of this term are well publicised, the term has gained currency through lack of a suitable alternative. To provide some more nuanced discussion we have, therefore, classified these banks into a series of peer groups based on certain characteristics as follows:

  • Retail full service
  • Specialist lenders – mortgage focused
  • Specialist lenders – mixed lending books
  • Retailer banks
  • Digital banks

Our dashboard includes financial information on certain of the digital banks which have entered the UK market over recent years. Due to the young age of these institutions, some of the metrics are not always comparable to those of the more established challengers. Throughout our analysis, we refer to the ‘Incumbents’ and ‘Big 5’, being the UK ring-fenced operations of Barclays, HSBC, Lloyds Banking Group, NatWest and Santander UK.

Recent developments

We have updated the commentary below based on our reflections of 2019 and 2020, although the financial data reflects FY19 year ends whilst we await FY20 financial results.

As in many parts of the economy, Covid-19 has driven a number of significant developments for the challenger bank sector:

  • A new TFS – TFSME: Announced by the Bank of England in March 2020 as one of a series of measures in response to the COVID-19 pandemic.
  • Regulatory driven payment holidays: Introduced by the FCA in the immediate wake of the COVID-19 pandemic, regulated lenders were obliged to offer an unprecedented degree of forbearance support to UK consumers.
  • Regulatory adjustments to capital requirements: As part of the suite of response measures to the impact of COVID-19, the PRA made a number of changes to the capital framework, including delaying implementation of Basel IV, and significantly enhancing the relief available in respect of IFRS 9 provision charges incurred from 2020 onwards.
  • Coronavirus loan schemes: Following the launch of the various Government-backed loan schemes earlier in 2020, many of the challenger banks sought and received accreditation from the British Business Bank, and have grown their SME loan books as a result.
  • Base rate reduction: The Bank of England reduced base rate to 0.1% in March 2020. This has led to further downward pressure on net interest margins. There remains continued speculation that further cuts to base rate may be on the horizon, including the possibility of negative rates, with the MPC indicating the need for negative rates to be part of its monetary policy toolkit. In February 2021, the PRA wrote to authorised firms setting an expectation that they should be ready to implement negative rates within six months.
  • Further new entrants: New entrants to the UK banking sector have continued to be authorised during 2020 and 2021, including DF Capital, Monument and Recognise.

Source: KPMG analysis
Financial analysis notes and basis of preparation

Explore the evolution of gross yield further in our interactive dashboard.

Threats and headwinds

Continued asset growth

Each bank peer group has reported continued growth in total assets with the retail full service growing total assets by an average of 2.3% in FY19 and the specialist lenders by an average of 8.8% in FY19. In 2019 we spoke about the challenges for Banks looking to continue to grow their loan books in light of an increasingly competitive environment. The unprecedented disruption to markets as a result of the Covid-19 outbreak has presented new challenges to lenders.

Compression in yields

The Challenger banks have reported compression in yields across a number of years in certain market segments, primarily mortgages:

  • A crowded market place. Despite the disruption brought by Covid-19 to the general market, it still remains that the UK ring-fenced banks have significant excess liquidity, which for many banks increased during the periods of national lockdown as customer discretionary spend reduced. This excess liquidity continues to keep down yields within the mainstream mortgage market although changes in mortgage market dynamics associated with Covid has seen a improvement in mortgage pricing.
  • Impact of stimulus: The TFSME launched by the Bank of England in March 2020 has provided a new source of cheap funding to the banking sector, enabling many participants to refinance their drawings from the previous TFS scheme, and providing a continued downward pressure on yields across the sector. In addition, demand for mortgages remains high given the current reduction in Stamp Duty, which the 2021 Budget extended to September 2021 in England and Northern Ireland, while in Wales the reduction has been extended to 30 June 2021.
  • Base rate: The reduction in base rate in Q1 2020 is likely to serve to put continuing pressure on the net interest margins of banks, with potential future negative interest rates creating scope for further pressure.

The opportunities

Mortgage lending

Responses for mortgage lenders include:

  • Focus on niches which command higher yields. Examples include first time buyers (including Help to Buy and the new mortgage guarantee scheme) and lending into retirement with some of the incumbents announcing moves into this space. In BTL, niche areas of potential focus include portfolio landlords and Houses in Multiple Occupation.
  • Maintain focus on the growing market segments. Examples include more complex mortgages where the industrialised underwriting approach is not appropriate, for example in areas such as complex incomes (e.g. self-employed, growing gig economy).

