This article was first published on the Practical Law website and in the PLC Magazine in June 2016.

Challenger banks, which are set up to compete with the larger traditional banks, have seen rapid growth in the wake of increased openness to change in the banking sector and a desire for more consumer choice. Their clever targeting of niche markets is opening up plenty of scope for growth. While this opportunity does not come without difficulties, the rewards for challenger banks that succeed can be considerable.

Challenger banks, which are set up to compete with the larger traditional banks, have seen rapid growth in the wake of increased openness to change in the banking sector and a desire for more consumer choice. Greater competition has become a key priority for the banking sector in the aftermath of the global financial crisis, the LIBOR scandal and regulatory reforms including Basel III. In 2010, the first new banking licence for more than 100 years was issued.

It is clear that challenger banks are injecting healthy competition into the market. In May 2016, a comparison of pre-tax profits showed an annual increase of £194 million for challenger banks and a £5.6 billion drop for the “big five” banks. There has also been a series of listings on the London Stock Exchange by challengers in the past couple of years, including Virgin Money in November 2014 and Aldermore Bank in March 2015.

While traditional banks remain at the fore, things are on the up for challenger banks. Their clever targeting of niche markets is opening up plenty of scope for growth (see box “Challenger banks in the UK”). While this opportunity does not come without difficulties, the rewards for those that succeed can be considerable.

The potential constraints

Setting up any new business can be tough and it is even more difficult in a sector that is dominated by long-established, trusted brands and has a number of legal and regulatory hurdles.

Compliance challenges

New entrants to the banking sector are met with a long list of compliance requirements. These include: the Banking Act 2009; the Financial Services and Markets Act 2000; the Insolvency Act 1986; the Consumer Credit Act 1974; the Prudential Regulation Authority (PRA) Rulebook; and the Financial Conduct Authority (FCA) Handbook.

There has been a view that the regulatory regime tends to favour incumbent banks. In light of this, the PRA has begun to instigate change. It is working closely with EU authorities to encourage competition and choice in the banking sector by helping to ensure that banks of different sizes and business models can compete on an equal footing across the EU. However, it will take time for these changes to filter through and challenger banks need to be prepared to commit time and money to meeting the requirements.

Capital requirements

Theoretically, the rules relating to capital requirements apply equally across all banks. In practice, however, the fact that challenger banks are deemed to be riskier propositions than their more established competitors means that they are generally obliged to hold a proportionately greater amount of capital.

Following Basel III, challenger banks must use a standardised approach to calculate the amount of capital required to make certain loans. This approach often requires more capital to be set aside, in light of the higher risk rating of challenger banks, than if using the internal advanced model that large banks use. The advanced model takes into account the banks’ historic trading record and accumulated evidential data and is not, therefore, available to newer banks. The fact that challenger banks are required to hold more capital, relatively speaking, means that it is much harder for them to offer competitive rates.

A number of challenger banks are lobbying the Treasury for changes to their capital requirements. This has led the PRA to conduct a fresh examination of the capital requirements regime. The results and recommendations of this examination will be published later in 2016.

New corporation tax surcharge

In the summer Budget of 2015, the Chancellor of the Exchequer introduced an 8% surcharge on the profits of banks in the UK, in addition to the existing corporation tax at 18% (see News brief “Summer Budget 2015: a bit of give and take”, ). In force since 1 January 2016, the surcharge applies to all banks with annual profits of more than £25 million and so affects those at the challenger end of the market. It adds an additional financial constraint on these more niche businesses, which have until now been exempt from the bank levy that was introduced in January 2011.

Senior managers regime

Effective from 7 March 2016, the new senior managers regime (SMR) aims to make it easier for regulators to hold senior executives of banks and other financial institutions to account over regulatory breaches (see feature article “Senior managers regime: strengthening accountability in banking” and Briefing “Senior managers and certification regime: food for thought for in-house lawyers”).

