Why banking's smaller players are bulking up

They sought to shake-up the UK’s banking sector and give customers a real choice from the established big four or five players – but now Britain’s ‘challenger’ banks are themselves coalescing into larger entities or being taken over.

The first big consolidation came in June 2015 when TSB, which has 4.5% of the current account market, agreed a £1.7bn takeover by Sabadell, the Spanish lender, barely a year after it had been spun out of Lloyds Banking Group.

After that was the £850m takeover, in June last year, of Shawbrook by a private equity consortium.
Next came the £1.1bn deal, in November last year, that saw Aldermore, one of the UK’s digital-only players, bought by FirstRand of South Africa.
:: Virgin Money receives £1.6bn takeover offer
And now Virgin Money, probably the best-known of the challenger banks, finds itself on the receiving end of a £1.6bn offer from CYBG, the owner of Clydesdale Bank and Yorkshire Bank, prompting speculation that more tie-ups could follow.
The move by CYBG looks pretty cute in terms of its timing.
Sir Richard Branson’s Virgin Group, which owns 35% of Virgin Money, has been rumoured for a while to be a willing seller of its shareholding.
The big four – RBS/NatWest, Barclays, HSBC UK and Lloyds – would be prohibited from buying Virgin Money, as would the fifth-largest player, Santander UK.

Image: Challenger bank TSB has been mired in IT problems
That left as the likeliest buyer either a foreign bank or one of the three other ‘full service’ big challenger banks of comparable size – CYBG, TSB and Metro Bank.
TSB is currently pre-occupied with sorting out the recent problems with its IT systems, while Metro Bank is currently absorbing a £500m book of mortgages recently acquired from the private equity firm Cerberus, which has left some in the City speculating that it will need to raise fresh equity this year.
Accordingly, this was a good time for CYBG to pounce.
But why is consolidation in the air?
One reason is that, despite the explosion of new arrivals in the banking world in recent years, the barriers to entry remain incredibly high for any competitor to really make inroads.
The big four have around three in every four current accounts while, in business banking, they account for four in every five accounts.
Accordingly, there is pressure to come together, to build scale more quickly.
Another factor has been the rising cost of regulation and of doing business generally.
Andy Golding, chief executive of OneSavings, another of the UK’s challenger banks, recently suggested the new General Data Protection Regulations (GDPR), due to be introduced later this month, were like “an open heart surgery project” for a bank the size of his.

Rules requiring all banks to hold a certain amount of capital against products like mortgages also benefit the big four to five incumbents, who have years of data and customer information to back their lending decisions, while disproportionately affecting the challenger banks.

Image: The owner of Clydesdale Bank appears to have timed its offer for Virgin Money well
Then there are the rising costs of maintaining a branch network.
Higher staffing costs and increases in business rates mean that, for challengers who have branches, their overheads are, by definition, higher than the crop of digital-only challengers to have emerged in recent years.
However, they also hobble the ability of such banks to compete against the big incumbents, who have been able to take an axe to costs, via branch closures, more quickly.
Also potentially spurring consolidation is the fact that the wider economy is less encouraging.
The Bank of England’s Term Funding Scheme – an emergency measure to help encourage banks to continue lending following the Brexit vote – and the older Funding for Lending scheme, put in place by the former Chancellor George Osborne, have now come to an end.
Those schemes were a considerable support to the challenger banks and, without them, lenders are far more dependent on either the wholesale markets or on attracting deposits from savers to help fund their future lending.
That is harder for the smaller challenger banks than it is for the big four or five.
Meanwhile, in some product areas such as mortgages, the incumbents are flexing their muscles.
And not just the incumbents: the recent price war in personal loans was triggered largely by the banking arms of the big UK supermarkets.
Another factor is the weaker pound.
This enabled Sabadell to buy TSB and FirstRand to buy Aldermore, as well as allowing Singapore’s sovereign wealth fund to take a stake cheaply in OakNorth, another digital-only lender.
Lastly, there are valuations.
All banks are, effectively, a geared play on the economy in which they operate and, as prospects for the UK economy have deteriorated, so have the valuations of banking stocks.
That is why CYBG feels it can get away with offering just slightly over Virgin Money’s book value when, in the not-too-distant past, shares of Virgin Money and other challengers have traded at substantial premiums to their book value.