Framing New Futures: Challenger Banking Report 2017

Framing
new
futures
Challenger banking report 2017
October 2017
Content
Foreword........................................................... 3
Challenging definitions ..................................... 4
Introduction....................................................... 8
Challenger bank financials: plain sailing?......... 12
Technology: the great leveller.......................... 14
Capital ideas: avoiding inertia.......................... 16
Conduct and customers: the edge.................. 18
Conclusion: natural evolution .......................... 20
© 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Challenger banking annual report 1
Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
© 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International
Foreword
Shifting landscapes
We titled the 2016 Challenger bank report ‘A New Landscape’. The past
year has shown that the banking scene remains in flux.
The complexity and diversity of UK banking is typified by the sheer amount of time we spent debating what to
call the non-Big Five banks and how to categorise them.
‘Challenger banks’ looks like an increasingly poor term – a gross generalisation. Nevertheless, it has stuck as
a way of describing almost any organisation that does something the traditional Big Five do, but which isn’t a
member of that group. So we stick with it. Next year? Maybe not.
Trying to find types of ‘Challenger banks’ that help us and our clients understand the forces at work in any
useful way is equally frustrating. We debated chronological waves of new banks; categories based on size; on
breadth of offer; on digital adoption; and on business model.
In the end, however, the platformisation of the banking sector not only makes such labels misleading, it also
fails to account for rapid changes both across the sector and within individual players. Even just categorising
new entrants that have strong existing brands in other sectors makes this a fruitless task.
As you’ll see, to overcome this problem we ended up with three very broad groups: Classic, Contemporary
and Nouveau Challengers.
The really interesting strategic decisions for banks – big or small, branch-led or digital, niche or mass market
– will be driven less by where they come from and more by where they are heading. So while this report
summarises the state of play with today’s Challengers, its main purpose is to outline how they might respond
to the drivers of change.
The Challenger banks continue to get more numerous and diverse. But many will not pass the threshold for
further growth. The evolutionary forces and revolutionary change will result in acquisitions, partnerships and
even extinction for some entities and potentially whole types of banks.
What’s clear from our own work with Challengers is that creativity and adaptability – as in all evolutionary
systems – are the key. Read this report in conjunction with Challenging Perspectives, our companion report
featuring the views of a dozen bank CEOs, and that message will come through loud and clear.
Richard Iferenta, Head of Challenger Banking
Challenging
definitions
‘Challenger bank’ is a catchall term that describes
any organisation outside the Big Five. But it does
little to explain the breadth of their ambitions or the
complex business models they employ. Is there a
better way?
4 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
Since the financial crisis in 2008, more than Nouveau Challengers
Nouveau Challengers tailor their
50 institutions have been granted a banking licence in services to customers in underserved
the UK – there were 13 applications to the Prudential markets, around cutting-edge
technologies or with services that
Regulation Authority in 2016 alone. bleed outside the boundaries of
Countless others have launched They have the resources to innovate traditional banking – for example,
services that don’t require a licence, in-house – but they’re not averse to Revolut, B-Social and Iam Bank.
but that have traditionally been partnerships or acquisitions to stay The Nouveau Challengers do not
offered by banks. We have also seen competitive. Many in this group are seek to compete with the big High
brand new approaches that seek to not full-service provision, nor do they Street players at all, recognising that
disrupt the market, providing a step- intend to be. By blending traditional customers in the future are more likely
change in customer experience or and innovative banking services, many to use banking services from multiple
technology deployment. Classic Challengers have achieved organisations channelled through
strong balance sheet growth over the platforms and apps. These businesses
A significant proportion of these new
past few years. reduce competition by creating “blue
players exploit underserved niches,
and all strive to differentiate from the These banks might be considered to oceans” of uncontested market space.
Big Five banks. be beating the Big Five at their own The main trial for Nouveau Challengers
game, using more modern systems will be in raising brand awareness
Many Challengers argue that the
free of legacy conduct issues and and winning over customers to new
challenge has already taken place,
building resilient, trusted brands. ways of thinking about money as a
and that the label is now redundant.
They’re more interested in dominating series of lifestyle choices. Reliant on
their chosen area of opportunity Contemporary Challengers technology, they also need to stay
than competing with those High Technology focus creates value in at the cutting edge and ensure new
Street incumbents. these banks’ distribution channels risks around data and conduct are
and brings life to commoditised managed without creating a costly
‘Challenger’ remains little more products. Banks in this category are compliance burden.
than convenient shorthand, But predominantly planning to be digital-
the diversity of an ever-changing first (and likely digital-only), offering
market suggests we need some new customer support via online chat
ways of looking at the strategies of or call centres. Cloud architectures,
these banks. streamlined third-party systems
and open application programming
Classic Challengers interfaces (APIs) offer a low cost base
Blending traditional and innovative with high efficiency.
models, these banks seek and exploit
Contemporary Challengers may
scale in their customer base and often
be more likely to partner with, or
a branch network. Their relative cost of
even consider themselves to be,
regulatory compliance remains lower
Fintech companies. Riding the wave
than for smaller Challengers. Classic
of platformisation, these banks are
challengers, including the Co-operative
gateways to a rapidly growing network
Bank, TSB and Virgin Money, feature
of interlinked, specialised product
elements of classic banking, having
providers and financial technology.
a branch network, taking deposits,
Contemporary Challengers such as
making loans – they’re flexible
Atom, Monzo and Starling hope to
enough to exploit new technology
create a marketplace for financial
and business models for innovative,
services, with banking operations at
customer-focused services.
the core.
Contemporary Challengers need to

