RAYMOND HURLEY - DEALS M&A
17 NOVEMBER 2016
Challenges for the Challenger Banks How many is too many?
The next wave of UK banking M&A “Being a bank director is like being a pilot of an aircraft: it’s years of boredom and seconds of terror” That quote from a US banker may have crossed the minds of the directors of Tesco Bank following the recent ‘unprecedented’ fraud perpetrated against it. Tesco Bank is one of a cluster of smaller and mid-sized UK banks referred to as the ‘Challenger’ banks. In the noisy court of public opinion, they are generally viewed as less tainted than their larger peers in the post financial crisis era. Much heralded as an important corrective to the dominance of the ‘Too Big to Fail’ UK banks (also known as the Big Five), many Challenger banks have been capitalising on the ‘trust agenda’ which the large established lenders had signally lost. There was a time when the imposing bank vault loomed large in a customer’s trust calculus – bigger banks have stronger vaults. In light of Tesco Bank’s recent cyber fraud attack, customers may now surmise that the same applies to virtual vaults – bigger banks should have capacity to invest in better cyber security. Is this just the latest example of the limitations inherent in the business models of smaller scale Challenger banks?
Faster growth
Challenger bank gross lending grew by 56 per cent in 2015 (Source: CML)
Higher returns
Larger Challengers’ 2015 RoE averaged 9.5%, smaller Challengers: 17%, and the Big 5: 4.6% (Source: KPMG)
Market focus
UK Challengers dominate new SME lending outside London and in the BTL segment (Source: Avention)
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CHALLENGES FOR THE CHALLENGER BANKS
RAYMOND HURLEY
17 NOVEMBER 2016
Storm clouds on the horizon Away from Tesco Bank’s headline inducing misfortunes, the market prognosis for the UK Challenger bank sector has on balance been positive Observers however point to several post Brexit challenges that suggest darkening clouds on the horizon. At the heart of those challenges is the issue of scale.
• Cost of funding pressures abound – this year’s
The Challenger banks are not a homogenous group. There are the larger Challengers such as Clydesdale & Yorkshire (CYBG), Virgin Money (VM) and TSB and the smaller Challengers such as Metro Bank, OneSavings Bank (OSB), Aldermore and Secure Trust Bank. And true to form, new digital Challengers such as Atom, Mondo, Starling and Tandem will disrupt Challenger bank business models that may have appeared innovative a few short years ago.
• Buy-to-let (BTL) lenders, a segment that
structural decline in the UK’s interest rate outlook will squeeze margins further and negate the Challengers’ deposit gathering incentives that are centred on ‘best buy’ tables. While the BoE’s Term Funding Scheme offers some respite, in the case of some lenders the net effect may simply be to offset the withdrawal of the BoE’s Funding for Lending Scheme when it expires in 2018.
several of the Challengers are particularly weighted in, are caught in the pincer effect of adverse tax changes for BTL landlords and potentially higher regulatory capital intensity from Basel III risk weight adjustments to BTL portfolios. Add to that concerns about a slowdown in mortgage lending (CML data since Brexit referendum contains mixed messages) and it’s starting to look like a perfect storm for the Challengers.
Each of the Challenger’s strategies emphasise differentiation, whether in their ‘unique’ customer experience, specific customer demographic or specialised product offerings. So far this has resonated with their customers and delivered commensurate financial results for most players. But among the darkening clouds for the sector are the types of challenges that only greater scale and a bigger balance sheet can alleviate or better absorb:
“Challenges that only greater scale and a bigger balance sheet can alleviate or better absorb”
• Interest yields are declining as higher rate
post crisis lending vintages are being refinanced at tighter pricing or being replaced by lower yielding new loans. This phenomenon is disproportionately impacting smaller and mid-sized banks
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CHALLENGES FOR THE CHALLENGER BANKS
RAYMOND HURLEY
17 NOVEMBER 2016
platforms of the larger Challengers CYBG, TSB and to a lesser extent VM.
Scale up or get out Constraining overhead growth relative to income growth is more feasible for larger institutions
The inverse correlation between the CTI ratio and higher return on equity and price-to-book metrics is not coincidental. Shareholders in the larger Challengers will expect ever increasing cost efficiency, particularly while the revenue growth outlook remains uncertain. So how are
In his book ‘Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase’, author Duff McDonald opined “When you're in a commodity business, the only way to thrive is to be a lowcost producer. And when you're selling money, you're in a commodity business.”
“When you're in a commodity business, the only way to thrive is to be a low-cost producer” the Challengers to square the circle of continuing to invest in the digital customer experience, in ultra-secure ‘virtual vaults’ (cyber security measures) and in ever more complex regulatory compliance tools, while simultaneously containing growth in overhead spend? The only viable route to achieving and sustaining such efficiencies is through scale and therefore M&A.