However, these responses tend to come with greater exposure to credit risk. In a more uncertain economic climate, the number of banks who are willing to move down the credit quality curve in order to maintain yield is likely to decrease as was seen with the reduction in the number of mortgage products available to higher LTV borrowers during the course of 2020.

SME lending

The impact of Covid across many industry segments has seen strong demand for SME lending. The implementation of the various Government-backed support schemes has met some of that demand. As at 21 February 2021 total amounts lent under CBILS and BBLS were £22.0 billion and £45.6 billion respectively. Please see for more details on the government support schemes available to SMEs.

Once the immediate impact of Covid on businesses starts to ease, we expect demand for traditional products will re-emerge, in particular:

  • Specialised and asset finance. Whilst the mainstream/prime market has seen intense competition which has impacted yields, there continue to be opportunities for higher yields in more specialised areas (e.g. where specific asset knowledge is required).
  • Cash flow solutions. There is an increasing need for cash flow solutions, especially as businesses will need to deal with the impact on working capital from increases in the working capital cycle arising from Brexit on both importers and exporters. Integrated payments and finance solutions are anticipated to grow.
  • Capability & Innovation fund. The Capability & Innovation Fund launched in 2019 as part of the Williams and Glyn package of remedies has focused attention on both banking services to SMEs together with, specifically, availability of lending products to SMEs. A number of challengers have benefitted from this, including Virgin Money, Atom Bank and Starling, whilst other institutions s have decided to return funds, e.g. Metro Bank and Nationwide Building Society.

Key contacts

James Gill

James Gill
Director, Deal Advisory
james.gill@kpmg.co.uk

Peter Westlake

Peter Westlake
Director, Strategy
peter.westlake@kpmg.co.uk

Source: KPMG analysis
Financial analysis notes and basis of preparation

The impact of the reductions in the bank base rate in the first half of 2020, the launch of the Term Funding Scheme for SMEs, and the cut in NS&I savings rates in November 2020 has resulted in an easing of the upward pressures on cost of funds, which many challengers were experiencing prior to 2020. This is can be seen in the rates in the best buy tables falling over the course of 2020, with the best easy access rate as at March 2021 being c. 0.45%.

Unlike in the previous financial crisis access to the UK securitisation market returned relatively shortly after the initial Lockdown in the UK.

Threats and headwinds

The Bank of England funding schemes

Term Funding Scheme (“TFS”) and Term Funding Scheme for SMEs (“TFSME”)

In our 2019 report, we commented that the need for banks to repay amounts drawn from the Bank of England’s funding schemes, TFS and FLS, would contribute to upward pressure on funding as the competition for retail deposits increased. As at 31 December 2020, amounts outstanding under TFS had reduced to £50.1 billion, down from £108.2 billion at 31 December 2019.

However, in March 2020 the Bank of England launched the TFSME. The TFSME was part of the package of measures announced by the Monetary Policy Committee in March 2020 with the aim of supporting the UK economy during the disruption caused by the Covid-19 outbreak.

Participating banks and building societies are able to borrow at a rate close to the Bank Rate for up to four years. Participants can draw down up to 5% of their real economy lending at inception, with further drawdowns linked to their volume of SME lending.

To 31 December 2020, participants have drawn £68.2 billion in funding, which is likely to have offset the impact on demand for retail deposits across the sector to fund repayments due under the TFS.

New entrants

In our report last year, we highlighted new entrants, such as Marcus by Goldman Sachs, putting pressure on retail deposit pricing. The pressure from new entrants eased during 2019 and has continued through 2020, with a corresponding reduction in best buy rates on retail savings, which currently sit at c. 0.45%, reduced from the c.1.50% seen previously. This will be an area to monitor throughout 2021 with the recent news that JP Morgan is set to launch a UK digital retail bank.

