Meet the ‘Challenger Banks’

By Mark Somers, Technical Director at 4most Europe 

The economic risks of a more fragmented banking system…

Big banks are in decline. That’s what many politicians are trying to achieve and what some experts are predicting will happen in the near future; whether that speculation will ring true, only time will tell. But for the UK, a more fragmented banking system brings with it many implications both positive and negative in terms of the economy and of course, the consumer.

The drivers of that fragmentation – risk management, technology and public perception – make the trend more likely to happen. Politicians and regulators have learnt from bitter experience that having a huge bank on the point of failure is very risky; they could bring down the whole economy as in Ireland, Spain or Portugal. Because of this big banks are being ordered to directly create challenger banks (e.g. TSB and Williams & Glynn’s) and to put in safety nets that are becoming so expensive that the efficiency benefits of being a big bank are becoming smaller.

The second strand comes from technology. Big banks have an inflexible, monolithic IT infrastructure that is painfully slow to adapt to change. New players are entering the market who don’t have this technology millstone to overcome and who can provide payment and match savings to borrowers more conveniently and effectively.

Finally, public perception of many big banks is not good. They have low approval ratings and following scandals from PPI to Libor fixing, have been seen as not worthy of customers’ trust. As such the bigger, older brands have a lot of work to do to polish up their tarnished reputations.

The advantages

So let’s start with the good news. A more fragmented banking system undoubtedly means increased competition which should in turn drive down costs for the consumer. It also puts more pressure on banks to innovate and lead the market with improved and diverse services – again good for the consumer. Banks are also demonstrating a greater appetite to pursue different strategies leading to diversification of risk across the banking sector itself. From a regulatory point of view, there is less risk for the regulator to feel pressurised by a few large banks into resisting change. From an economic perspective, there is also less risk of Government having to bail out ‘too big to fail’ banks and hence reducing UK plc borrowing costs.

Of course, not all change is for the better and although there are some potentially positive implications associated with a more fragmented banking system, on balance, there are also a number of risks for the UK economy and its constituent consumers to consider.

The potential risks

Now for the less optimistic news; fragmentation will lead to smaller banks, with less risk diversification, implying smaller ‘capital cushions’ (or a lower return on equity). Potentially, this makes it more likely for an individual bank to go bust at some point in the future and reduces the returns of many pension funds. Of course, the idea that more bank bankruptcies is a sign that the system overall has a lower risk, will be a challenging message for the PRA (Prudential Regulation Authority) to manage and communicate.  From a regulatory perspective, there is more work for the regulator in terms of understanding the detailed workings of many institutions, leading to higher costs which in the end, get passed onto the consumer.

Although greater competition for banks has its upsides, it potentially exerts pressure on individual banks to increase their risk appetite to compete in the market (the danger is, it is easier to promise increased returns by entering higher risk segments which may not be adequately reflected in modelled capital requirements, than by making genuine improvements in efficiency and service levels).  It will also take much longer to implement banking system wide changes as there will be more parties to negotiate with.

Greater flexibility for a ‘healthier’ approach

So, a few comments on the good and the bad; but is a more fragmented banking system really a good thing or is it a disaster waiting to happen? My view is that overall, a more fragmented system is a good thing, but it will require flexibility on the part of the regulator to accommodate a more rapidly changing market and to move to a setting where banks are allowed to fail, but where the system overall is much ‘healthier’.

The downside is if the PRA is unable to facilitate the change to enable banks to compete in a more fragmented banking system, then it is likely that less well-understood, non-banking entities will increasingly erode this market. For example, peer-to-peer lending for banking core lending businesses, (with the likes of Paypal and perhaps even Bitcoin competing for the transactional elements). This may give the PRA less control in the long run in terms of how the banking system operates as it becomes increasingly distributed and ‘virtual’.

4most Europe Ltd is a specialist analytics consultancy operating out of London and Edinburgh. The company provides a range of products and services across credit risk, fraud and marketing, working with blue chip clients predominantly in the banking, retail and mobile sectors. The company offers a flexible, competitive model, either working with clients to manage regulatory change or delivering and implementing business critical solutions.