There’s value in this niche and nimble bank

Bearing this in mind, it is now worth looking seriously again at Paragon Banking (PAG). The lender’s March year-end means its results aren’t due until early June, but its recent updates have underlined some key features that elevate it above the competition.

Today’s Paragon is very much the product of the financial crisis and its aftermath. It suffered a near-death experience when it was unable to access wholesale market funding in 2008, which – in an eerie parallel with Northern Rock – meant it had to arrange a large standby rights issue. Unlike Northern Rock, Paragon ultimately survived, and came to understand that it needed a much broader range of funding and sources of deposits, while concentrating its lending on specialist borrowers.

A good example of this is Paragon’s focus on the UK specialist buy-to-let (BTL) market. Its market share is described by Fitch as “modest” at 4 per cent, although its share of the highly specialist professional BTL market is much higher. This part of the market is deeply dependent on client-lender relationships, which in Fitch’s view helps to keep Paragon’s overall margins higher than its competitors.

Trading on the up

The importance of these relationships is also reflected in redemption numbers. At the end of the first quarter, £204mn-worth of loans were redeemed, equal to an annual rate of 6.4 per cent, compared with over 13.5 per cent at the same point in 2023. In other words, Paragon’s clients are happy to stay with the company after their initial term deals expire, which has not been a trend at other specialist lenders such as OSB (OSB). Here, customers have rushed to refinance, leading to softer-than-expected loan growth and consequent underperformance. OSB’s customer base is also less specialised than Paragon’s, and focuses more generally on borrowers in the south-east of England, rather than a particular market niche.

Operationally, Paragon’s last trading update, which led many analysts to upgrade their forecasts for the year, was illustrative of the group’s model. Deposits rose by 7 per cent in the quarter, leading to year-on-year growth of over 26 per cent. The company used this extra liquidity to make a £400mn repayment of the group's term funding scheme – a pandemic measure that was made available to banks via a lower interest loan from the Bank of England.   

Paragon itself isn’t without uncertainty about the year ahead, particularly over the pipeline that translates into loan advances. In the first quarter, BTL advances were 40 per cent lower at £336mn due to a lower pipeline at the start of the quarter, although the situation had reversed at the end of the period, and climbed to £560mn.

While this is clearly promising, it also underlines just how dynamic and uncertain the lending market is even within a single quarter, although positive enough in Paragon’s case to radically change the outlook for the next period. It will also depend on how the BTL market performs this year. According to the National Residential Landlords Association (NRLA), Paragon has taken steps to expand its loan book.  

Those steps include a reduction in the reference rate from 5.5 to 5 per cent, as well as an extension in the maximum loan term from 25 to 35 years, and a reduction in the minimum years of experience BTL landlords are required to have from three to two. While this may risk more loan defaults, it does show that the company has some operational flexibility to respond to market conditions.  

It also illustrates how operational gearing can work in the context of a bank and that it also requires underlying market growth for its balance sheet to expand. The company’s total lending book currently stands at £15bn, up just 1 per cent in the three months to December and an indication that the BTL market is currently hard going. Paragon’s strategy is to win specialist market share at the expense of its smaller rivals.    

Rates are key

Paragon, like all specialist finance houses, is ultimately dependent on the direction and quantum of interest rates. There are conflicting signals that there will be a rate cut at some point, although pointedly the deadlines keep slipping, which may affect Paragon’s NIM if it fails to manage its cost base effectively.

Luckily, the bank has a good record of keeping its operating costs under control, and Numis forecasts that these will be broadly stable at £179mn this year. The broker currently projects that the NIM will be between 3 per cent and 3.1 per cent, although this could shift if base rates fall.  

The valuation argument is nuanced for Paragon. Valuations across the sector are generally bombed out, with little sign that higher rates and wider NIMs, plus large-scale capital returns, are really tempting investors back into bank shares. This is despite some high-profile asset managers – long-time banking share sceptic and former banking analyst Terry Smith being the most high-profile example – looking seriously at the sector again after a long hiatus.

The main decision, for those inclined, is whether to buy a very cheap share such as Barclays (BARC) – rated at five times earnings for 2024, with buybacks of £10bn supposedly guaranteed over the next three years – against a price/earnings ratio of 7 for Paragon and a dividend yield of around 6 per cent. The key point to remember is that bank earnings are tied to the size of a company’s assets on the balance sheet. The greater the expansion, the greater the flow of earnings.

Since the financial crisis, it has proved next to impossible for large UK banks to significantly expand their balance sheets. In fact, balance sheets have shrunk dramatically – by 70 per cent in some cases – and the age of ever-bigger banks looks to have ended.

However, this is less of a problem for banks further down the pecking order, which have more leeway to expand their balance sheets when conditions allow. In the specialist market, deposit flows and capital ratios are both higher, in Paragon’s case the 14.7 per cent CET1 (common equity tier one) ratio is one of the highest in the sector, which allows a certain flexibility when it comes to expanding the loan book.

In short, investors’ choice is between Paragon’s higher levels of operational gearing, lower cost base and market specialisation, and the larger, cheaper, but essentially static high-street banks. The sheer amount of management effort required to move the needle on any of Lloyds’ (LLOY) key performance measures makes turning a super tanker around simply a matter of planning and operational procedure, by contrast.

Paragon’s small and nimble business model is a good combination in a competitive market and at a price to book value ratio, based on Numis’s estimates, of 0.8 for 2024, there is still value to be had despite the recent rebound in the share price.