- Nationwide set to buy Virgin Money in deal worth nearly £3bn
- It comes just weeks after Tesco agreed to be bought by Barclays
- Could this pave the way for further activity in the mid-tier banking sector?
Nationwide’s deal to buy Virgin Money marks the second acquisition of a mid-tier bank to be proposed in a matter of weeks.
The planned sale of both Tesco Bank and Virgin Money to larger rivals is a significant development, not least because both started out as challengers to the big lenders.
As the main high street banks shore up their position, and digital banks like Monzo and Starling continue to innovate, these challengers are facing a more uncertain future.
Acquisitive lenders, low valuations and more flexible neobanks could pose a threat to the original wave of challenger banks – and could mean further consolidation down the line.
What’s happened to the first wave of challenger banks?
In the 1990s a new kind of challenger bank emerged, hoping to disrupt the big four banks – Barclays, HSBC, Lloyds Banking Group and NatWest.
As well as Virgin Money and Tesco Bank, these included Metro Bank, TSB, Aldermore Bank and Sainsbury’s Bank.
Two decades later, a new wave of app-based banks like Monzo and Starling came on to the scene – and there was real hope that both traditional and digital challengers could disrupt the market alongside one another.
But it hasn’t quite worked out in that way.
Some of the mid-tier banks have already been bought by bigger banks. TSB was acquired by Spanish banking giant Sabadell in 2015, and South Africa’s FirstRand snapped up Aldermore two years later.
Metro Bank, which launched in 2010, has been plagued with issues which culminated in an emergency cash injection last autumn. It has since announced that it will axe 1,000 staff as part of an £80million cost-cutting drive.
Like Virgin, Tesco and Sainsbury’s entered the market in the 90s, hoping to use their existing store network to offer banking products.
In the late 90s the credit market was booming, which dramatically changed as we hit the financial crisis. The profits that they envisaged back then have never materialised Alper Kara, professor of banking and finance at Brunel University
But Tesco recently offloaded its banking division to Barclays for £600 million, while Sainsbury’s plans to withdraw from the banking market.
‘The profits that they envisaged back then have never materialised,’ says Alper Kara, professor of banking and finance at Brunel University.
‘One reason is that in the late 90s and early 2000s the credit market was booming, which has dramatically changed as we hit the financial crisis of 2007.
‘In the post-crisis period, the capital requirements for banks’ credit risk got much tougher, which made banking even more capital intensive and expensive.’
With even the incumbents struggling to gain ground as interest rates reached historic lows, the likes of Tesco and Sainsbury’s also suffered.
Kara adds: ‘Other mid-tier banks are struggling to compete for the same reasons. Virgin Money lacked scale. Metro Bank, running a very expensive branch-based service, suffers from high cost to income ratios, denting its profits.’
> What will the Virgin Money sale mean for customers?
Why did the challengers fail to disrupt banking?
The challengers haven’t delivered on their promise, and in recent months the big four banks have gone from strength to strength.
As competition for deposits grows, the challenging economic backdrop has favoured the big banks and their big balance sheets.
They can also better absorb the rising costs associated with anti-fraud and anti-money laundering regulation.
Kara says: ‘At its core, the banking business is about economies of scale and requires large capital deployment. Challenger banks, which are not a uniform group, do not seem to have enough of either.’
The sheer size of the legacy lenders means it is harder for small and mid-sized banks to gain meaningful ground.
Ian Lance, fund manager of Temple Bar Investment Trust, which holds shares in NatWest and Barclays says: ‘The appropriately high regulatory oversight of the banking sector presents a challenge for new companies to take meaningful share from incumbent banks, perhaps insulating banking from the threat of obsolescence more than in some sectors, where competition is fiercer and barriers to entry lower.
‘Whilst consumers will frequently switch between broadband providers or utility companies, research has revealed that British citizens rarely switch bank accounts, even if unhappy with the service received’
Big banks keen to snap up more rivals
The other barrier for challenger banks is increasingly acquisitive banks as they finally see their net interest margins and profits rise again.
Laith Khalaf, head of investment analysis at AJ Bell says: ‘Bank valuations are currently low which encourages acquisitive behaviour, because the buyer can pick up assets at a knock-down price.
‘With interest rate margins also likely to fall as monetary policy is tightened, banks may also be looking for ways to bolster their earnings in the medium term, and buying a competitor at an attractive price is a short cut to organic growth.
‘Healthy balance sheets also create the necessary conditions for a cash splash. There is a limit to how far activity can go without raising the alarm at the CMA, however.’
Most banks are trading at low valuations, and all trade on discounts to tangible book volume – NatWest is on a price to earnings ratio of 5x and Barclays is on 4x – which means there is plenty of scope for bargain-hunting.
While Nationwide’s offer for Virgin Money came in at a 38 per cent premium on the share price when it was announced, at 220p a share, it actually marks a discount to Virgin’s tangible book value of 360p a share.
With high street banks’ coffers boosted thanks to higher rates, the original challengers have an uphill battle trying to gain further ground.
They’re also facing a challenge from neobanks like Starling and Monzo in keeping pace with digital transformation.
Kara says: ‘Many consumers prefer to bank online using innovative mobile apps. Digital challengers found a space of their own in the banking market via technological specialisation and, not having the branch networks, operating at lower costs.’
These banks, which are often backed by venture capital funds, also tend to be valued on growth rather than profitability which can ease the pressure somewhat.
‘For now they seem to be the ultimate challengers to mainstream banks,’ adds Kara.
The challenge posed by the neobanks has also pushed the bigger lenders to invest more into their digital capabilities.
Lance says: ‘Banks are incorporating and adapting fintech approaches to change the way they interact with their customers.
‘This not only heads off the risk of technological obsolescence – with the well-funded banks able to put substantial resources into such efforts – but also makes these processes more pleasant and efficient for customers, increasing customer experience and retention, and lowering the cost of service delivery.’
All of this means that mid-tier banks are facing challenge from both the legacy lenders and the plucky upstarts. So are recent deals indicative of a wider trend?
Rich Wagner, chief executive of small business-focused Cashplus Bank says: ‘I’ve been predicting consolidation across the digital challenger and wider banking sectors for a few years now, and to be honest it hasn’t happened as quickly or to the scale I expected.
‘Consolidation plays like Nationwide’s proposed acquisition of Virgin Money don’t necessarily signal the end of the first generation of challenger banks, but it is a demonstration that it often makes sense for larger, traditional institutions to buy rather than build.
‘It may also be a sign that current market valuations of publicly traded banks are creating good conditions for deals to be done.
‘I believe the trend of acquiring for capability will continue as innovation will be driven by smaller more agile digital players.
‘But that doesn’t mean that every new challenger will be absorbed by a bigger bank. Some will go it alone, and I would also expect to see some consolidation among challengers themselves.’
Some links in this article may be affiliate links. If you click on them we may earn a small commission. That helps us fund This Is Money, and keep it free to use. We do not write articles to promote products. We do not allow any commercial relationship to affect our editorial independence.