Can challenger banks really take on the Big Five?

Can challenger banks really take on the Big Five?Challenger banks are a growing force in the financial services industry. They’ve significantly outperformed their larger rivals in terms of return on equity (ROE) over the last year – and the smaller the bank, the bigger the growth.


The latest KPMG annual report showed smaller challengers, such as Metro, OneSavings and Shawbrook, generated 17 per cent ROE in 2015, rising from 15.8 per cent the previous year.


Virgin Money, TSB and other larger challenger banks saw ROE jump from 8.8 to 9.5 per cent between 2014 and 2015. Meanwhile, the Big Five (RBS, Lloyds, Santander, HSBC and Barclays) produced returns of 4.6 per cent last year.


While these institutions enjoyed double the ROE from 2014, their gains were less than half that achieved across large challenger banks and over 70 per cent lower than smaller challengers. So how are these newer businesses gaining such a competitive edge in the market?

The lure of challenger banks

Challenger banks continue to carve out opportunities within the retail-banking sector. Pre-tax profits rose £194 million across challengers last year, while the Big Five reported losses of £5.6 billion.


One of the key benefits that have enabled newer market entrants to remain profitable is a simplified business model with less complex product sets, especially across niche lending categories.


As a result of these offerings, smaller institutions have reduced costs as a percentage of income from 52.1 to 48.5 per cent. Challengers overall are also providing more lucrative savings rates for customers, albeit at greater risks to themselves.


KPMG highlighted several other key reasons why challengers are outperforming the Big Five:

  • Simpler IT systems
  • Fewer legacy compliance problems
  • Better automation and streamlined processes
  • Cheaper real estate
  • Minor regulatory changes

A fairly new addition to the challenger landscape is digitally focused firms, which could gain market share by providing greater personalisation, transparency and data-driven services.


“If these new kids can successfully combat customer inertia, at scale they could blow the incumbents out of the water,” said Warren Mead, global head of fintech at KPMG.

Levelling the playing field

While the future may look rosy for up and coming banks, they still face various hurdles before they can take on the Big Five. For example, the bosses of eight challenger banks recently wrote to the competition watchdog to complain that current regulations give well-established institutions a significant advantage.


Barclays, RBS, HSBC and Lloyds already enjoy a 77 per cent share of UK current accounts, and a recent Competition and Markets Authority (CMA) investigation was designed to assess ways to level the playing field.


“New entrants into a market are an important source of competition and innovation, and we are well aware of the current barriers to challenger banks in UK retail banking,” said Alasdair Smith, chair of the retail banking investigation, in his report.


“What’s really holding them back is their ability to highlight to customers how new offerings compare with their current deal.”


However, challenger bank leaders hit out at the CMA’s initial findings as “naïve” in a letter to Mr Smith. They argued that their institutions face higher costs of funding and disproportionate capital requirements. According to the signatories, challengers have to set aside ten times more capital despite taking on the same credit risks as the biggest six banks.


Meanwhile, regulatory changes in the buy-to-let sector, which accounts for approximately 15 per cent of challengers’ balance sheets, place increased pressure on revenues. Amendments include the loss of the ‘wear and tear’ allowance, higher stamp duties on second homes and new restrictions on interest tax deductions for specific investors.

Recruitment within challenger banks

Newer banks face a range of opportunities and challenges. Their size and flexibility enable them to adapt more quickly to changing market conditions, but they are often more vulnerable to regulatory shifts and capital burdens.


Nevertheless, established banks are scaling back across various core areas of their business, and alternative finance providers are moving quickly to occupy these spaces.


Our research shows that high growth in the segment, combined with the risks that challengers must overcome, has led to more of these institutions recruiting across corporate governance departments.


Specifically, Barclay Simpson has noted an increase in risk management, cybersecurity, compliance and in-house legal roles. As challenger banks enhance their market share, we can expect the demand for greater corporate governance capabilities within their operations to rise even further.


These institutions require qualified and experienced people who can not only guide the business through the regulatory landscape but also contribute to innovation and strategic planning.


Challenger banks may not quite have the sway to break the dominance of the Big Five, but if they continue to expand their influence, corporate governance professionals may consider emerging firms an increasingly attractive prospect.


Our 2016 Market Reports combine our reviews of the prevailing conditions in the corporate governance market together with the results of our latest employer surveys.


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