Challenger banks remain vulnerable despite successes
Buy-to-let has boosted some post-crisis entrants but reasons for caution persist
Pity the class of post-crisis challenger banks. The final year of the decade was not kind to the likes of Metro Bank and CYBG, now Virgin Money UK.
For a time they seemed poised to capitalise on the taint left by the financial crisis on Britain’s legacy bank brands of Barclays, HSBC, Lloyds and RBS.
Instead, 2019 left Metro with its own capital concerns and the combined Virgin Money-CYBG with a market capitalisation 40 per cent below the companies’ pre-merger levels 17 months earlier.
Other challengers stumbled too. Santander took a €1.5bn writedown on the value of its UK business in September. The supermarkets, no strangers to price wars, conceded defeat in the mortgage market where interest rates for home loans have been under sustained pricing pressure as HSBC and Barclays extended their market share. Tesco Bank sold its mortgage book; Sainsbury’s Bank has stopped new mortgage lending and is in the process of selling its back book too.
The new generation, of Monzo and Revolut, Atom and Tandem, with models built for the branchless age, may yet give the big four UK retail banks a better fight.
But on the public markets, it was a distinctly pre-crisis area of banking that yielded some of 2019’s best challenger banking victories: buy-to-let mortgages.
While net interest margins (a key measure of bank profitability) have been sliding across the high-street banks, specialist lender Paragon Banking Group defied the trend. At rival OneSavings Bank, they were flat, but analysts have found themselves enamoured of its sector-beating return on tangible equity of roughly 25 per cent. Its takeover of rival Charter Court Financial Services, completed in October, has only enhanced their adoration.
“By far the greatest bank the world has ever seen? What more could we have hoped for?,” asked Investec’s Ian Gordon after OneSavings Bank’s latest quarterly results in November.
Both Paragon and OneSavings are products of the government’s post-crisis push to increase competition, even if they are not entirely new to challenger banking. OneSavings was formed out of the Kent Reliance building society after a capital injection by private equity house JC Flowers in 2010; it got its banking licence in 2011.
Buy-to-let booms have fuelled Paragon’s growth before. As the property market collapsed and liquidity evaporated in late 2007 to 2008, banks declined to renew its funding. Collapse was only avoided by a rights issue so deeply discounted that those who did not take up their rights were diluted by 96 per cent. Paragon was granted its licence in 2014.
Supporters of Paragon argue that this time really is different. Tax changes mean the latest buy-to-let boom has already faded, for one thing. Amateur landlords with a property or two are being chased out of the market. In their place are professionals with sizeable portfolios and companies investing in build-to-rent properties.
The sources of funding have also changed, diversifying the risk of another credit crunch. Retail depositors have been lured (much like with the Icelandic banks in 2007-08) by some of the best savings rates on the market. These clock in at a much more prudent 1 to 2 per cent rather than 2008’s 7 per cent rates.
A monoline securitisation-funded buy-to-let mortgage lender in the previous era, Paragon — like OneSavings — is now a fully fledged bank with £6.4bn of retail deposits, and £1.45bn of commercial loans to add to its £10.3bn 2019 mortgage book. The commercial lending book grew 28 per cent in the year to September and retail deposits rose 21 per cent, though the mortgage book shrank slightly. Its share price climbed close to 40 per cent during the year.
Over at OneSavings Bank, loan growth was 15 per cent, and 21 per cent excluding asset sales at newly acquired Charter Court. Shareholders had to make do with a mere 23 per cent increase in the stock.
Reasons for caution in the sector abound, nonetheless. The Bank of England expounded some of them in June, when it warned that unnamed fast-growing lenders may be underestimating the risks to their business models from a downturn. Of the 20 companies the bank reviewed, many counted on ambitious growth to offset rising defaults in old business if the economy faltered. It was over-optimistic to assume significant growth in generally falling markets, the BoE said.
Buy-to-let and small business lending are vulnerable in a downturn. UK-focused banks’ share prices are vulnerable, too, to the domestic political climate. That gave OneSavings a December post-election boost as the Conservative victory eased property price fears, but leaves investors exposed if the Boris bump evaporates as quickly from the housing market as it has from sterling.
Paragon and OneSavings had a good year. But until they have been through another cycle, investors should not underestimate the challenges these challengers face too.