As well as addressing misconduct, the SMR requires high standards of conduct in areas such as policy, procedures, regulation, compliance and the mitigation of risk. Individuals may also be required to show that they have taken reasonable steps to prevent, stop and remedy regulatory breaches. Where the standards fail to be met or complied with there is the risk of financial penalties, public censure and custodial sentences. It is claimed that the SMR is adding significant compliance costs to banks.

Retail banking investigation

The Competition and Markets Authority’s (CMA) two-year investigation into retail banking was announced in November 2014. It found that about 77% of personal current accounts and 85% of business accounts were controlled by a small number of banks.

The CMA published its provisional recommendations in May 2016 (see box “CMA remedies for retail banking”). Here, it outlined problems with weak competition in the retail banking sector in the UK. Overall, 60% of customers have stayed with the same bank for more than ten years and 90% of business customers get their loans from banks where they have their own current account.

Customer inertia and caution

When it comes to breaking into a new market, attracting and retaining customers is vital to success. In the UK banking sector, where the “big five” banks have established a stronghold, the challenge is considerable. Consumers are understandably cautious when making decisions about trusting a firm with their income and personal savings. Many consumers and investors are reluctant to change their banking service provider and even more reluctant to approach a new name on the market. As data from the Financial Times shows, out of a total of 51 million UK bank accounts, only 124,615 current account switches were made in March 2016 using the seven-day transfer service.

In contrast to the US, where there is already strong competition in the banking sector and a higher turnover of business start-ups and closures, UK consumers are more wary of investing in new brands. Deciding on where to invest money is a big decision and consumers need to feel that they are making the right choices. Winning trust and confidence is key to the success of any challenger bank and this is where larger concerns such as Virgin Money are a good example. Already linked to an established brand, Virgin Money’s high street presence has no doubt helped to give consumers a sense of security and familiarity. Added to this, it has also invested heavily in its public relations and advertising.

Other regulatory and environmental issues

New entrants into the banking sector will need to consider other challenges, including their ability to respond to current economic conditions and, in particular, the current low nominal economic growth and the low interest rate environment. Challenger banks will also have to consider issues such as: how they respond to heightened regulatory scrutiny; the raft of new customer protection regulation, data protection and anti-money laundering laws; and cyber-crime.

Rising to the challenge

Despite the challenges, the rewards are out there for those that get the strategy and focus right. The sector’s growth figures demonstrate this and show that there is room for healthy competition alongside the established banks. A number of lessons can be learnt from larger challenger banks that have made strong gains in their target markets.

Engage with the regulatory regime

Lobbying in response to the capital requirements regime is already creating an impetus for change. Actions by the PRA and FCA to try to make it easier for new banks to access advice and gain new licenses represent positive steps, as does the CMA’s investigation into the retail banking sector.

In January 2016, the PRA and FCA launched a new bank start-up unit, which is a joint initiative to provide information and support to newly authorised banks and prospective banks in the UK. This goes a long way to increasing engagement between these start-up businesses and the industry regulators. New banks benefit from: the new bank start-up unit helpline; access to supervisors at both the PRA and the FCA; regular capital and liquidity reviews, if appropriate; monthly regulatory update emails; invitations to relevant seminars; and invitations to events on key regulatory topics.

As well as engagement with their regulators, new banks need to recognise the importance of working closely with specialist legal advisers and of investing heavily in compliance, risk monitoring, and systems and controls.

Establish a robust business structure

Challenger banks have proved successful where they have demonstrated a clear strategy, a strong business plan, a robust business structure and a rigorous compliance programme to mitigate potential risks. Firms must also bear in mind that the UK’s financial services regime is a fast-changing one and that they need to make sure their policies and procedures are kept up-to-date (see box “Policy checklist”). In addition, they must carry out appropriate due diligence and invest in appropriate systems, controls and infrastructure.