Increasing regulatory requirements

Capital markets activity around institutions’ minimum requirement for own funds and eligible liabilities (MREL) moved sharply into focus during the last two years. The number of challenger banks within the scope of MREL is likely to increase over time as they continue to grow in size. MREL will continue to be a costly source of funds for the challengers, and represent a significant upward pressure on cost of funds. A Consultation Paper is due in summer 2021 on MREL, which Challenger banks are hopeful will lead to an increase in the size threshold and a change in the treatment of transactional accounts.

The opportunities

Diversify retail proposition

Many of the Challengers are currently funded entirely through notice and fixed terms savings products. In an increasingly competitive market, a response to funding pressures may be to diversify into other retail deposit products. Although a number of the digital challengers have built their business models centred on current accounts, very few of the specialist lenders have entered this market. Equally, a number of the challengers have not yet made the decision to access the instant access savings market. The reduction of NS&I interest rates in November 2020 has created additional liquidity which presents an opportunity to diversity the funding base.

Current accounts
Instant access savings

Access new forms of funding

For the challenger banks who have larger funding requirements, the institutional market could provide an alternative source of funding whilst allowing them to grow their lending capabilities, and optimising the mix of funding cost and tenor.

Two examples of this are:

Key contacts

Jeremy Welch

Jeremy Welch
Partner, Deal Advisory
Jeremy.welch@kpmg.co.uk

Source: KPMG analysis
Financial analysis notes and basis of preparation

The benign macro-economic environment that the UK experienced over the last decade came to an abrupt end in March 2020. However, the full macro-economic impact of Covid-19 on the UK economy is yet to be felt. Unprecedented levels of government and regulatory support have softened the impact on the economy and on challenger bank cost of risk. There is no crystal ball for 2021 and there is a wide range of possible outcomes on UK employment, GDP, house prices and other drivers of credit losses. Please see for more details on our UK economic outlook.

Threats and headwinds

Benign conditions have flattered most lenders and asset classes over recent years. The events of early 2020 have caused a stark change in perspective. 2020 has seen a significant reduction in the indebtedness of UK consumers, but there has been a significant increase in debt advanced to businesses.

Macro-economic risk

Some classes of lending are more cyclically exposed than others to a downturn. We’ve outlined below how some of the major classes of lending might respond:

Mortgages: minor cost of risk increase

Even in a downturn, credit losses for most UK mortgage books should be low outside of extreme scenarios; LTVs are strong enough to absorb moderate price corrections, rates are low, many people are fixing at longer terms and new affordability checks ensure good interest coverage.

Some specialty mortgages may be affected differently, for instance equity release or limited company buy to let lending.

Cards/Personal Unsecured: moderate cost of risk increase

In a sustained downturn credit losses will always increase on unsecured lending. Well managed books should still be profitable as demand for credit increases, provided that pricing and limit discipline is maintained.

SME: moderate cost of risk increase

Losses are likely to increase from current levels, albeit actual losses incurred by the institution should be defrayed by the various government guarantee schemes. Loss rates are likely to vary a lot across the various different lending models that service this client base. Where asset finance has been provided to businesses in the services sector in relation to soft assets, losses may be highest as a result of low residual values.

CRE: moderate cost of risk increase

CRE is a very mixed market at the moment. For example retail CRE prices have dropped significantly and will continue to do so as the move to online retail continues to bite. For lenders we can expect to see a similarly mixed impact, some lenders will see losses while others may emerge relatively unscathed. Sectoral exposure will be key with the impact of the move towards move hybrid working being felt most in office property.

Brexit

The formal exit of the UK from the European Union on 31 January 2020 and the agreement of the new trading relationship in December 2020 has not served to fully resolve the uncertainty associated with the Brexit process. The full impact of the new trading relationship will take time to materialise as business’s adapt their operations. Whilst the uncertainty has been reduced this period of adaptation has the potential to provide further headwinds to cost of risk. Challenger banks are mostly UK only operators so the impact will be the indirect effect from the wider economic changes and specific sectoral exposure.

The opportunities

Get the basics right: Focus on best practice

Challenger banks who have focussed on best practice will be best placed to respond to a turning in the credit cycle:

  • Understanding the book. Without detailed stratifications of risk exposure and sensitivity it is hard to identify emergent pockets of risk. Measuring, monitoring and anticipating credit losses and risk concentration is essential.
  • Underwriting quality. Maintaining standards in this environment must focus on first principles and fundamentals. Taking into account emerging default experience, will be a key success factor for those who come out of the crisis with good credit quality lending books.
  • Cautious growth. Exercise caution in selecting which areas to continue to grow. Given pressure on yields, this may lead to decisions to pull back from or entirely exit areas of the market.

