Cautionary tales for challenger banks

The question of competition in UK banking services is a hot topic on the face of it there is any number of fintech’s, service providers and would-be challengers looking to carve out a niche for themselves in a market that is dominated by the big four institutions.

We regularly see updates and news stories about how well the newcomers are growing and how many new accounts and users they are picking up. In reality, though they have barely scratched the surface and face an uphill struggle to make further progress and perhaps an even bigger one to become consistently profitable.

To get an insight into the challenges and obstacles that startups face in the challenger banks sector we need look no further than the second and third tiers of UK banking and the experiences institutions within those. Take the Co-operative or Co-op bank hardly a newcomer it was established 145 years ago but in recent times it has struggled to carve out a niche for itself or a least one that is profitable.

Co-op bank was an early adopter of socially aware and ethical policies which it’s put in to practice for the last 25 years. In theory at least that ethical stance should have made the bank popular with an audience of increasingly ESG aware investors and savers which turn should have helped the bank grow in scale and profitability and yet that hasn’t been the case.

In fact, rather than expanding the Co-op bank has had to close branches make staff redundant and was ultimately forced to hoist a for sale sign over its head earlier this year. The only suitor forthcoming for the Co-op bank was the US hedge fund Cerberus named after the multiheaded dog which guarded the gates of hell in Greek mythology. The FT reported yesterday that talks between Cerberus and the Co-op bank had concluded without the fund, which already owns 5% of German lender Commerzbank, being able to agree on terms.

UK supermarket Sainsbury decided to shutter Sainsbury’s bank earlier in 2020 and is said to be open to offers on its mortgage book that follows a similar move by rivals Tesco in 2019 who sold its book of mortgages to Lloyds Banking one of the largest UK’s mortgage lenders for £3.8 billion.

Perhaps the most cautionary tale from the sector is that of Metro Bank famous for bucking the trend of branch closures and instead boldly setting up shop on high streets across the UK.

However, behind the slick marketing machine and feel good PR stories Metro bank had made a massive error by buying and then miss-valuing a substantial book of mortgages which it acquired because it hadn’t been able to attract enough UK borrowers to its mortgage products implying that it had been muscled out by the UK’s big four banking brands.

Once Metro Bank realised its mistake it was forced to raise money from shareholders to shore up its balance sheet and sell off portions of its mortgage book that it could no longer afford to own and probably never could because it didn’t have the necessary collateral. Metro bank sold another £3.0 billion worth of Mortgages to NatWest group last week.

UK investment bank Liberum published a 150-page research note on UK challenger banks and specialist lenders last week as it took up converge of the sector its pick of the 5 listed UK challenger banks are One Savings Bank or OSB which Liberum views as the most profitable of the banks under its coverage and which it believes is worth £5.35 per share compared to the current price of £4.11. It rates the stock as a buy. As to Metro Bank Liberum say they can find no investment case and believe that the troubled lender may need to raise new money in 2021/22.

Those challenger banks and fintech’s in the lower tiers of UK banking should look at these cautionary tales and consider whether aiming for the big time is the right strategy or whether a niche position might be more tenable and more profitable over the longer term.