Find key points of differentiation

There are many different models among challenger banks. While achieving a cost advantage may not always be possible given the issue around capital requirements, differentiation through available resources (including brand, distribution and products) and capabilities (including culture and service) are popular strategies.

A focus on brand and reputation is one effective way to build trust and tackle the challenge of customer inertia. Virgin Money, which is purely a retail bank that is focused on savings, mortgages and credit cards, has done this successfully and has leveraged the brand strength of the wider group. As an attractively-branded newcomer to the market it has seen a strong performance in its lending results, particularly in residential renting.

Another newcomer, Atom Bank, has attracted attention for its digital model. It is a financial technology (fintech) company that brings experience from chief executive Mark Mullen (who previously ran First Direct) and chairman Anthony Thompson (a driving force behind the launch of another new high street bank) and has a strong customer service focus. It also appeals to a new generation of customers who are confident in using online services. For example, its first savings accounts are only available through the bank’s Apple Store app.

Seek expert legal advice when needed

As any start-up business will appreciate, getting a new venture off the ground takes a lot of upfront investment of time, resources and money. Everything is centred on building the business and so legal processes can be seen as a distraction from that. However, to protect the value that business owners and shareholders are building, both now and in the future, it is vital to create a corporate structure that makes sense and to ensure that key documents are put in place.

Looking to the future

The future for challenger banks remains promising given the regulators’ commitment to transparency, competition and choice in the banking market. The steps being taken to support new entrants in getting their businesses off the ground is clearly good news for challenger banks but should also be good news for consumers, the sector as a whole (including the more established banks) and the economy. New banks must be prepared to work hard, however, in order to capitalise on these opportunities. This means rising to the regulatory challenge and getting the business strategy and proposition right.

As with any new business venture, challenger banks need to stay in tune with what customers are looking for from their providers. They also need to engage with the regulators, stay open to change, and ensure that they get the right legal advice regarding their structure and operation. Challenger banks that get this right could enjoy rich rewards and make a powerful contribution to the UK’s banking sector and economy.

Challenger banks in the UK

There are now more than 20 challenger banks operating in the UK. They are making their mark often by following quite different business models and approaches to their “big bank” rivals. As a general rule, they tend to fall into one of the following categories:

  • Online only in the financial technology (fintech) sphere.
  • High street branches with a focus on customer relationships.
  • Focus on lending to SMEs.
  • Emphasis on ethical banking.
  • Focus on short-term finance and bridging loans.
  • Retailers, such as diversified arms of some of the leading supermarkets.
  • Offshoots of traditional banks.

CMA remedies for retail banking

In its 17 May 2016 provisional decision on remedies in its market investigation into retail banking, the CMA said that the biggest banks should not be broken up as this would not significantly improve the market. It also did not recommend sweeping structural changes, such as ending free in-credit banking or forcing lenders to hive off branches as ways to boost competition. Instead, to stimulate more competition, the CMA recommended that:

  • Customers should be signed up automatically for text alerts, warning them that they are about to go overdrawn and giving them time to pay money in.
  • Banks should prompt customers regularly to check that they are getting good value, for example, when interest rates change.
  • Customers should be able to use a simple app to help them to compare accounts and switch if they wish to.
  • The price of loans should be more transparent to help business customers.
  • UK banks should set a monthly charge on unarranged overdrafts on personal current accounts and warn customers before they go overdrawn to help them avoid the charges. The caps to overdrafts would be set by the banks, rather than the CMA, in a bid to increase competition.

The CMA is expected to deliver its final recommendations later in 2016.

Policy checklist

New banks should create, and keep up-to-date, the following policies:

  • Policies for ensuring compliance with all applicable legislation and the rules and guidance issued by the PRA and the FCA in the PRA Rulebook and the FCA Handbook.
  • Whistleblowing policy.
  • Personal account trading policy.
  • Conflicts of interest policy.
  • Complaints handling policy.
  • Market abuse policy.
  • Responsible lending policy.
  • Dealing with vulnerable customers policy.