Underwriting & Pricing

If the composition of the current lending book ceases to meet a bank’s risk appetite for the associated return, then taking the decision to exit the line of business may be most efficient way to release capital. For example, a number of market participants are in the process of exploring selling or securitising certain loan portfolios.

Key contacts

Alex McGowan

Alex McGowan
Managing Director, Deal Advisory
alex.mcgowan@kpmg.co.uk

Source: KPMG analysis
Financial analysis notes and basis of preparation

Cost:Income Ratio: value creation through operating model cost optimisation

The recent trends in cost:income ratio have been mixed across the different peer groups of the challenger banks. The average cost:income ratio for Full Service Retail challengers in 2019 was 87.5%. Meanwhile the Specialist Challengers, Specialist - Mortgages peer group have achieved an average cost:income ratio of 43.4%.

Assessing cost:income ratio in isolation of understanding the business model and the underlying operating model which is required to deliver it provides an over-simplified view of efficiency (e.g. a branch based proposition will intrinsically have a higher cost:income ratio than one that is badged as purely digital).

A further consideration is that whilst these are all categorised as challenger banks, they have not all been created equal. Those that have been carved out from larger organisations are now being hampered by legacy operating costs and the investment required to update compared to those which have been established without the ‘legacy debt’, with new operating models which are underpinned by modern technology platforms.

The opportunities

Irrespective of the distinct peer groups, themes around transformation and innovation to control and reduce cost and become increasingly efficient continue to be dominant for the Challenger Banks as pressure around income yields intensifies.

For the Full Service Retail Banks with larger and/or complex operating models, the challenge will be in achieving the volume and scale required to reduce the unit economics around cost to acquire and cost to serve which underpin their operating cost base.

For the Specialist Challengers, the challenge will be positioning for growth through the introduction of new products, propositions and services or even expansion into new markets or geographies, without the cost base increasing uncontrollably. There are a number of strategies that the challengers are employing:

“Digitisation Plus”

Increased digitisation of the Operating Model

Whilst process efficiency achieved through lean and process simplification and the use of robotic process automation has become common-place in reducing costs, elevating this to the next level where Data and Analytics combined with Machine Learning and Artificial Intelligence are incorporated into the Operating Model will be the real step change for Full Service Retail Banks.

Creating fully automated end to end customer journeys from the initial interaction to making the right decision and then executing on that decision without any human intervention will drive real efficiencies.

“Eco-system Efficiency”

Becoming a utility player

Whilst some of the Specialist Challengers have actively developed their Operating Models based on utilising an eco-system of partners to reduce operating costs, Full Service Retail Banks continue to maintain a number of in-house capabilities which are cost intensive.

With the ever increasing level of intermediation happening across the entire value chain, Full Service Retail Challengers have the potential to utilise a wider range of partners which provides an opportunity to reduce costs through removing the need to have in-house capabilities.

“Become a platform player”

Leveraging the operating model more effectively

Challengers have the ability to improve cost:income ratio through leveraging their existing operating model by the provision of banking services to other organisations.

For example, Starling has launched a partnership with Form3 to provide real time access to Faster Payments or OakNorth which is actively looking at how they could develop and take to a global banking market a “banking as a service” model that allows other institutions wanting to get into the commercial banking/lending space a scalable solution. There is potential for more of the full service retail challengers to move in similar directions.

“Spans & layers”

Efficient organisational design

Increased digitisation and automation, the utilisation of eco-system partners and creating more effective back office functions, creates the potential to streamline the organisation by standardising spans of control and reducing management layers. This is most applicable to the more legacy Full Service Retail Challengers who have the size, breadth and depth of operating model to take advantage of this strategy. In addition, changes to working patterns driving by the pandemic will allow for greater use of technology to continue to digitalise the operating model.

“Joining forces”

Consolidation to maximise operating models and the cost:income ratio

The most radical strategy to improve the cost:income ratio is consolidation. We have already begun to see the effect of this consolidation, such as through the CYBG/Virgin Money and OneSavings Bank/Charter Court Financial Services transactions.

