Sir Mervyn King, the former governor of the Bank of England, described “the indiscriminate withdrawal of lending” to small and medium-sized enterprises (SMEs) as one of the worst effects of the 2008 banking crisis. Some big banks reduced their lending dramatically and some withdrew from market segments as they sought to rebuild their balance sheets and reputations, and their much-vaunted relationships with long-standing customers were revealed as hollow constructs as they pulled in loans and terminated overdraft facilities.
However, the withdrawal of the traditional banks from the SME lending market provided a golden opportunity for a wave of “challenger banks”, which swept in to fill the niche. “It was a revolution waiting to happen,” says Dave McCarthy, chartered accountant and CFO at Atom, which was approved as “the UK’s first digital” bank in 2015 and opened for business to SMEs in April this year. “The industry had become sluggish, bloated and inward looking. Banking still rests on 300-year-old models that revolve around branches; one of the last industries to embrace digital. So we [he and fellow founders Mark Mullen, now CEO, and Anthony Thompson, chairman] thought ‘let’s have a go’.”
Dave McCarthy, chartered accountant and CFO at Atom
The big advantage of traditional banks is that they have big balance sheets, lots of capital and the systems to manage that effectively
But there’s more than one way to skin a cat. Another challenger, Metro Bank, launched to great razzamatazz in 2009 as “the first new high street bank in over 100 years” and bases its service proposition on its network of “stores” and relationship managers. There are currently 42 stores, mainly in “commuter London”, but five more will open by the end of the year.
There are plans to launch in cities including Leicester, Bristol and Northampton next year, and within the next 10 years Metro aims to have up to 250 across England and Wales. Aldermore, meanwhile, “an SME-focused bank” that opened in 2009, is something of a hybrid. Its offering is primarily digital, but while it has no branches, it also speaks to its customers by phone or face to face at one of its 11 offices, or wherever they are based.
Despite their different models, the challengers are united in their desire to offer great service to their SME customers. By this they mean a set of products aimed squarely at them, including asset finance, invoice finance, commercial mortgages, buy-to-let mortgages and savings accounts; no tricks or hidden penalties; and ultra-quick decisions on loan applications.
“Big banks can offer cheaper products because their cost of funds is lower, but we can give someone an answer in two hours rather than four weeks,” claims Aldermore CFO James Mack, also a chartered accountant.
And they can do this, he continues, because whereas the big banks have such huge volumes of business that they need automated processes, at Aldermore the decision about whether to grant or decline loans is “underwritten” by human beings. “It’s not that we’re taking on riskier propositions; it’s just that we take time to review what the big banks don’t have time to, or doesn’t fit into their mould, and we make it work.”
Metro Bank prides itself on being able to open a current account for a customer, complete with cards, PINs and personalised cheque books, within 15 minutes. “We enable everything through the stores,” says CFO Mike Brierley FCA. “Last week, for instance, a small business came into one of our stores because their point-of-sale machine had failed and their bank had told them it would take two weeks to replace it. We sorted it out for them in 40 minutes.”
However, despite their strong service ethic, the challenger banks have very different views about relationships. For Metro, relationships are absolutely core to its model. “We want to build relationships with trading businesses, who have felt neglected or unwanted by the big banks. Each store has a director and business managers who get out and about with local businesses and the local accountants, lawyers and so on who are a conduit,” says Brierley. “Every one of our customers has a local dedicated relationship manager.
"They may hand a customer off to a specialist team – healthcare, franchise – but the main relationship stays with them, and decisions are made close to the customer. We like to look people in the eyes.”
However, others believe that advocates of relationship banking see it through rose-tinted spectacles.
“We did lots of research about what customers want and ‘relationship banking’ as such wasn’t on the list,” says Atom’s McCarthy. “Customers were a bit negative about the relationship model on the grounds that people change regularly and you don’t actually see them that often – they tend to turn up at the end of the year when they have something to sell. People can get hold of us very quickly, but we don’t go knocking on doors.”