meet the expectations of shareholders
by gaining scale, creating value and
carving out definitive, differentiated
niches of products or customers.
Brand Technology
Five key A diverse and crowded market

means consolidation is inevitable.
Brand differentiation and strength
We’ve seen many Challengers
focus on technology that allows
them to plug into external
drivers will be a critical component

towards high levels of customer
engagement to ensure survival.
We expect significant additional

services, such as investing or
shopping. Platformisation is here
to stay.
In the short-term, we expect

attempts to build brand awareness. to see more Challengers use
In many cases that will mean technology to create flexibility
partnering with better-established in their operation and control
brands – as Tandem sought to do infrastructure costs.
with House of Fraser.
Cloud services (well-established),
Challenger banks are now fighting open APIs (soon to be mandated
a ‘personality’ war, with trust and through Open Banking), AI (more
recognition the spoils. compellingly in the longer term)
and a host of newly emerging
technologies will be significant
factors in deciding which banks
will win.
Customer experience Deal-making Regulation
Challenger CEOs told us this The strategy, timing and execution Challenger banks have seen rapid
year that differentiated customer of acquisitions and partnerships is growth in the wake of increased
experience sits at the heart of their critical for the future of all breeds openness, as well as customer
offer. It’s the foundation of organic of Challenger. desire for tailored, cheaper and
growth and helps them to carve more modern banking services.
Inevitably, some of those deals
out a market niche.
will involve larger, incumbent Emerging capital rules in Basel IV
Challenger banks must now players buying up capabilities, will continue to shape Challenger
make their services sticky technology, loan portfolios, brands appetites for different products
as well as easy to use and or customers developed by and services, as well as defining
available. Customer experience Challengers. As markets evolve, their drive for scale and stronger
is about expectations, and across new opportunities emerge thanks balance sheets.
customer and B2B markets, those to changes such as Open Banking
Brexit also creates significant
expectations are rising in line and even Brexit, so we can expect
regulatory upheaval that
with experiences from a host of a solid run of partnerships of
Challengers must begin preparing
other sectors, such as retail and all kinds.
– most importantly – consumer for now.
tech services.
Great customer experience and

customer propositions must clearly
drive value for the Challengers and
their investors.
Introduction
We were right to question the idea of the
‘Challenger banks’ as a homogenous group last
year. Their aims, methods, opportunities and
challenges are incredibly diverse. Based on the
perspectives of their CEOs and the forces now in
play, further upheavals are inevitable.
Financial performance: Technology: The most compelling entrants will
sustaining momentum cost and flexibility offer value beyond banking, perhaps
in the form of a digital ‘concierge’ that
The robustness of the sector is Data privacy and cybersecurity have
wraps banking more seamlessly into
evident from the financial results (see moved up the agenda even without
day-to-day life (see our report on ‘The
page 9). Aggregate return on equity the additional pressure of GDPR. Open
future face of the invisible bank: Meet
is up; the Challengers are reducing Banking will see new risks – especially
EVA’). Expertise in brand, data and
their cost ratios; and have maintained with non-banking brands becoming
customer engagement will be decisive
net interest despite the on-going low ‘trusted third parties’ for banking data
– strengthening the hand of tech
rates environment. and transactions – and opportunities
giants, who already fill that concierge
around shared customer data.
Capital ratios are also improving, and role and also happen to have ready
many of the larger Challengers are For Challengers, this should be a access to capital.
self-sufficient as their balance sheets simpler task than for incumbents with
grow – up 22.5 percent over 2015 a tangle of legacy systems (see page Choppy waters ahead
among the smaller entities. 13). Newer, more open, simpler and Organic growth is clearly still on
cheaper technology infrastructure has the agenda for many Challengers.
We continue to watch for potential
long been a competitive advantage We expect to see more deal
impacts of Brexit. As yet, there’s
for Challengers, although that may be activity – whether in mergers and
no visible impact on the financial
narrowing a little as they mature and acquisitions, less rigid partnerships
performance or valuation of
some enter new markets and layer or platform sharing – as the market
Challengers. This may change as
on functionality. evolves. Consolidation is clearly one
negotiations unfold.
potential endgame.
Regulation: Customers:
There are deep currents at work as
a critical year ahead scale and experience the market strives to maintain enough
In our Challenging Perspectives: CEO flexibility to adapt.
The regulatory landscape is shifting
insights report published earlier this year,
– not least with the Second Payment
the Challenger bank CEOs we spoke to
Services Directive (PSD2), Open
agreed that relentless customer focus
Banking, International Financial
is key (see page 19). For the app-only
Reporting Standard (IFRS) 9 and the
players – such as Atom and Starling
General Data Protection Regulation
– the proposition is convenience and
(GDPR). But changes to capital
user experience, and we see continued
adequacy rules might also make a
advantages from smarter, simpler
huge difference for Challengers
technology in maintaining this edge.
(see page 16).
Retailer banks – such as Sainsbury’s
The Prudential Regulation Authority
or Tesco – have expertise in value
(PRA) is shifting to help insurgent
transfer, turning shoppers into banking
banks make the change to the
customers. As the retail side of
Internal Ratings Based (IRB) approach.
their businesses becomes driven by
But as the Basel rules continue to
data and analytics (and by granular
put pressure on all banks, we see
customer insight), their banking offer
potential pitfalls for Challengers. Many
should also yield more value.
need to attract capital in order to meet
their customer growth ambitions, and Brand is expensive to build, particularly
higher adequacy requirements could in banking where trust is so important.
decelerate those plans or require a With the benefits of Open Banking
shift in strategy. set to materialise in 2019, new
players might enter the market with
ready-made brand propositions.
App-only banks
These new entrants are trying
Areas to watch to capitalise on customer use

