The future of banking and the role of challenger banks

Blogpost: Alexandra Zeitz, St. Antony’s College, University of Oxford

Speaker: Cyrus Ardalan, Chairman, OakNorth Bank
Chair: Alexandra Zeitz, St. Antony’s College, University of Oxford

The banking sector in the UK is undergoing a transformation. In 2010, the Bank of England issued the first new banking license in one hundred years to Aldermore. From 2013 to 2016, 14 new banks have received licenses, and there were reports in mid 2016 that a further 20 new banks had applied for licenses. This proliferation of new “challenger banks” is reshaping the financial landscape in Britain.

Cyrus Ardalan, formerly Barclays Vice Chairman (Investment Banking), is the new Independent Chairman of OakNorth Bank, a challenger bank specializing in financing to small and medium-sized enterprises (SMEs). In his presentation at PEFM this term, Ardalan gave an insider’s perspective on the changes in the British banking sector and gave his explanation for the rise in challenger banks, which he chalked up to regulatory changes and technology shifts. 

The British banking sector remains highly concentrated. The “Big Five” banks (HSBC, RBS, Barclays, Santander, Lloyds) control 90% of the market in personal banking, corporate financing and SME lending. Nevertheless, challenger banks are reshaping the landscape. These include larger challengers such as Clydesdale and Yorkshire, TSB, and Handelsbanken, which in many cases are longer established and have relatively large portfolios of loans. Smaller challengers such as OakNorth, Metro, Aldermore and Shawbrook received their licenses in the more recent profusion of banks. Retailers offering financial services, such as ASDA, M&S or Tesco, are also challenging the dominance of the Big Five, but are not “challengers” in reshaping the model of banking, according to Ardalan.  The defining traits of challenger banks, says Ardalan, are their simplicity, transparency, innovation and focus on a particular niche. As such, they present a sharp break with the previously prevailing paradigm in banking. This model of universal or “department store” banking is based on extreme vertical integration, with banks providing and hugely wide range of financial services to an extremely diverse client base. This model had the advantage of facilitating cross-selling, economies of scale, and regulatory arbitrage.

However, Ardalan argues that important background conditions have changed, now making alternative models of banking more attractive. Firstly, regulatory reforms in the aftermath of the Global Financial Crisis have shifted the profitability of universal banks. “Too big too fail” banks are increasingly “too big to manage,” given increasing regulatory stringency. Diagnosing lack of competition as one of the sources of instability, the Bank of England has adjusted regulation to encourage new entrants to the banking sector. The Bank’s Prudential Regulatory Authority launched a New Bank Start-Up Unit together with the Financial Conduct Authority in January 2016. 

In addition to these regulatory changes, Ardalan highlighted the importance of technological shifts that have made it possible for new banks to operate without the economies of scale offered by large universal banks. OakNorth, for instance, was the first British bank to use cloud computing for its core systems, which Ardalan said allowed the bank to be far more agile in scaling up its business, paying only for the IT services it requires at any one time. 

Other challenger banks, such as Atom or Fidor Bank, have built their entire business models on new technologies: Atom describes itself as the “UK’s first bank built exclusively for mobile,” while Fidor is a platform-based bank modeled in part on social media platforms.  

What challenger banks share, according to Ardalan, is their targeting of niches neglected by the Big Five. OakNorth, founded by two entrepreneurs, has concentrated on lending to start-ups and growing SMEs. These businesses often struggle to procure financing from the Big Five, lacking the assets to secure loans. By contrast, OakNorth has focused specifically on these borrowers, in some cases providing loans against businesses’ cash flows, rather than secured by assets.

This emergence of highly-focused banks, argues Ardalan, heralds a move towards vertical and horizontal disaggregation. Some seminar participants were skeptical whether challenger banks’ impact will be truly revolutionary. Challenger banks may be taking advantage of traditional banks’ current reluctance to lend to certain segments but be unable to compete once traditional banks’ appetite for lending picks up again. Traditional banks might also buy up challenger banks, absorbing their loan books, leaving challenger banks a temporary phenomenon rather than a shift in the banking paradigm. 

However, Ardalan was confident that several of the new challenger banks address clear gaps in the market. He stressed challenger banks are not seeking to replace traditional banks, and are in many cases focusing on niches that big banks are insufficiently nimble address. The diversification of the British banking sector is a dynamic and continuing process, one that customers and regulators will be watching closely.