UK challenger banks: looking for consolidation in all the wrong places


Louise Bowman
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Expectations of further M&A following CYBG’s approach to Virgin Money might be wildly optimistic.


It was not the set of results that Clydesdale and Yorkshire Bank Group (CYBG) CEO David Duffy wanted to announce, given that his bank had made an ambitious £1.6 billion bid for rival Virgin Money just over a week beforehand.

On Tuesday, the UK lender revealed a first-half loss of £76 million, thanks in part to a £350 million charge for the mis-selling of payment protection insurance. There was a deafening silence on the progress of the proposed merger itself.

Euromoney spoke to Duffy in November 2015 when the idea of a merger was already on his mind. “The only path to consolidation is if we’ve earned the right to the conversation with investors,” he told us then. “We have to deliver on this franchise.”

Whether that has happened is clearly open to question. Nevertheless, in early May, CYBG pitched an all-share deal to Virgin Money shareholders, offering them 1.13 CYBG shares, which would leave Virgin Money with 36.5% of the merged organization.

The logic of such a merger is clear, but it is not the deal that Duffy envisaged when he spoke to Euromoney two and a half years ago.

“There are parts in the south, where, if it was a complementary product profile and if you’re extending [...] the number of customers that you are accessing, then [an acquisition] could make sense,” he said then. “Mortgages would be less attractive because [the bank] already has that capability nationally.”

Well, Virgin Money is all about mortgages, but what it also has is a strong brand identity, which CYBG desperately wants.

The latter already has a low-cost deposit base and established SME franchise. Virgin Money is dogged by a costly deposit base and negative sentiment surrounding credit cards, but the value of its brand – it is 35% owned by Virgin Group – is what is important here and CYBG will have to pay up for it.


Lawrence Guthrie,
Houlihan Lokey

“For UK public company offers, typically you either buy for cash and pay a proper premium of 30% to 40% or you do a merger on a share-for-share basis at nil premium,” says Lawrence Guthrie, managing director at Houlihan Lokey, which recently acquired Quayle Munro. “The current offer is neither fish nor fowl. I suspect that Clydesdale need to add a cash offer at a proper price.”

Quayle Munro advised Pollen Street Capital and BC Partners on their acquisition of UK challenger bank Shawbrook last year.

The fact that CYBG has made an offer for Virgin Money at all is seen by many as an indication of the impact that the change to Prudential Regulatory Authority rules on Pillar 2A capital, which were brought in in February last year, will have in this sector.

Most challenger banks are now in the process of transitioning to internal ratings-based risk weights rather than the standardized approach. Analysts at Berenberg reckon that this transition could reduce risk-weighted assets at CYBG by £4.4 billion, freeing up 55p excess capital per share, meaning that the acquisition would not require further capital.

The withdrawal of the Bank of England’s Term Funding Scheme (TFS) in February this year has also been a catalyst for change in the challenger sector, as banks scramble to find alternative sources of cheap funding to replace it. Virgin Money had taken £6.4 billion of funding from the TFS by the time the scheme closed, while CYBG had taken £2.25 billion.

Despite the fact that the CYBG’s offer for Virgin Money looks a long way from secure, the approach is being hailed as evidence of long-predicted consolidation in this sector.

Yawning gap

The challengers have certainly done precious little challenging so far: if this deal goes through, a combined organization would leapfrog TSB to become the fifth largest UK bank with £80 billion of assets, but that still leaves a yawning gap between numbers five and four: Santander, which has total assets of £300 billion.

The largest UK lender is Barclays with £1,120 billion assets, followed by Lloyds with £800 billion and RBS with £710 billion. Initiatives such as the RBS alternative remedies package, under which 220,000 eligible Williams & Glyn customers will be incentivized to switch accounts to other UK challenger banks, will see some deposit growth at the larger challengers, but otherwise their progress has been painfully slow.

The widespread expectation that many will now merge to give themselves scale to compete could, however, be wide of the mark. Those mergers that have crossed the line – in addition to the Shawbrook sale, Aldermore was taken over by FirstRand last year – were not evidence for this.

“Neither Aldermore or Shawbrook were consolidation plays,” points out Guthrie. “The theory of bank consolidation is fine, but it is not really about creating a genuine challenger and more about saving costs.”

With the market dubbing pretty much all smaller banks as challengers, there appears to be far more potential for consolidation than there realistically is.

“There is a difference between the likes of Virgin Money and Clydesdale on the one hand and specialist banks like One Savings, Secure Trust and Close Brothers on the other,” says Guthrie. “The latter are not challengers – they are specialists that are focusing on parts of the market that the high-street banks have either never been in or have exited after failing to do properly.

“OneSavings, Secure Trust and Paragon have all grown significantly and will over time cease to be able to be niche banks. They are also being worn down by regulation and will suffer the negative aspects of becoming institutional, but without sufficient scale to compete with the clearing banks on more vanilla business.”

In all likelihood, the real challengers in UK banking will be the new digital-only offerings rather than the existing, smaller banks.

“A real potential challenge for the high-street banks does come from the newer digital banks with completely fresh technology,” Guthrie argues. “High-street banks adapting to new technology is very difficult – as TSB has shown. These newer players could really eat into the high-street banks’ core markets of providing banking services for the masses in the future.”