“Technology Estate Optimisation”

Cloud adoption and technology agility

The costs associated with the technology estate of all challenger banks are a major driver of cost:income ratios.

Effective strategy and subsequent execution to operate off a technology estate which is flexible and agile from how it is hosted (e.g. cloud based) through to how the platform can be scaled using modular functionality, through to the ease of integration into other technical components, e.g. ability to utilise APIs to adapt to the services and propositions at speed reduces cost and is effective to maintain.

Full Service Retail Banks operating analogous to the big banks have the opportunity in this instance to learn from the incumbents, for example LBG who are accelerating their move to a cloud based architecture using the fintech Thought Machine.

Key contacts

Axe Ali

Axe Ali
Associate Partner, Deal Advisory
axe.ali@kpmg.co.uk

Phil Murden

Phil Murden
Partner, Management Consulting
phil.murden@kpmg.co.uk

Please also see KPMG regulatory insights.

The mass economic disruption caused by the Covid-19 pandemic has led regulators and central banks the world over to prioritise the flow of funds to the real economy leading to an easing of capital requirements and the UK is no different. The question remains how long this more accommodating attitude will continue as regulators balance the importance of economic recovery with the micro-prudential health of banks.

One of the key elements in supporting the economic recovery is ensuring there is appropriate competition in the banking sector. It is therefore little surprise that a parallel theme for the PRA in 2020 has been addressing regulatory impediments to competition. Sam Woods speech about the need for a ‘Strong and Simple’ framework for smaller banks is the clearest sign that the PRA intends to introduce a more graduated approach to capital rules rather than the ‘one size fits all’ which, depending on its scope and final form, could present opportunities for the challenger banking sector as it develops.

Whilst there are still clouds on the horizon, these appear perhaps less ominous than a year ago. Although there are a number of challenger banks captured by the MREL(“Minimum requirement for own funds and eligible liabilities”) regime and which need to build up resources to meet end point requirements from 2022 onwards, the PRA has published a Discussion Paper in December 2020 which indicated an openness to easing the burdens on certain newcomers. We can expect further details for how this will take shape in 2021. Likewise, the implementation of Basel IV has been delayed by a year to 2023 due to COVID (and there are discussions ongoing about potential future delays). In both cases, attitudes from regulators appears to be more accommodating. However, it’s important not to over-state this. As of the time of writing, neither MREL nor Basel IV have gone away and both could still present long-term pressures to capital requirements. As such, both MREL and Basel IV remain the cornerstones of long-term capital planning decisions, encouraging challengers to evaluate and invest in moving to the internal ratings based (“IRB”) approach to mitigate the impacts.

Developments from COVID-19

We have updated the commentary below based on our reflections of 2019 and 2020, although the financial data reflects FY19 year ends whilst we await FY20 financial results.

  • There have been a number of responses to the COVID-19 pandemic which have been designed to mitigate the impact on bank’s capital ratios and ensure continued financing of the real economy.
  • The first development in March 2020 was the decision from the Financial Policy Committee (‘FPC’) to reduce the Countercyclical Buffer (‘CcyB’) rate to 0% until March 2022.
  • This was swiftly followed by a number of other interventions from the PRA – ranging from clarifications of its views on the capital treatment of government guarantees, the use of capital buffers and IFRS 9 provisions to new policy initiatives such as allowing firms to apply for a nominal pillar 2 requirement (to mitigate the impact of expected RWA volatility due to COVID).
  • Probably the most significant intervention, however, came from the EU in the form of the CRR ‘quick fix’ package in June 2020 which applied directly in the UK. This made a number of adjustments to the CRR rules, in particular:
    • Amendments to the IFRS 9 transitional provisions to allow banks to add-back 100% of additional Stage 1 and Stage 2 provisions incurred since 01 January 2020 until 2022;
    • Acceleration of the changes to the SME supporting factor which reduces risk weights for SMEs; and
    • Acceleration of the more permissive treatment on intangible software assets.
  • The collective immediate impact of these changes is to reduce or remedy the pressures of COVID on UK banks.

However, the longer-term impact may be more interesting. All of the changes are likely to outlast the acute phase of the crisis and some of the changes (e.g. SME supporting factor) are permanent. As such, the capital headroom created by these measures does not just guard against downside risks but can be used by challenger banks to support longer term growth.