Aldermore’s Mack takes a similar view. “Relationship banking is not part of our model,” he says. “Our customers come to us via accountants and solicitors and we provide them with the particular expertise and products they are looking for. With other banks, people can try to set up a business account and talk to a business adviser, and find that the earliest appointment is six weeks ahead. In any case,” he asserts, “relationship managers in branches have been deskilled so they are not much use to customers anyway – they are little more than glorified diary keepers.”
Richard Iferenta, partner and head of challenger banking at KPMG
The UK market is big and the bigger banks still have challenges
Atom’s research found what customers actually wanted was something straightforward, transparent, honest and convenient – and, above all, good value. “They saw traditional banking as a bit like a tax – they pay for a service but aren’t quite sure what they get in return,” claims McCarthy.
To date, Atom has launched only secured loan products for its SME customers, but other products are in the pipeline, including one, which is in test phase, that helps improve customers’ clarity about their own financial situation and highlights areas they may need to address.
“It looks at their own accounting systems and sees patterns – like their debtor days might be increasing, for example. That helps them, and it helps us too because it gives us the data that allows us to suggest targeted products and removes the need for us to do an extensive annual review,” says McCarthy. “Providing more and more added value is our direction of travel.”
An obvious potential differentiator of the challenger banks is a more ethical approach than the one that became manifest in some of the bigger banks after the 2008 crisis. Mack says he wasn’t the only one who joined Aldermore from the bigger banks “because we were tired of the mud-slinging and wanted to challenge the status quo in terms of customer service”. He continues, “Transparency is critical for us, and our four founding principles – reliable, expert, dynamic and straightforward – drive us still.”
Atom’s McCarthy believes a more ethical approach should be a hygiene factor: “People have to believe that you are ethical, but actions speak louder than words.” Atom has designed some fundamental things into its model that underpin a more ethical approach. For example, no one gets a cash bonus, but everyone gets a share bonus at the end of the year. “The key is to build a business in which people have a long-term stake – it creates an entrepreneurial feel and sense of ownership.” This, as he says, drives behaviour.
Similarly, simplicity and transparency are enshrined in product design. “We don’t try to capture value from inertia, which is where the banks have traditionally created a lot of profit; we don’t launch attractive products and then reduce the interest rates on them. Our view is, ‘this is what we do, if you like the sound of it, come to us’.” <;p>
One of the biggest challenges the challengers face is overcoming inertia among customers, who are more likely to change their partner than their current account. However, they don’t see their lack of marketing budgets as a particular problem, united in their belief that no-one believes banking advertising anyway.
“Our brand recognition was 80% in London last year, and for ABC1s and those in employment it was 85%, and we achieved that on a marketing spend of £50,000,” claims Brierley, adding that the Metro stores, which are in prime sites, often near transport hubs, do a lot to market themselves.
Aldermore and Atom, meanwhile, have been building their customer bases through referrals from intermediaries, but are increasingly gaining business directly through word-of-mouth recommendation and social media.
“If you can show that you are different, you can persuade them to move,” says McCarthy. “Yes, we have to earn our stripes, but some of the intrinsic attitudes and barriers are starting to change.”
Warren Mead, global co-head of fintech at KPMG
If these new kids can successfully combat customer inertia at scale, they could blow the incumbents out of the water
Setting up a new business is not easy, but setting up a new bank – particularly a new model of bank – brings a whole different level of complexity, and the challengers have had to jump through endless regulatory hoops and, in some cases, help the regulators grapple with what is for them new territory too, in order to secure their licences. Raising capital from high-quality backers is an important component, but, for Atom at least, the systems and processes side continues to be the toughest nut to crack, says McCarthy, “because we need different solutions from what’s been done before”.
