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UK Challenger Banks Are Failing SMEs, New Report Says

As U.K. lawmakers continue their sweeping investigations, crackdowns and overhauls of the banking industry, small businesses have a lot to gain – and, perhaps a lot to lose – from these legislative efforts. SMEs continue to struggle with late payments by their corporate customers, and small business owners are tasked with financing their operations by the dizzying array of lending choices.

At the heart of these issues are the banks. The U.K. is dominated by the so-called Big Five mainstream banks: Lloyds, Royal Bank of Scotland, Barclays, Santander UK and HSBC. With their decline in SME lending following the financial crisis, the U.K. saw a surge in alternative lending players.

For Prime Minister David Cameron, who recently secured a sweeping victory in last month’s general elections, these new competitors are good news, as the solution to the dominance of the Big Five, he says, is to promote the introduction of challenger banks – new, smaller banks and alternative lenders – and not to break up the existing leaders.

But new research from accountancy group KPMG has found that these challenger banks that have so far emerged are often no better than the mainstream banks, and are in some cases even worse.

What’s Working, And What’s Not

KPMG’s report found that many of these challenger banks, which include players like Metro and TSB, are not sufficiently improving upon the failures of the mainstream banks in areas like customer service and financial products, making them less likely to actually pose as competition against the Big Five.

Many challenger banks originate from the Big Five themselves, causing these new rivals to adopt similar business practices. Williams & Glyn, reports highlight, will emerge on the market from RBS, while TBS has roots in Lloyds. But even some of the independent innovators, like digital banking startup Atom, were found to offer mobile banking services with quality no better than the major banks – and often worse.

“For those challengers focusing on customer service or cost as a differentiator, this could be a major hurdle for the future,” said KPMG’s head of challenger banking and alternative finance Warren Mead about the report’s conclusions.

In fact, KPMG found, some of the challenger banks are beginning to morph into Big Bank lookalikes themselves. Large challenger lenders saw a 2.1 percent return on equity in 2014, compared with the 2.8 percent return seen by the mainstream banks.

But the news was not all bad. Smaller rivals, like OneSavings and Paragon, saw average returns of 18.2 percent. Clearly, Mead told reporters, it is the smaller challenger banks that are driving growth in the segment, while big banks are faced with high operating costs. Smaller banks are instead seeing their operational costs decrease, according to findings.

Similar patterns are seen in the lending statistics among banking players. Large challenger banks saw lending increase by just 3.2 percent between 2012 and 2014, while the Big Five saw a decline by 2.1 percent. Smaller challenger banks, however, saw a spike in lending by 32.3 percent.

According to experts, it is small banks’ ability to focus on underserved populations that allow them to see such growth and profitability. Reports site SME lender OneSavings Bank, which saw a return on equity of 31 percent in 2014.

SMEs Still Struggling

While the U.K.’s small business lending ecosystem has earned the attention of policymakers, the market appears to be over-saturated. KPMG’s research reveals that some of the smaller alternative lenders and bankers are improving the situation for SME borrowers, but largely uncovers shortcomings of the increase in competitors. But as these challengers enter the market, some experts say they actually overwhelm SME owners with too many lending options.

The Financial Times on Tuesday (May 26) profiled OakNorth, one of the U.K. challenger banks looking to lend £1 billion to SMEs in the next five years, with plans to become fully profitable in its second year. These players are seen mostly as a positive addition to the sector while the government pushes for more competition against the Big Five.

But research from Funding Centre released last month found that U.K. borrowers are buried in alternative lending choices. “The alternative finance space has grown at a phenomenal rate in the last year but the sheer number of platforms is now daunting,” said Funding Centre founder David Stevenson at the time.

Worse, separate studies suggest that SME borrowers are just as distrusting of alt-lenders as they are of mainstream banks, due mostly to the high fees and potential hidden costs of these challengers. Alternative Business Funding found in April that the hidden fees of alternative invoice financing products for SMEs could add nearly $640 million in extra charges every year for SME owners.

With KPMG’s newest findings, it becomes even more evident that a more populous lending market in the U.K. has not yet necessarily led to a more competitive one, and SMEs continue to struggle as a result.

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