Threats and headwinds

MREL

  • MREL (“Minimum requirement for own funds and eligible liabilities”) is designed to ensure that banks have sufficient ‘gone-concern’ loss absorbency to allow effective resolution by the Bank of England. The requirement is calculated on the basis of a bank’s Pillar 1 and Pillar 2A capital requirements, so is driven to a considerable extent by a bank’s risk weighted assets.
  • For many smaller banks the MREL requirement equals the capital requirement and there is no need for any additional resources. However, when a bank meets a certain size threshold (£15-25bn of assets) or has a certain number of transactional accounts (40-80,000), the Bank of England will set an incremental MREL requirement. The size of this varies between banks, but for many the MREL requirement is equal to 2x the Pillar 1 plus Pillar 2A capital requirement.
  • To the extent that banks do not have sufficient capital to meet the incremental MREL requirements, they can issue a range of MREL-compliant liabilities (e.g. senior non-preferred debt). This is also commonly (although not necessarily) accompanied by a certain amount of group restructuring since it is common for MREL to be issued from a passive holding company and down-streamed to the operating entity rather than issued by the bank itself. For those firms which do not already have a holding company, this can involve complex group restructurings where the regulatory requirements need to be balanced against legal, tax and accounting impacts.
  • There are currently 11 challenger banks and building societies which have MREL requirements over and above their capital requirements. These institutions are faced with the challenge of either carrying more regulatory capital or issuing MREL-compliant debt, either of which drives up cost of funds and reduces margins.
  • For this reason, it has been seen as a barrier to growth and competitiveness which has prompted the Bank of England to launch a Discussion Paper in December 2020 on the approach to setting MREL. This will lead to a Consultation Paper in summer 2021 and a revised MREL policy framework by the end of the year. It is too early to speculate what this review will result in. However, Challenger banks are hopeful that it will lead to an increase in the size threshold and a change in the treatment of transactional accounts.

Basel 4

  • Basel IV (or more accurately the second phase of Basel III), was originally due to come into force in January 2022 but the profound impacts of COVID has led regulators to postpone the implementation by one year to January 2023 (with potential for further delays).
  • Basel IV will impact all challenger banks but not all challenger banks equally. Specialist lenders on the standardised approach are likely to see the most significant increases in capital requirements due to the potential for higher risk weights for buy-to-let exposures.
  • The aim of the revised standardised approach is to make it more risk-sensitive and an improved back stop for the IRB approach. In practice the most significant changes have occurred around property exposures. Property risk weights will now rise in stages in line with loan to value ratios, and property lending where cash flows depend on the underlying property, such as buy-to-let, will have increased requirements reflecting their perceived higher risk.
  • As such these changes have been a driver for some Challenger banks to move towards the more sophisticated IRB approach to capital, as three challenger banks have already done (CYBG/Virgin, TSB and Co-op Bank). IRB heads off some of the potential capital increases from Basel IV and reduces capital requirements compared with the standardised approach. However, it is not a magic wand. Basel IV, will introduce minimum floors that restrict the impact of IRB to a maximum of 72.5% of the equivalent standardised approach capital requirements. Whilst these floors arguably pose more problems to the large incumbents who are already on IRB, they nevertheless cap the benefits that Challengers can expect. IRB is still a valuable investment, but the returns are not what they once were.
  • To gain IRB accreditation, banks are required to have significant amounts of data about how their lending books have performed in the past, to build and demonstrate the effectiveness of a range of complex, predictive credit loss models. Although IFRS 9 has meant many banks have had to invest more in credit risk loss modelling, the step up to IRB is still significant and a hurdle.

Opportunities

The regulatory outlook for challenger banks has brightened over the past year – the PRA’s willingness to review MREL and its plan for a ‘strong and simple’ regime could both present major opportunities for the Challenger banking community. In addition, a Treasury commissioned report on ring-fencing which is due to report to Parliament in Q1 2022, could further play in Challengers’ favour. However, it is important not to become complacent. We still do not know the outcomes of these changes and in the meantime there is no getting away from the fact that the disparity between the standardised approach and the IRB approach creates an un-even playing field, and requirements such as MREL and Basel IV are likely to make things more challenging. In this context, challenger banks need to be careful and strategic in their capital management. The future will reward those who invest more in capital planning, modelling and careful product design.

