What is the future of challenger banks?

Big Red v blue boxing gloves with big red having the advantage, on white background

Post-Brexit uncertainty stalks the banking sector but will the challengers or the legacy lenders steal share?

Britain’s bank shares were battered by the UK’s Brexit vote, with challenger brands worst hit, but despite initial market reaction, some analysts believe that the newcomers are better placed to prosper in the years ahead.

The challengers may lack the international earnings of their high-street competitors and are more dependent on a healthy UK economy, but on the other hand they are nimble and can harness new technology without the drag on momentum posed by the legacy systems of older lenders.

A week after the referendum result, Reuters calculated that the shares of Aldermore Bank, OneSavings Bank, Shawbrook Bank and Virgin Money had fallen by 37 per cent on average, compared to a fall of 21 per cent for Britain’s four largest banks during the same period.

However, challenger banks and specialist lenders  had a strong 2015. They grew their gross lending by 56 per cent last year, according to the Council of Mortgage Lenders. The growth gave the sector a 2.9 per cent increase in market share. Banks grew their gross lending by 4 per cent and building societies by 9 per cent. Aldermore recently reported profit before tax of £59m for the first half of 2016, up 50 per cent from the previous year’s £40m.

Shawbrook Bank deputy CEO and managing director of property finance Stephen Johnson says: “UK-focused banking and house building stocks are invariably hit by a slowdown in the UK economy but if there were a big economic downturn I’m not sure that challengers would fare any worse than the major banks. Generally, specialist banks are better capitalised than larger ones and we are closer to our customers and so better positioned to deliver a more focused and sustainable service proposition.”

Johnson argues that Brexit will give challenger banks opportunities because a lower interest-rate environment will put more pressure on the big banks’ revenues. The major players have much bigger backbooks of low-cost trackers and will have to focus on cutting costs, so this will mean poorer service for their customers. Their risk appetite could also shrink if they become fearful of the economy.

PwC reported in July that nine of its 10 challenger clients that had been planning to set up a new financial services firm before the June referendum were still committed.

Meanwhile, research into UK challenger banks produced by Citigroup only five weeks before the referendum indicated that the challengers looked resilient.

Citigroup stated: “With fewer regulatory headwinds, little legacy conduct risk, superior promoter scores, a lack of inefficient legacy systems, more optimum branch networks and stronger volume growth, we prefer the challenger banks sector to the incumbent large-cap domestic UK banks.”

Citigroup acknowledged the EU referendum as a key risk for the challenger banks but forecasted average income growth for the sector of around 20 per cent per annum for the next three years, highlighting, among other things: low overhead costs due to the majority of their products being distributed via intermediaries; experienced management teams; strong capitalisation; and low loan losses, because loans have been originated in a tougher regulatory environment since 2008.

Niche successes
Among the specialist niche players there are plenty of examples of impressive progress being made in areas that the major high-street banks have turned their backs on in pursuit of high-volume and easy-to-administer business.

Magellan Homeloans – which points out that, because it is not in fact a bank, the term ‘challenger’ is more appropriate – reports that its monthly lending volume is five times what it was only a year ago.

Specialising in impaired credit lending and complex prime, it entered the mortgage market in mid-2013 offering an alternative to the ‘Computer says no’ approach by using a skilled underwriter to understand the borrower’s requirements in great detail.

Magellan Homeloans managing director for lending Simon Read says: “We spend a lot of time gathering information to prove the credit rating of a borrower and, on the impaired credit side, a lot of our borrowers would fail the credit scoring systems of the major players.

“A lot of businesses had to close between 2008 and 2010 because of the credit crunch but we realise that was a one-off, which there was not much they could do about, and they will be all the more determined not to let it happen again.”

Read also highlights Magellan’s greater willingness to lend to borrowers up to the age of 75 for residential loans as something that sets apart the firm from larger lenders, pointing out that the high-street banks normally require pension income for those going beyond age 65. It assesses whether a potential borrower’s employer is likely to permit them to work beyond state retirement age, and it considers options that other lenders may disregard. For example, it may point to the possibility of downsizing from five bedrooms to three when the borrower’s children have left home.

Aldermore Bank is not short of admirers in the intermediary space, having entered the UK mortgage market in 2009. It focuses on buy-to-let and first-time buyers and, like Magellan, scores highly with regard to older customers.

Highclere Financial Services director Alan Lakey says: “Aldermore fills a very valuable niche in the market. Most lenders put a 70 or 75 age limit on buy-to-let, which, although a mortgage, is actually an investment. Aldermore has an age limit of 85 and operates in a far more sensible manner.”

Shawbrook Bank, which specialises in professional buy-to-let and second-tier mortgages, wrote its first loan in April 2011. By the end of 2015 the property finance element of the balance sheet was £2.1bn. Similarly, Fleet Mortgages, a buy-to-let specialist that entered the market in January 2015, already has £520m of loans under management and hopes to do £1bn next year. It has never had an arrears case.

