Only a few forward thinking individuals could have predicted, even as little as 10 years ago, that the biggest lending institutions would find themselves 'challenged' by a wave of new entrants to the banking market, many online. But that has happened.
The innovation from challengers within the banking industry that, arguably, followed the arrival of Metro Bank in 2010, is certainly here to stay. This represents a test to smaller mortgage lenders and larger financial institutions, in both similar and different ways.
Although the new arrivals, the so called 'challenger banks', currently account for just 4% of all UK business mortgages and charges, that number masks a significant share of the current lending market involving loans to small and medium sized enterprises . Indeed, as at the end of April 2016, 34.4% of UK corporate bank debt was with challenger banks, ranging from circa 25.4% of central London corporate bank debt to as high as 46.5% in Northern Scotland.
This may be in part explained by less active lending in the SME market by the larger/largest banks, allowing the challengers to aggressively gain market share in this space. Nevertheless, the larger banks and lending institutions undoubtedly still dominate what is now seen as the more secure parts of the lending market. This is likely to remain the case in the short to medium term, particularly given uncertainties that have been injected into the economy by the Brexit referendum vote, and the perceived exposure to SMEs to any resulting downturn in the UK economy.
Nevertheless, the challengers, with their appetite for some of the niche lending markets, and reputations of innovation, are raising serious questions for smaller mortgage lenders and the bigger banks. The new entrants market aggressively; and often they sell an improved customer experience frequently developed on custom-built digital platforms that function smoothly, and are at the cutting edge of the fintech revolution within banking.
Smaller established lenders and the bigger banks know what they want to do digitally, but can sometimes be held back by legacy software that limits capacity to rapidly change their offering and drive down costs in the face of assertive new entrants. It is no longer enough (if indeed it ever was) to just add a platform onto a legacy operating system, which might be compared to giving the most advanced smart phone to a non-tech savvy user. Whilst they will, presumably, be able to use it as a phone and, for texting, their lack of ability to utilise the phone to its full potential will result in their experience being almost exactly the same had they fired up their old pre-3G brick mobile phone.
Instead of seeking to grow tech in house, or even buying in new tech by acquiring one of the new entrants, the future for established institutions may be to collaborate with developers of fintech to rapidly bring new products to market. Collaboration in this space has a proven track record -, just look at the success of apps on mobile devices since they were introduced in 2008, enriching both the platforms that host them, their developers, and the lives of customers in once unanticipated ways. Indeed, collaboration with the right fintech operation may allow any given lender to consistently stay on the leading edge of developments in this space.
The large established banks are also being forced to adapt in other ways. Resources may not be an issue, but dealing with legacy software certainly is. The necessary policy, procedures and systems they have in place can also be a hindrance to developing products in a rapidly changing lending market, particularly as today’s innovation can quickly seem an out-dated idea within a very short span..
But well-established brands do have some unchallengeable advantages, including deep experience of working in a highly regulated environment and strong risk control and security systems already in place. The brand security that they have is invaluable. The vast regulatory experience and innate understanding of banking products gives them a hugely significant head-start in operating in such a regulated industry.
Indeed, the challengers, of course, also face challenges of their own. One of these is actually securing business, particularly with the regulatory requirements of ‘Know Your Customer’ and anti money laundering requirements. This is harder for a pure-play digital bank to achieve with no branch network where people can be met and authenticated. But innovation, of course, is everything. Several online offerings intend to require potential customers to scan in their identification material before they open an account. Others may link up with larger professional service providers to essentially outsource the work. But clearly customer on-boarding remains a hurdle to be overcome.
New entrants to banking are not spared the rigours of operating in a highly regulated market; even creating all of the terms and conditions for their entire range of financial products from scratch can be complex and costly.
In addition, the capital reserve requirements that challengers face have already been written about in length. Suffice it to say that challenger institutions as a body feel that such requirements unfairly impact on their business model; and they may have a point. Crudely put, even if the worst were to happen, the collapse of smaller financial institutions is unlikely to cause the same systemic risks to the wider economy that the more onerous capital requirements that were brought in post GFC to mitigate against. Arguments are being made for adopting the American model of requiring larger institutions to hold proportionality more capital vis a vis the smaller institutions than is currently the case, which, it is contended, will in part level the playing field. But those arguments have not yet been won.
Another area of particular concern to the challengers is the 8% tax surcharge on profits, which was introduced with the 2015 Budget on any bank profits above £25 million. A number of challengers argue that this disproportionately impacts smaller and newer entrants to the market by limiting their growth potential.
Whilst the lending market is clearly changing, and this is in significant part as a result of the emergence of challenger brands, it is important to keep challenger banks in perspective, without in any way detracting from what they represent in terms of energy, innovation and competitive edge. The big financial institutions have history and sheer scale on their side; and they are already adapting fast to a world they know is in constant digital change. After all, even on the current impressive growth rates it would still take many years for even the biggest challengers to 'catch' the major banks and a number of the established players in terms of market share of the lending market. That assumes of course, that the challenge of the challengers does not illicit a response in kind.
First published in the October edition of Mortgage Finance Gazette.
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