Overall the future for challenger banks requires more capital and will reward those who invest more in capital planning, modelling and careful product design.

Key contacts

Simon Walker

Simon Walker
Partner, Risk Consulting
simon.walker@kpmg.co.uk

Steven Hall

Steven Hall
Partner, Risk Consulting
steven.hall@kpmg.co.uk

Nicholas Mead

Nicholas Mead
Director, Deal Advisory
nicholas.mead@kpmg.co.uk

Close
0%

View the full dashboard

For a more in-depth view of the results of the sector, visit the full challenger banks results dashboard below

Click here

Term Funding Scheme (TFS)

The Term Funding Scheme was part of the package announced by the Monetary Policy Committee in 2016 with the aim to pass‑through the cut in the Bank Rate to the interest rates faced by households and businesses.

Participating banks and building societies were able to borrow at a rate close to the Bank Rate for up to four years.

The Scheme closed in February 2018 and drawn funds will need to be repaid within four years of the transaction date.

  • Total borrowings
  • Challenger borrowings

Source: Bank of England, as at 31 March 2019

Current accounts

Pros Cons
  • Potentially low cost of funding
  • Large available market
  • Digital entrants have shown that demand exists for alternative current account providers
  • Systems costs may be prohibitively high
  • In a lower interest rate environment, the cost benefit from current accounts is reduced
  • Attracting customers to switch their main current account continues to be a challenge for the newer entrants
  • Level of bonuses and other features attached to current accounts may offset lower funding costs
  • Ability to grow current account book beyond a certain threshold may be limited by the MREL threshold

Instant access savings

Pros Cons
  • Access to the largest part of the UK savings market (c. 55% of deposit balances)
  • Compared to current accounts, a relatively simple product to launch
  • Some systems development for those currently only offering term and notice accounts
  • Higher customer expectation of online/mobile interface
  • Historically many customers have used instant access accounts with their primary current account provider, limiting access for the challenger banks

Asset based financing

Institutional investor base (securitisation or covered bonds)

Pros Cons
  • Cheap funding with pricing based on an asset pool /and the issuer credit rating
  • Issuance program can be set up to allow swift market access
  • May be able to receive derecognition of assets and reduction in associated capital
  • Large initial admin requirement and ongoing burden
  • Treasury may lack experience in the instruments
  • Enhanced levels of disclosure required

Corporate / unsecured financing

Institutional investor base (senior unsecured bonds)

Pros Cons
  • Simple structure with a minimal ongoing administrative burden
  • Highly liquid institutional investor market
  • Issuance program can be set up to allow swift market access
  • More expensive than asset based financing
  • Pricing may be dependant on the issuer's financial position as well as the underlying rates
  • Treasury functions may lack experience in the instruments

Classifications

Peer group description Characterised by Examples
Full service retail Full range of lending products
Current account
Branch network
CYBG/Virgin Money
Metro Bank
TSB
Co-op Bank
Specialist lenders More limited product set
Targeting specific customer niches
Primarily mortgage lenders:
Charter Court Financial Services
OneSavings Bank
Cambridge & Counties Bank
Paragon
Mixed lending books:
Aldermore
Close Brothers
Shawbrook
Retailer banks Limited product range
Leveraging the retailer’s brand
M&S Bank
Sainsbury’s Bank
Tesco Bank
Digital banks Mobile-first, app based Atom
Monzo
Starling
Tandem

The full classification of banks within our dataset is available in the basis of preparation.

Notes on preparation

In the interactive dashboard, the banks are classified as follows:

  • Retail full service: CYBG plc (Clydesdale Bank Plc prior to 2015), Co-op Bank Bank Holdings Ltd (Co-op Bank Bank plc prior to 2016), Bank of Ireland (UK) plc, Svenska Handelsbanken AB (publ) (UK division), Metro Bank plc, TSB Banking Group plc, Virgin Money Holdings plc.
  • Retailer: Tesco Personal Finance Group Ltd, Marks and Spencer Financial Services plc, Sainsbury's Bank plc.
  • Specialist - mixed: AIB Group (UK) plc, Aldermore Group plc, Cynergy Bank Ltd (Bank of Cyprus UK Ltd prior to 2018), Close Brothers Group plc, Provident Financial plc, Secure Trust Bank plc, Shawbrook Group plc, Unity Trust Bank plc.
  • Specialist – mortgages: Cambridge & Counties Bank Ltd, Charter Court Financial Services Group plc (Charter Court Financial Services Group Ltd prior to 2017), Hoggant Limited (holding company for Hampshire Trust) for 2015-17 and Hampshire Trust plc for 2014/13, OneSavings Bank plc, Paragon Banking Group plc (Paragon Banking Group plc prior to 2017), United Trust Bank Ltd.