The variability in the cost-to-income (CTI) ratio across a selection of the Challengers is reflective of their different business models and segment focus. While not an immediately relevant metric in the case of Metro Bank as it continues to invest heavily in market share acquisition, the sub 50% level being achieved by specialist lenders such as Aldermore and OSB stands in contrast with the more expensive operating
WHY SIZE MATTERS…
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THE NEED FOR SCALE
SHIFT IN REGULATION
SHAREHOLDER STORY
In a low interest world, optimising the CTI ratio while sustaining digital and cyber security investments requires scale
Basel III shift towards higher risk weightings on BTL portfolios favours larger and more diversified balance sheets
Challengers’ valuation premium is dependent on maintaining ROE out-performance. Meanwhile some major PE backers want out
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CHALLENGES FOR THE CHALLENGER BANKS
RAYMOND HURLEY
17 NOVEMBER 2016
UK banking M&A 2017 The deals that might unfold next year In their letter to the Chairman of the Treasury Select Committee earlier this summer, the CEOs of seven of the UK Challenger banks observed that “If the pool of opportunity available to the smaller banks becomes too crowded, the Challengers will become the challenged.” Or as Dick Rosenberg, former CEO of Bank of America, put it over 20 years ago in relation to the US banking market, “there are just too many banks in this country chasing too few customers.” Perversely, instead of becoming counterweights to the dominance of the UK’s Big Five banks, the Challengers risk competing with and cannabilising each other rather than the established order.
expectations are rumoured to have fallen from £1.3bn to £850m? VM might be sufficiently attracted by the deposit base on offer, even if W&G’s geographic footprint isn’t ideally aligned with VM’s market strategy. RBS and the UK Government will enthusiastically welcome any new approaches that would inject some competitive intensity into the sale process. The operational complexity of the proposed disposal has seen RBS take a £345m write-down this year on its investment in the standalone IT platform for the business and could yet result in an EU penalty for failure to complete the disposal in the prescribed timeframe.
So how might a Challenger bank consolidation play out? Who will set the ball rolling by completing the first deal? CYBG is the latest contender to have a go at acquiring RBS’ Williams & Glyn business, while Santander seems to be back for its third attempt. Might Sabadell/TSB muscle-in also given that pricing
“If the pool of opportunity available to the smaller banks becomes too crowded, the Challengers will become the challenged”
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CHALLENGES FOR THE CHALLENGER BANKS
RAYMOND HURLEY
Among other UK banking deals that we can expect to see unfold over the next 12 months is the Government’s disposal of some or all of the legacy £16bn Bradford & Bingley mortgage portfolio, as well as smaller scale disposals of non-core assets by the Cooperative Bank. The major loan buyout houses could have a funding advantage over the Challengers in competing for the assets, although VM may be well positioned to leverage favourable investor sentiment in the capital markets to secure acquisition funding at the right price. Investor confidence is high following VM’s successive impressive financial results and their proven portfolio acquisition capability.
17 NOVEMBER 2016
shareholders want underwriting risk, there are plenty of listed banks to invest in, or better still, loan buyout funds. The logic of scale must surely dictate that the smaller Challengers will
also be consolidated in due course, particularly given overlapping geographic and product strategies in certain cases. The original private equity backers who brought a number of them to IPO in recent years, continue to hold significant stakes in those banks which they will want to exit as the lifecycles of the relevant funds reach maturity. Most have been posting strong financial results through recent consecutive reporting periods - marketing these assets while their financial track record is strong might be wiser than waiting to see if that really is a storm on the horizon.
It has been suggested by more than a handful of dealmakers that Tesco Bank might end-up ‘in play’. Now that their core retail franchise is back on track, do Tesco shareholders really want the idiosyncratic risk that running a fully licensed and regulated bank entails, particularly in light of the recent cyber fraud attack? There are risk and capital advantages to white-labelling FS products rather than underwriting them. And if
AND THE WINNER WILL BE… While financial metrics and economies of scale corroborate an inevitable consolidation, questions of “cultural alignment” or “strategic fit” may be the overriding criteria in the Challengers’ decisions to move forward with M&A or not. Banks and their regulators remain wary of M&A overreach particularly given the fallout from financial crisis related M&A that continues to haunt both RBS and Lloyds Banking Group. The successful Challenger ‘Consolidator’ will be the one whose management team combines visionary leadership and careful judgment based on rigorous and disciplined analysis. In the words of JPMorgan’s Jamie Dimon, “Don't do anything stupid. And don't waste money. Let everybody else waste money and do stupid things; then we'll buy them.”
© 2016 Raymond Hurley 5