In A New Landscape, its report on challenger banks published in May this year, KPMG suggested that what some have described as the “golden age” of the challenger banks may be over now that the traditional banks have returned to growth and regulators and politicians seem less inclined to give the new pretenders “special treatment”.
The challengers themselves don’t believe they have been treated any more leniently than any other bank – in fact, in some ways, it’s been quite the opposite. “The same rules apply to us as apply to the big banks, and we have to meet the same standards – quite rightly,” says Mack. “The only exception is on capital requirements: the bigger banks use the internal-ratings-based (IRB) approach [to assess credit risk], which is much more difficult for smaller banks to do because it is such an arduous and lengthy process, so we have to use a standardised approach. This means we have to hold 15 times more capital than a larger bank does to offer the same-sized loan.”
A long-awaited report from the Competition and Markets Authority in May did nothing to level the playing field, concluding that older and larger banks do not have to compete hard enough for customers’ business.
“That capital imbalance is the principal thing that prevents us providing the lending we would like to, and compromises the economic impact the challengers can make,” adds Mack. And the 8% corporation tax surcharge imposed on all banks by then chancellor George Osborne last year is “not helpful”, says Brierley, particularly as it is perceived as a way to subsidise bigger banks.
“We’ve had no great leg-ups,” agrees Atom’s McCarthy. “We’ve done well because the big boys were so inwardly focused.”
But they are pragmatic, and believe that their transparent, good value products, combined with convenience and excellent service, will continue to attract customers from their larger rivals.
The innovation, choice, increased competition and ethical approach that the challengers bring is not only good for customers, it’s good for society too, says Richard Iferenta, partner and head of challenger banking at KPMG. “The opportunity for them is huge. The UK market is big and the bigger banks still have challenges. The new banks have no legacy issues – like PPI – and they have cutting-edge technology rather than creaking infrastructure, so there is no drag on their cost/income ratio.”
Do businesses understand the lending options open to them?
No, say the challenger bank CFOs. “We find that our small business customers rely on advisers, local accountants or a good relationship manager at the bank to point out the best options for them,” says Metro Bank’s McCarthy.
The good news is that ICAEW, in conjunction with the British Business Bank, has just relaunched its Business Finance Guide, which provides a comprehensive view of the financing options available. As David Petrie, head of the Corporate Finance Faculty at ICAEW says: “Many small businesses feel they lack the time to explore funding options, or are nervous about taking on additional debt against a backdrop of uncertainty. Equally, lots of companies are holding onto cash and not investing it.“The Guide is an easy way for them to look at the options and the new challenger banks, with their offerings targeted squarely at SMEs and a strong service proposition, could represent valuable solutions."
But while everything’s to play for – and foreign entrants are joining in too – there will inevitably be consolidation, although it’s difficult to predict what form this will take. For example, might fintechs (financial technology businesses) steal a march over both traditional and challenger banks? Even Atom, digital player that it is, is not sure.
“The big advantage of traditional banks is that they have big balance sheets, lots of capital and the systems to manage that effectively,” says McCarthy. “Fintechs are more nimble and put customers in touch with different products. Atom, at the moment, is actually a bit of both. We are not sure how or when it will break, so we are keeping a foot in both camps. There is a logic that suggests that banking can develop in both ways, which is good for customers, because it will lead to the idea of the ‘one stop shop’, which is how traditional banks have operated, being replaced by a more transparent approach towards finding ‘best value solutions’.”
McCarthy believes that banks will become “quasi platform providers” that help customers find the best products for their financial needs. “This is certainly the direction of travel for us, and though we can determine the best solution through the analytics we do, we won’t necessarily provide all the solutions ourselves.”
KPMG’s report suggested that the challenger banks’ future success will come either from a massive increase in the rate of account switching in the UK or by their creating new markets for themselves through radical disruption of traditional financial services products. Either way, concluded Warren Mead, global co-head of fintech at the firm: “If these new kids can successfully combat customer inertia at scale, they could blow the incumbents out of the water.”