CYBG has a September year end, and as a result the 2018 financial statements do not include the impact of the acquisition of Virgin Money. Virgin Money's financial results are separately presented within the dashboard.

The dashboard focusses on UK challenger banks with an established trading record over the 2014-2018 period. As a result, the dashboard does not include the results of many of the new 'digital' challengers that have shorter trading records.

Within the 'Specialist' category, banks have been classified as 'Specialist – mortgages' where their lending books are predominantly secured on property. These books may include owner occupied residential mortgages, buy-to-let residential mortgages and SME lending secured on property.

Information has been obtained from published annual financial statements. No adjustments have been made for one-off/non-recurring items. Loans and advances to customers are presented inclusive of fair value adjustments for hedged risk.

We have taken the following approach to calculate each of the key performance indicators used in this report. These key performance indicators use the reported results. Given that there are no standard definitions for these items, they may differ to the KPIs reported by the banks in their published financial statements.

  • Pre-tax return on tangible equity: profit before tax attributable to the shareholders, divided by the average of opening and closing tangible equity.
  • Gross yield: the gross yield is calculated as interest income divided by the average of the opening and closing total assets.
  • Cost of funding: cost of funding is calculated as total interest expense divided by the average of opening and closing total liabilities.
  • Net interest margin (NIM): the NIM is calculated as total net interest income divided by the average of the total assets.
  • Cost-to-income ratio: the CTI ratio for each sub-division of Challengers is calculated as total operating expenses divided by total operating income. Separately disclosed costs relating to stock exchange listings are excluded from total operating expenses.
  • Cost of risk: Impairment charge on loans and advances to customers divided by the average of opening and closing loans and advances to customers.
  • RWA intensity: RWA intensity is calculated as risk weighted assets divided by total assets.
  • Loan:deposit: Loans and advances to customers divided by customer deposits.

Peer group averages are calculated as a simple average of the banks within the peer group. The following banks have been excluded from calculation of peer group averages either because information is not available or that the institution is an outlier:

  • Pre-tax return on tangible equity: Co-operative bank, Handelsbanken and Provident.
  • Loan book growth rate: Handelsbanken, Hampshire Trust, Charter Court Financial Services (2014-16).
  • Gross yield: Handelsbanken and Provident.
  • Cost of funding: Handelsbanken.
  • Net interest margin: Handelsbanken, Provident.
  • Cost:income ratio: Co-op, Hampshire Trust (2014-15)
  • Cost of risk: Handelsbanken, Provident.
  • Total assets and liabilities growth rates: Provident, Hampshire Trust
  • CET1 ratio: Handelsbanken, Charter Court Financial Services (2014-16), United Trust Bank (2014-16)
  • Loan:deposit ratio: Handelsbanken, Paragon
  • RWAs as a percentage of total assets: Handelsbanken, Cambridge & Counties, Charter Court Financial Services (2014-16), United Trust Bank (2014-16).

At the time of publication, 2018 data was not available for Hampshire Trust or Cynergy Bank.

The financial results for entities with reporting periods longer than 12 months have been adjusted as follows:

  • The 2015 results for Sainsbury’s Bank reflect the 14 month period to 28 February 2015. The income and expenses presented in the dashboard have been adjusted downwards by a factor of 14/12.
  • The 2018 results for Aldermore reflect the 18 month period to 30 June 2018. The income and expenses presented in the dashboard have been adjusted downwards by a factor of 18/12.

Handelsbanken present their results in Swedish Krona. These have been translated into sterling (£) using the relevant period end or period average exchange rate.

CSS section (editor note) (do not delete)
CSS section (do not delete)
JavaScript section (do not delete)