Challengers salami slice away at established banks dominance

The news that Paragon Bank (with an initial capital of only £12.5m) has become only the second new bank to be launched in the last one hundred years (Metro Bank being the first one), the first one to be authorised by the PRA (Prudential Regulation Authority) and to take advantage of the move by the regulator to simplify the process of setting up a new bank, is hardly going to have banks such as Barclays, Lloyds and RBS quaking in their boots. But is this just one more step in a trend that the big banks cannot afford to be complacent about?

The primary reason that Paragon has decided to apply for a banking licence
is not so it can take on the established banks with a full offering of consumer
current accounts and mortgages. It is so that it can take consumer deposits as
a means of funding loans for the existing Paragon Group business. With interest
rates low but expected to rise this should mean a lower cost of capital for the
loans that they make than going into the wholesale market. With the experience
that Richard Doe, the former ING Direct UK Chief Executive, brings from his
former employer the new bank should be a success in competing for deposit
balances. The low cost direct model for deposits has already been proven by the
likes of the now defunct Egg and ING Direct. Whilst the press release from
Paragon may talk about offering loans and asset finance it is clear from the
recruitment of Richard Doe that the new bank will be initially focussed on
raising the all important deposits.

Paragon Mortgages specialises in the Buy To Let (BTL) market for the
residential market and has been very successful at this surviving during the
crisis where the likes of Bradford & Bingley and Alliance & Leicester
failed. It is this focus on a specific customer segment that gives it the
advantage over the Big Five UK banks – Barclays, RBS, Lloyds, HSBC and
Santander. It has taken the opportunity to build deep expetise in Buy To Let
and are front of mind for mortgage brokers looking to play BTL business.

Competition in the BTL sector was decimated following the financial crisis
with many small players and building players going out of business. However
competition is picking up again with all of the Big Five, Nationwide and some
of the other building societies increasingly attracted by the bigger margins
that the Buy To Let market attracts over owner-occupied residential mortgages.
Paragon is, to many extents, the incumbent that the other banks have to shake.
It should still be able to succeed in this market because it isn’t just another
business for them it is the only business segment they are in. Paragon does not
have the cost of running expensive branch networks distributing either directly
or via brokers. As long as they can continue to excel in the service they
provide to brokers and to landlords they should be able to continue to punch
above their weights against the larger generalist players.

While the politicians champion the idea of a few large challenger banks
coming into the market to take on the Big Five banks and reduce their market
shares in deposits, current accounts and lending, with the Labour Party
suggesting that they will break the banks up should they come into power, a
different reality is going on in the market. The likes of TSB (still owned by
Lloyds Banking Group but due to float), William & Glynn’s (owned by RBSG
and, again, due to float) and Tesco Bank attract the most attention from
politicians and the media, but in the background smaller niche players have
quietly gone about picking off rich segments of the traditional banks market
share.

Handelsbanken with its 170 branches, largely in market towns, has targetted
SME customers and private customers with above average earnings who appreciate
having a local branch with a local manager who is empowered to make decisions
rather than leaving it to the computer or Head Office has quietly gone about
building a sizeable, highly profitable and satisfied customer base. Aldermore
launched in 2009 focussed on SME customers has lent more than £3bn pounds.
Metro Bank has focussed on customers in urban areas that like both visiting
branches and having extended hours. There are other focussed challengers either
already out there or preparing to launch.

Competition to the dominant banks from
challenger banks is already here, it may not always be head on and obvious but
rather by quietly salami slicing away the better, more profitable cuts from the
market share of the established players, while the big banks are left with less
desirable segments. It is for this reason the launch of Paragon Bank should be
welcomed as just one more step forward towards a more competitive banking
market.

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