Profit from the rise of challenger banks

Vernon Hill outside Metro Bank © Getty images
Venon Hill has set out to shake up banking

When American businessman Vernon Hill opened a Metro Bank in central London in 2010, it was the first new bank on the British high street for 138 years.

In true American style, the event was accompanied by stilt walkers in wigs, Dixieland bands, shoeshine crews, 5,000 cups of ice cream, jugglers and white balloons marked “JOIN THE REVOLUTION”.

Metro Bank does things differently. It’s open seven days a week, 362 days a year and until 8pm on work nights. You can get your new credit card printed in 15 minutes while your pet tucks into Metro Bank doggie biscuits and your kids suck Metro Bank lollipops.

“Britons are dying for revolution in the banking business, focused on service,” said Hill at launch, “and we are here to provide it.”

Hill set up Metro Bank to attract Brits dissatisfied with the established banks. Today, with nearly 300,000 customers, 26 branches, notions to float in 2016 and £770m of equity raised in private placings, it’s clear that the American upstart has had little problem doing that.

The success of this ‘challenger’ bank proves that there is an appetite in this country for different approaches to banking. And that’s not likely to change any time soon. It may have been over five years since the financial crisis hit, but Britons are still angry with the big banks.

In this issue of Penny Sleuth, I’m going to introduce you to another challenger bank, this time at the smaller end of the spectrum. Just like Metro Bank, the Isle of Man-based Manx Financial (MFX) runs an upstart bank with a new approach.

Just like Metro Bank, it’s pushing its way into the UK market from overseas. Stock prices have doubled over the last year and having spoken with the company’s managing director, I think there could be more to come.

We’ll explore the company’s strategy and growth potential in just a moment. First let’s look at why a market is developing for challenger banks, and why it’s growing fast.

Shareholders are starting to crack

For a long time, the big banks have enjoyed total dominance in the British market, but that’s been changing ever since the financial crisis struck in 2008. Revelations about dodgy dealing, mis-sold policies and bloated bonuses have turned many Brits off the big players, and that’s created an opening for the challengers.

If you want to see exactly how much the public has gone off the big banks, look no further than last week’s annual meeting of Barclays shareholders. It featured protests and an all-too-rare revolt by some institutional investors.

Not enough voted against the remuneration report to overturn it, but the row ensured bankers’ pay was back in the headlines.

And just to keep it in the spotlight, the government followed up by vetoing Royal Bank of Scotland’s proposal to pay 200% bonuses to favoured employees.

Barclays’ performance last year sums up the absurdities of the situation we find ourselves in with the banks. Profits were down 32%, yet bonuses went up by 10% to £2.4bn! Meanwhile, downtrodden shareholders had to make do with a flat dividend after supporting a £5.8bn rights issue last October.

It all points to a business being run for the employees above everyone else.

But not only are the banks too big to fail, they’re also too big to compete with. There isn’t enough pressure on them to raise their game. A major problem in domestic banking is that the big five clearers control almost 90% of the UK lending market.

They’re simply too dominant. So what should be done?

I’d say at the very least we need more competition in domestic banking to challenge the existing oligopoly. Metro Bank demonstrates that new entrants can successfully carve out market share here.

There’s also certainly a case to be made for splitting up the big players. TSB branches have recently been hived off from Lloyds. I’ll be interested to see what impact this ‘new’ challenger bank has on the market.

But there is another way…


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A new challenger emerges

The authorities have been keen to promote the challenger banks. The most prominent new start-up is Metro Bank, but just last week I spoke to another. Let me introduce you…

Manx Financial owns Conister Bank, and funds its lending entirely through deposits, which are in plentiful supply in its local market. And rather than being lent on the Isle of Man itself, three quarters of these funds then get lent in the onshore UK market. Not only that, but its loan book grew 30% last year.

When I spoke to managing director Fred Kelly, he told me that the internet means a physical branch presence on the mainland isn’t a necessity. Instead, Manx’s strategy is to attack the UK market through partnerships with non-bank distributors.

For example, car financing company Marsh manages a portfolio of loans on Manx’s behalf. Marsh knows the UK motor market better than Manx, so it underwrites the loans and collects the receivables. Profits are shared between the two parties.

Manx owns the loans, but non-performers have to be bought back by Marsh. This ensures the lending criteria are sensible and an agreed bad debt provision is built into the model.

This one has room to grow

Now, since it has only 1% of the Isle of Man deposit market, Manx can expand if it adds more distribution. Getting bigger is important, and not just to increase competitiveness.

High costs (regulatory, IT, compliance) create barriers to entry for small players. And the regulator has to balance supporting new entrants with its responsibility to protect consumers.

These smaller financials can make good returns. Last year’s burst of growth moved Manx into profit, resulting in a nice share price performance. Over the last year, its stock has doubled. I think smaller financials have a bright future – one of my Red Hot Penny Shares tips is in the process of applying for a banking licence and projects strong growth in the future.

Nor is Manx the only small outfit with potential. Other challenger banks making an impact in Britain include Aldermore, a small business lender, and OneSavings Bank, a mortgage and savings bank.

If you’d like to learn more about challenger banks and the part they play in a global trend towards alternative finance, check out this recent cover story in MoneyWeek magazine.

For now, the impact of these niche lenders on the broader banking industry is only going to be marginal. It simply comes down to scale. What we need is one of the more substantial players to really start making waves and become a true challenger. Sadly it’s hard to see that happening.

But as Metro Bank founder Vernon Hill said: “Change comes from new entrants and innovators, not from shuffling the deck.”

Watch this space.

This article is taken from our FREE penny share investment email Penny Sleuth.
Penny Sleuth is our FREE twice-weekly penny share investment email. Top penny share expert David Thornton will help you master the world of small cap investment. Each and every week he will pass on his simple, plain-talking insights and expertise that really could change your fortunes. Please enter a valid email address

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Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do

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