Prime competition
It is debatable, however, whether the term ‘challenger’ is appropriate for organisations that are not seeking to rival the major players.

Fleet Mortgages chief executive Bob Young says: “I am challenging other challenger banks but not the big players. The likes of Lloyds, Santander and RBS have physically too much firepower and would grind us down.”

Perhaps more worthy of the title are challengers with branch networks competing with the major banks in the prime residential mortgage market. Prominent among them is Metro Bank, which increased its book for mortgages and other loans by 125 per cent to £4.1bn over the year to 31 March 2016.

Having entered the mortgage market in 2012 and dealt with intermediaries on a nationwide basis since November 2014, Metro Bank is mainly focused on London and the South-east for direct business. But by 2020 it expects to have inc­reased its store numbers from its current 42 to 110 and to be covering the bulk of the country. As well as manually under­writing every appli­cation, it focuses heavily on customer service and convenience, with banking and mortgages available seven days a week on the direct side.

Metro Bank head of mortgage distribution Charles Morley acknowledges that demand for mortgages is not as high at weekends as on Mondays to Fridays but points out that a lot of people view properties on Saturdays and Sundays and want to get an idea of potential mortgage costs. The bank is famed for welcoming dogs to its stores, which provide water and biscuit bowls. It also provides lollipops for children.

Morley says: “We have plans to be a top 10 lender for prime mortgages from a new-business point of view but no specific timescale has been set. We would not rule out challenging the major six lenders on new business in the future but it’s not a current objective. The most important thing is to maintain customer service as we grow.”

Criticism of Metro Bank is conspicuously scarce and even other challengers are happy to sing its praises. Magellan’s Read, who has moved his savings and current account to Metro Bank mainly because it is open late and at weekends, says: “Virtually every other industry copes with being open at weekends, so why not the banks? It’s about meeting customer requirements and someone like me is busy during the week.”

Lakey, however, disagrees with popular opinion and calls Metro Bank “really weird”. When applying for an agency agreement he was not impressed at being asked how he abided by Financial Conduct Authority rules.

He says: “I took the view that any lender asking such unnecessary questions was not worth working with because I assumed it might take a similar approach towards my own clients.”

TSB, which split from Lloyds in 2013 and started from scratch in the intermediary market in January 2015, is also hanging its hat on its service proposition, pledging that all calls to relationship managers will be returned the same day. By the end of 2015 it was already claiming to be the eighth-largest player in the intermediary market for new business, but it does not expect ever to overtake any of the big players in this respect.

TSB mortgage distribution director Roland McCormack insists that “it’s not about market share” and says that the bank’s principal objective is to be trusted by intermediaries.

TSB is seeking emotional engagement, he says, adding: “The big banks are far too removed from the ground and are not in touch with what customers and brokers want. The number one complaint from brokers we talk to is that business development managers from other banks do not return phonecalls. This is partly the result of attitude but also they do not have time as they are typically looking after 500 firms. But our BDMs have a maximum of 100 firms.”

McCormack also reports that the second-biggest complaint from brokers in relation to high-street banks is about the lack of access to underwriters, with brokers having instead to use a call centre or third party. Around 20 per cent of TSB applications are sent to underwriters and in all these cases the broker is able to phone the underwriter directly.

Handelsbanken, which also differentiates itself on service but does only limited intermediary business through local branch relationships, has been another success story in the prime mortgage market, increasing its household lending by over 500 per cent to £4.81bn between 2008 and 2015. But again, it has no fixed targets.

A UK-based Handelsbanken spokesperson says: “We are not looking for volume and will simply grow to meet the demand that we find.”

Hard-to-rival market share
Even if any challengers active in the prime residential market had stated objectives of rivalling the major banks for new business, they would have their work cut out to achieve it soon. The most recent CML gross lending data, for 2015, shows Lloyds Banking Group to have the largest market share at 17.5 per cent, followed by Nationwide BS at 13.9 per cent, Santander at 11.9 per cent, RBS at 11.2 per cent and Barclays at 8.6 per cent.

Virgin Money, the largest of the banks commonly deemed challengers, was in eighth place with a 3.4 per cent market share, while One­Savings Bank, TSB and Aldermore had between 0.6 per cent and 2.2 per cent.

But John Charcol senior technical director Ray Boulger thinks some of the bigger brand names could close the gap over the longer term.

He says: “It’s certainly a possibility that Virgin, TSB and Tesco could catch up with some major lenders on new-business volumes, but they will not manage it in much less than 10 years. It would be hard for them to increase lending by more than 20 per cent a year but I feel they could increase it by a bigger percentage than the market as a whole, whereas the very big players are likely to grow more in line with the market.”

