Have challenger banks lost their fight?

After making considerable share price gains this time last year, challenger banks have taken a turn for the worse in an increasingly competitive banking environment

March 3, 2016

by Emma Powell

The term 'challenger bank' has been applied to a smorgasbord of financial services companies. In short, the moniker is commonly used to refer to those companies outside the big four lenders, aiming to capitalise on the withdrawal of the banking giants from parts of the credit market. Alternative lenders such as OneSavings Bank (OSB) and Aldermore (ALD) have delivered phenomenal pre-tax profit growth from lending to niche corners of the market, in particular professional landlords.

From a regulatory perspective, the attraction of the challengers is clear: escaping the recently ratcheted-up banking levy and compensation costs for past mis-selling of payment protection insurance (PPI), which is weighing on balance sheets at the major lenders.

Until recently, the share prices of many of the challenger banks mirrored the spectacular earnings growth reported by the subsector. However, in the past six months shares in specialist lenders Paragon (PAG), Aldermore and OneSavings Bank have taken a turn for the worse. The government's budgetary decision to ramp up stamp duty on buy-to-let properties and second homes from April has prompted doubts that this part of the mortgage market will be able to continue the strong run on demand for credit.

Of course, challenger banks are not immune to some of the pressures the major players are subject to. Speculation over 'lower for longer' interest rates has also weighed on the market's sentiment towards Virgin Money (VM), due to fears that lower interest rates could erode banks' net interest margins as they're unable to lend at higher rates.

The new contenders

Exactly what challenger banks can offer compared with their mainstream counterparts has been brought to the market's attention most recently by two challengers looking for outside investment to drive growth - CYBG (CYBG) and Metro Bank. Admittedly, Metro Bank hasn't floated on the London Stock Exchange yet, nor will it be publicly listed. Rather, the banking group will be 'introduced' to the market after a round of fundraising it's currently undertaking with existing investors. Yet the banking group was reportedly forced to cut its initial £24 share price offer back to £20 as a result of the market volatility which has marred the start of 2016. The start of trading has also been pushed back to 7 March 2016 from the original end of February deadline.

What could make Metro Bank more interesting to investors over its rivals is how central its branch network is to its growth strategy. Unlike other upstarts such as OneSavings Bank and Virgin Money, which operate via a network of intermediaries, Metro Bank directly runs a network of 40 own-brand stores across London and the south-east. Of course the group offers mobile and internet services, but its store network - open seven days a week - is a core part of management's aim to provide a "superior, retail-focused" banking group. Part of management's intention behind the fundraising is to support future store expansion, as well as growing balance sheet assets and increasing liquidity for shareholders.

The price of growth

Metro Bank's plans to draw in new customers appears to be working. Total deposits grew by 78 per cent during 2015, while customer accounts increased by almost half to around 655,000. Yet this growth has naturally come at a cost - operating expenses increased by almost half to £108m during 2014. Store expansion, with rental and staff costs, is part of this. Metro plans to open another nine stores this year and employ an extra 500 staff.

Reducing the cost-to-income ratio has become a crucial part of major banks' plans to strengthen their balance sheets and return to profit growth. However, the same applies for challengers such as newly listed CYBG. The group - home of the Clydesdale and Yorkshire banking brands - listed in February at an ultra cheap 0.58 times the group's net tangible assets, following its demerger from National Australia Bank. Those confused by the humble rating should look at a key measure of the stock's quality: the return on equity is just 5 per cent.

Cutting costs is also an important part of the newly demerged CYBG. While a strong bank network is an important part of the banking model in retail and small- and medium-sized (SME) markets, CYBG bosses want to 'optimise' the group's physical network. This will involve refurbishing flagship and other important branches, but will mean closing others. In the six months to the end of September last year the group already shut 24 branches.

Management's aim is to cut the group's cost-to-income ratio from a lofty 75 per cent at the end of September 2015, to below 60 per cent within the next five years. However, the best way to improve this ratio is for the bank to improve its loan book, and generate higher margins. After selling its lossmaking loan book to its parent company in 2012, CYBG's focus is on SME business, as well as retail lending. The group hasn't just boosted its mortgage lending, but also its SME lending, via a mix of overdrafts, asset finance and invoice finance.

Favourites

Shares in Virgin Money are trading at 1.3 times forecast net tangible assets for 2016. As a small but growing player in the mortgage market, the group is benefiting from the steady growth in mortgage approval rates. During 2015, the group increased its mortgage lending by 29 per cent to £7.5bn. Without the additional costs of a branch network, it's not surprising that the group has delivered such phenomenal pre-tax profit growth. Virgin's plans to expand into SME lending and with its growing credit card business this should boost its net interest income further.

Outsiders

Without adequate broker coverage, it's difficult to value CYBG on a traditional net tangible asset basis. The shares are still trading around 1.6 times the group's 2015 net tangible assets. This is a discount to competitors Lloyds and Virgin Money, the latter of which is trading at 1.2 times its forecast net tangible assets for this year. However, there are reasons why the shares are so cheap. Improving digital banking services has resulted in higher operating costs, which increased by 7 per cent to £731m. The group also has large-scale branch network costs, but with a lower return on equity. Its net interest margin is also just 2.13 per cent, which looks meagre compared with other alternative lenders, such as Virgin Money and Aldermore at 16.8 per cent at the end of June last year. Hold.

The various specialist lending segments are attractive because they're projected to grow as demand for credit increases. Furthermore, growth is supported by the government, given the ongoing SME credit gap. Currently each stock has a relatively small market share in each segment of the market in which it operates. Future growth will also result in operating gearing benefits being realised and we expect cost-to-income ratios to fall and to support sustainable attractive returns.

Customers are increasingly using intermediaries to facilitate their borrowing. SME customers are attracted to intermediaries because they can efficiently source an appropriate financing solution, while retail customers are increasingly attracted, given the growth in product diversity that can address their credit needs. Specialists' distribution models (which focus on intermediaries) sustain high growth, while the absence of large branch networks provides a cost advantage.

A key concern is that the recently established lenders have not operated over a complete credit cycle. However, we have examined the levels of provisioning of the specialist lenders and find they are prudent and well covered. Furthermore, analysis of asset quality shows 'non-performing loans' are at low levels, indicating that the businesses are high quality. We apply a severe cost-of-risk stress test to determine the impact on the specialist lenders of a sudden deterioration in impairments. The analysis shows that the specialist lenders can withstand such a shock and still deliver attractive return on equity. Reassuringly, such stress would be an earnings issue rather than one with capital, because our stressed estimates show that capital ratios remain above the Bank of England's minimum threshold.

The average net interest margin for the peer group has risen since 2013, benefiting from a reduction in the cost of funding, as the lenders participated in the government's FLS (the Funding for Lending Scheme created by the Bank of England to boost lending to SMEs and recently extended to 2018). The specialist lenders tend to focus on fixed-term deposits for funding and this is unlikely to change. Fixed-term deposits ensure an attractive stable funding base and will support lending growth. Additionally, we believe wholesale funding may represent a future opportunity to lower the cost of funds.

Anthony Da Costa and Stuart Duncan are analysts at Peel Hunt