Challenger banks - not quite game-changing

But analyst Justin Bates of broker Liberum urges caution for those expecting this raft of new lenders to dramatically shift the sector's competitive balance. He points out that the banking sector - at a product pricing level - was far more competitive at its market peak in 2006-07 than it is now, despite being dominated by a small number of big banks. "We're still some way below the capacity seen in 2006-07 and the challengers are starting from a low base," says Mr Bates. Accordingly, he's not expecting a big drop in the price of banking products. More players, it seems, doesn't automatically mean a more competitive offering for consumers of banking services.

That's not to say, however, that the challengers don't boast impressive near-term prospects. To begin with, regulatory pressures - including pressure to hoard capital - as well as the need to tackle legacy loan book issues, have left the big banks disinclined to take on too much risk in recent years. That has created an opportunity for smaller lenders. Indeed, Mr Bates reckons Close Brothers (CBG) "has been the biggest beneficiary of the malaise in the banking market". The ability of the smaller lenders to be more flexible than their big rivals - especially a faster approvals process - offers another advantage. The recovering economy should drive demand for credit, too. Overall, then, the challengers look well placed to take a "larger slice of a smaller pie", reckons Mr Bates.

Undoubtedly, and at a time when some big banks continue to struggle, growth among the challengers is eye-catching. Virgin Money, for instance - which bought Northern Rock's 'good bank' from the government in early 2012 - has seen mortgage balances grow at a compound annual rate of 16 per cent, compared with 1 per cent market growth. Aldermore, focused on lending to small businesses and homeowners, has delivered organic loan volume growth of 44 per cent (on a compound annual rate) since 2011's first half. Meanwhile, analysts expect TSB's loan book to grow 40 to 50 per cent by 2017. OneSavings Bank - formed from the purchase of Kent Reliance Building Society's mortgage assets in 2013 - is also doing well: at the half-year stage, it reported that organically originated loans had grown by a quarter. Similarly robust progress is being made at more long-standing lenders, such as Paragon (PAG) or Secure Trust (STB).

But retail investors need to think hard before jumping in. With the impending Aldermore and Virgin Money IPOs - where only about a quarter of each bank is being floated - the shares are being offered entirely to institutions. Moreover, valuations can appear a little stretched. According to some estimates, Aldermore's end-2014 net asset value could reach around £380m. Applying that to the lender's implied £800m market value - based on the mid-point of its indicative 217p-265p IPO price range - yields a multiple of 2.1 times. That's not so cheap: shares in big banks trade on rather more modest multiples. While it's hard to make similar judgement on Virgin Money, in advance of the publication of an indicative price, shares in some other challengers also trade on comparatively demanding multiples.

Neither should investors expect the current rush to market by smaller lenders to continue. True, RBS (RBS) will spin out Williams & Glynn - required by EU competition regulators as the price for state support during the financial crisis - by end-2016. Santander (Sp: SAN) is also expected to float its UK arm within 18 months. But such large and well entrenched players can hardly be considered new challengers. Meanwhile, Metro Bank - which is growing fast organically - said in January that it had postponed IPO plans until 2016. But Mr Bates does think that some peer-to-peer lenders - which he describes as "another form of challenger bank" - could yet consider coming to market.