Magellan’s Read does not envisage any of the newer challengers overtaking the major high-street banks in terms of new mortgage business unless consumer behaviour changes dramatically.

He says: “The high-street banks will continue to dominate the prime end of the mortgage market because they have the cheapest source of funds and can offer the best interest rates.

“But if you look forward 30 or 40 years, everything may be online in some shape or form and, as the high-street advantage will therefore be diluted, it will be easier for challengers to compete.

“But do not expect the high-street banks to take it lying down. When they see market share move they will change, because that’s what they’ve always done.”

Impact on major lenders?
Making a major grab for market share is not the only way to compete with the major banks, however. Some commentators believe the challengers have already put enough pressure on high-street lenders to jolt them out of their comfort zones.

London & Country Mortgages associate director of communications David Hollingworth recalls that, when the market contracted during the credit crunch and a lot of consolidation followed, the challenger banks provided sufficient competition from around 2009 onwards to ensure that the established players improved their offerings.

In today’s setting, therefore, he thinks Tesco, TSB and Virgin’s core products with good service and decent rates will force the big lenders to reassess their approach.

He says: “Santander has improved its service proposition and so has Barclays, while Halifax, which always had a good reputation on service, has occasionally been offering table-topping rates, which were not associated with it previously. These bigger challengers, unlike Metro and Aldermore, are still using largely computerised approaches for volume business but they have without doubt been beneficial.”

Additionally, challengers have influenced the major banks through innovation. Last September, for example, Metro Bank introduced a rate-switching portal for intermediaries, which other lenders have begun to imitate. This enables customers to choose from the entire range of Metro Bank products, while the intermediary can switch them quickly and earn a proc fee.

More replication by major lenders is likely once Atom Bank makes its imminent entry to the retail mortgage market. Atom plans to offer a high-tech proposition via a customer app, providing self-service, biometric registration and login, transparency and control of finances.

Atom, the UK’s first fully licensed digital-only bank, reports that it has raised all the capital required to start lending, that its customer app will be fully live in the next few weeks and that its mortgage sales and originations platform is in the final stages of user acceptance testing.

Atom Bank director of retail mortgages Maria Harris says: “We will be a mainstream lender but will be using our technology and automation to do the simple stuff really well.

“Our blend of technology and people means we can support areas of the market that are not always well served, such as shared ownership, the self-employed, contractors and lending into retirement.

“Our ambition is to be a true challenger and to change the world of banking for the better, permanently.”

However much the high-street banks may want to follow suit, nevertheless their progress is likely to be impeded by their legacy systems. Atom Bank and other recent challengers – along with those to come – have the advantage of being able to build their full customer journey from scratch, which is something that even Brexit cannot take away from them.

Invaluable challenger banks are here to stay


Brian Murphy
Head of lending
Mortgage Advice Bureau

At MAB we deal with a broad market, incorporating those that may be categorised as challenger banks, such as Aldermore, Metro Bank, OneSavings Bank and Precise Mortgages. In addition, other specialist mortgage brands such as Bluestone, Magellan and Pepper assist underserved sectors.

The common focus of all of them is that they do not take a one-size-fits-all approach, trying instead to understand the individual customer’s bigger picture. They have the ability to examine complex personal incomes and company accounts to determine where the income sits, as well as consider different individual circumstances.

Furthermore, they are able to change and adapt quite quickly. Being new businesses, they are fleet of foot and, if they decide to embark on a policy change, it is often implemented quickly and to maximum benefit.

They listen to broker feedback all the time and this ongoing dialogue ensures that they can promptly respond to both broker and consumer needs.

So what could the challengers do to improve? There are areas of the market in which some of them currently choose not to play, such as shared ownership. This sector is also not served well by some of the high-street brands but represents growing consumer demand and an evolving market that can offer relatively low-risk yet good-margin business for lenders. Diversification into these evolving sectors could be a way for challengers to drive more volume and set themselves apart from their high-street counterparts.

A good example of this is the move by Aldermore and Precise into the Help to Buy arena. Some may argue that this is ‘niche’ but in effect it is just homebuyers buying new-build property, albeit with an equity loan. What these organisations have done is observe where consumer demand is growing and evolve their processes and systems, along with their ‘can do’ approach, to gain traction among brokers in order to take on the high-street brands and provide a competitive product that customers are actively seeking.

The challenger bank and specialist lender sector has grown significantly in recent years and several new players are due to come to market in the next few months, all of which have aspirations and intentions to fulfil existing underserved areas and also challenge high-street lenders for market share in some of the more niche areas of mainstream business. This makes it an exciting time for the industry.

Competition is always a healthy thing because, ultimately, it provides the customer with more options. So I am pleased that challenger banks are here to stay; they provide an invaluable part of the lending ecosystem and increasingly meet the needs of a much more diverse customer base.