UK Challenger Banks Head for a Reckoning After Metro’s Troubles

Metro Bank Holdings Plc’s glitzy branches made it the poster child for the UK’s smaller banks. Its current problems, which culminated in a rescue deal over the weekend, highlight just some of the difficulties facing challengers in a market long dominated by far bigger rivals.

(Bloomberg) — Metro Bank Holdings Plc’s glitzy branches made it the poster child for the UK’s smaller banks. Its current problems, which culminated in a rescue deal over the weekend, highlight just some of the difficulties facing challengers in a market long dominated by far bigger rivals.

By setting out to grab market share from Britain’s main retail banks — Lloyds Banking Group Plc, HSBC Holdings Plc, NatWest Group Plc and Barclays Plc — many mid-sized lenders have built a customer base but struggled to convince investors that their growth plans are worthwhile.

Low valuations, together with an industrywide battle for deposits, are expected to eventually lead to more consolidation in the sector. 

Lack of Growth 

“Challenger bank” has come to mean any banking provider outside the big four whose dominance was entrenched by a wave of mergers and closures in the 2008 financial crisis. The likes of Virgin Money UK Plc and Vanquis Banking Group Plc can trace their roots back over a century, while digital challengers Starling Bank and Monzo didn’t exist a decade ago. 

Smaller players have started to erode the position of the biggest lenders in the past few years, according to the Financial Conduct Authority. Innovative digital services and consumers’ growing enthusiasm for switching helped to knock the market share of the biggest four lenders down from 68% to 64% of current accounts in the four years through 2021, it said in a review last year. 

But that trend benefited digital startups more than mid-tier challengers and now, a mix of higher interest rates, capital requirements and a perceived bigger credit risk has driven up funding costs, making it harder for them to compete with incumbents.  

Specialists such as mortgage lenders OSB Group Plc and Paragon Banking Group Plc successfully carved out their niche when big banks had to retreat from riskier lending in the wake of the financial crisis. Yet “there just isn’t a story here that sets the pulse racing,” said Robert Sage, an analyst at Peel Hunt.  

Some investors are also concerned that the UK’s economic downturn might bring a wave of loan defaults, though it hasn’t materialized so far. “Credit risk is as benign as you could hope, but it’s only going one way from here,” Sage said. 

Idiosyncratic Issues

Then there’s a wide range of issues that are specific to certain banks. 

Metro Bank launched in 2010 as the UK’s first new high-street bank in over a century. While it’s built a network of more than 75 branches, it’s lost money for the past four years, and its shares have struggled since it published incorrect information on its risk-weighted assets in 2018. 

Investor confidence was hit again in the past month when Metro said it was uncertain when regulators would grant a long-sought approval to use internal risk models for residential mortgages. The setback ultimately led to last weekend’s financing deal with investors. 

Read More: Banker Planned Metro Bank Rescue From Miami’s Billionaire Bunker

The riskier, under-pressure bonds of some smaller British lenders continued their recent decline even after Metro Bank’s rescue, as its travails highlighted the scale of the challenge of taking on large peers who face fewer capital constraints.

Paragon, whose 10-year bonds have traded at record lows this month, has been trying to get a nod on using its own internal risk-models for years. In July, it said final preparations for its updated submissions to the Bank of England’s Prudential Regulation Authority were underway, following “extensive feedback” from the watchdog.

However, nearly every observer sees Metro Bank’s emergency capital raise as a result of its own missteps. The rescue has no implications for UK lenders, S&P Global Ratings wrote on Monday, adding both the large and small banks it rates have “more stable business models and more robust capital and earnings” than Metro. 

Virgin Money, the largest of the challenger lenders, managed to raise £300 million ($368 million) of regulatory capital in August, in a process that was oversubscribed several times over. 

Read More: Riskier Bonds of UK Challenger Banks Dip on Metro Bank Travails

Vanquis, meanwhile, slumped to the lowest level in over 30 years this summer after higher costs and provisions pushed it to a loss. The former FTSE 100 firm, which dropped the Provident brand when it closed its door-to-door lender, is buying Snoop — a money-saving app started by challenger bank veteran Jayne-Anne Gadhia — to expand its business into customer budgeting.

Read More: Vanquis Chairman Snowball to Exit as Share Price Languishes

Co-Op Bank went through several restructurings after discovering a £1.5 billion hole in its balance sheet in 2013. The former co-operative is now owned by a group of hedge funds — and could be at the vanguard of a consolidation round that the industry has been predicting for years. 

Alternative Routes 

Higher interest rates have dried up cheap funding, but the shift has made banks offering current accounts, which typically pay no interest, an attractive source of capital for specialist lenders. Co-Op Bank is currently in a sale process that has attracted that cohort of banks, according to media reports.  

Global banks seeking to grow in the UK could also be among challengers’ potential suitors. Past examples include TSB Banking Group’s £1.7 billion acquisition by Spain’s Banco de Sabadell SA in 2015. 

About two years later, South Africa’s biggest lender, FirstRand Ltd., bought London-based challenger Aldermore. The move helped expand FirstRand’s offshore funding and cut its dependence on the South African government’s credit rating at the time. 

Buyout firms are sure to be in the mix as well. Shawbrook, a specialist lender founded in 2011, was acquired by BC Partners and Pollen Street Capital in 2017. Its owners are considering a tie-up with Co-Op Bank, the Telegraph reported in August. Takeover talks between Carlyle Group Inc. and Metro Bank fell apart in 2021. 

For challengers that are traded on the stock market, abandoning their public status could “cut costs related to the listing and some compliance costs,” said Barclays analyst Grace Dargan. 

Still, lenders would still face the same regulatory hurdles as well as competitive pressures from both incumbent lenders and digital-only banks such as Monzo and Starling. 

Going private “isn’t a panacea,” Dargan said.  

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