Does Metro Bank signal wider issues in the challenger bank model?

Three days later, Metro Bank announced it had secured a £325mn capital raise and £600mn debt refinancing package. Its announcement dated October 8 said that “current capital levels constrain the company’s ability to grow lending balances significantly in the near term”.

But does Metro Bank’s capital package indicate wider issues in challenger banks’ business models?

The individual institutions within the challenger bank cohort are all quite different, says Simon Kent, global head of financial services at Kearney, a management consulting firm.

“Some of those challenger banks are performing extremely well. Their balance sheets are typically less than £20bn, but they’re in a very specific niche where their proposition is differentiating, and they're able to succeed and to thrive.

“Those challenger banks that are between the £20bn to £100bn in assets space have got many more challenges, because they are large by their very nature. And they are, in a number of cases, providing a similar product set to the big six, operating in the same spaces as the big six. So they’re having to ‘take the market’, not ‘make the market’.”

Metro Bank: total assets

Kent also says that successful challengers have found “niches and opportunities” outside of where the big UK clearing banks play, and that sometimes those niches are more difficult for the large clearing banks to deal with at scale.

“In a number of cases, the clearing banks have had to improve their proposition, customer experience and user experience, driven by the advances that the challenger banks have made.

“It’s fair to say that delta is becoming much smaller now, and therefore the challenger banks need to have that differentiated opposition in a niche, where they can operate outside of where the big six find it easy.”

Longer opening hours, seven days a week

While its competitors reduce their branch networks, Metro Bank plans to open more. Its branches also have longer opening hours, and open on Sundays.

“Metro Bank’s business model is based on excellent branch-based customer service,” says Alper Kara, professor of banking and finance at Brunel University.

“Many consumers value the choice of visiting a branch and the human touch. However, in an environment where even the big four diversify their business by offering more digital banking solutions and reducing branch presence, relying on such a labour-intensive business model may be challenging.

“The key question here is whether the demand for branch-based banking services is still large enough for Metro Bank to carve a niche, in order to sustain its business model and grow.”

Mazars’ head of UK financial services, Gregory Marchat, agrees that challenger banks are a necessity in the banking landscape.

“They bring customer-centricity and modernity, elements often lacking in traditional banks. They appeal to the younger customers who see them as a real alternative to the banks that have been there forever.”

But Marchat adds that innovation and agility cannot replace the security provided by a strong capital position.

“Holding a banking licence is expensive and generates a heavy regulatory cost. Most of the challenger banks absorb these costs through successive capital raising, funding every new phase of their development similarly to tech start-ups.

“But when capital is raised to compensate prospective shortfalls, it creates fear and directly impacts share value, making capital raising even more complicated and costly.”

James Lowen, co-manager of the JOHCM UK Equity Income Fund, which counts Barclays and NatWest among its top 10 holdings, says that he likes to see “well capitalised” businesses. He says that common factors among the banks his fund holds are excess capital, share buybacks and dividends.

When capital is raised to compensate prospective shortfalls, it creates fear and directly impacts share value, making capital raising even more complicated and costly.Gregory Marchat, Mazars

Lowen also describes the cost structures of big banks as “well controlled” and, in some cases, going down.

“What these big banks are doing is they’re reducing costs by reducing branches...The other thing that the large ones have is what we call a ‘structural hedge’ – this is money in things like current accounts that they can reinvest.

“As some of these banks have said this week, what’s rolling off now was invested five years ago at 50 basis points, and it’s going to be reinvested at 5 per cent, which is where five-year swaps are.

“So that’s a big tailwind in terms of income. That’s very visible, we can see what’s going to happen next year and the year after and the year after, because it’s five-year focused.

“Whereas the challenger banks have to compete quite aggressively to get current accounts in the first place, and they haven’t got the legacy customer bases that the large banks have got.”

Metro Bank’s capital package came after an update issued in September, in which the bank said the Prudential Regulation Authority had indicated that more work was required by the company on its advanced internal ratings based (AIRB) application for residential mortgages, and that approval would not be attained this year.

“While Metro Bank continues to engage with the PRA on its application, there is no certainty that approval will be obtained, the timing of any approval or the level of any reduction in risk-weighted assets and consequential reduction in regulatory capital requirements that might be achieved,” the update in September read.

And in a presentation following the capital package announcement in October, Metro Bank chief executive Daniel Frumkin said: “We built a £7.5bn mortgage portfolio in anticipation of getting AIRB.

“And I think one of the things that we need to decide strategically at the board level over the next handful of months is whether we need to reposition that £7.5bn of mortgages, make it maybe a bit smaller or a bit more specialist and really start to stretch our legs in commercial and corporate funding.”

Indeed, in its capital package announcement, Metro Bank said its “envisioned growth strategy includes a gradual shift in asset side growth towards specialist mortgages and commercial lending to maximise risk adjusted returns”.

JOHCM's Lowen, who holds Paragon in the top 10 of his portfolio, says that smaller banks are gradually making applications to use internal models.

“We expect we’ll see Paragon’s internal model be allowed by the PRA in the first half of next year; and that means their capital requirements will come down.

“So those companies that are able to move onto their internal models over the next year, two years, three years, four years, will be at a competitive advantage because they can write the same business for lower capital requirements, so return on capital will be higher.”

While Metro Bank has said it is unlikely in the near term, whether its AIRB application will get the regulator’s approval remains to be seen.

Chloe Cheung is a senior features writer at FTAdviser