of digital technology. Since they
have no costly branch networks or
in 2017/18
call centres, it’s all about the app.
Monzo reported 240,000 active
customers earlier this year and
estimates that this will go up to
half a million by year end with the
launch of their current accounts.
The secret to success for all app
based banks will be large scale
customer capture.
Open Banking Payments
and PSD2 Even before PSD2, the
payments space was evolving
Customer centricity is a
fast – see the recent Vantiv/
fundamental value of Open
Worldpay merger. The UK’s
Banking and could result in a
Payment Systems Regulator
new wave of ‘customer layer’
believes up to ten new providers
entrants and payment initiation
could gain access to the
service providers.
interbank payment systems
this year.
Challenger
bank
financials:
plain sailing?
With the wind at their back, most Challenger
banks have built on last year’s improving financial
results. They have shrugged off Brexit fears and
continued to grow. But there are signs of choppier
waters ahead.
Profitability continues to continue to have cost of funds that Capital ratios: strengthening,
are more than double those of the despite lending growth
improve for Challenger Big Five, at 2.0 percent compared
Capital ratios within the Challenger
banks as they become to 0.8 percent, reflecting both the
sector remain strong. Smaller
age of their deposit books and their
more diverse, but we product propositions.
Challengers increased their average
CET1 ratio to 15.5 percent in 2016,
continue to watch for from 14.4 percent in 2015. This
potential road bumps Credit quality: partially reflects the significant impact
that could impact so far, so good of corporate activity at Metro and
The larger Challengers’ lending books Secure Trust Bank. Excluding these
financial performance. are still predominantly secured on banks, the small Challengers saw
residential property. As a result, they a more modest increase from 14.7
Returns continue to improve for
continue to report a low cost of risk of percent to 14.9 percent.
the Challenger sector. The smaller
0.12 percent, down from 0.14 percent
Challengers continue to report sector- The larger Challengers reported a
in 2015.
leading performance, with pre-tax reduction in their average CET1 ratio
returns on tangible equity at 23.6 The small Challengers reported a from 16.6 percent in 2015 to 14.8
percent in 2016, from 20.5 percent higher cost of risk at 0.56 percent, percent in 2016, as they continued
in 2015. an increase from 0.48 percent in to grow their lending3. The larger
20152. We’ve seen increases in cost Challengers will be seeking to
Larger Challengers (excluding the
of risk among three out of nine small become capital self-sufficient in
Co-operative Bank) reported returns
Challengers, as their lending books the near future, with organically
on equity up from 8.6 percent in 2015
continue to mature and season. The generated capital supporting their
to 11.5 percent in 2016. These figures
small Challengers, predominantly organic growth ambitions.
benchmark well against the Big Five
recent entrants to the market, have
incumbent banks, which achieved an Many of the Challenger banks – in
not been through a full credit cycle,
average return of 4.4 percent in 2016. particular the smaller ones – continue
and the impact of potential adverse
to be at disadvantage compared
A key driver of improved returns for changes in the wider UK economy on
to the Big Five incumbents in the
the smaller Challengers has been their financial performance remains to
way that they calculate their capital
leveraging of the cost base. The be seen.
requirement. They calculate risk-
average cost-to-income ratio of the
weighted assets – a key input to
smaller Challengers reduced from Growth: no Brexit dip… yet capital ratios – on the standardised
66 percent in FY14 to 58.8 percent The Brexit referendum saw the share approach, in contrast to the larger
in FY15 and 40 percent in FY16. The prices of the listed Challengers fall participants use of internal models.
scalable, flexible operating platforms an average of 22 percent by the These varying approaches, combined
deployed by new entrants allow them end of June 2016, compared to H1 with the differences in lending mix,
to expand lending books without performance. All the Challengers mean risk-weighted assets represent
associated increases in operating remain almost exclusively exposed 27.1 percent of total assets for the Big
cost base. The smaller Challengers to the UK economy – and investors Five, compared to 45.1 percent for
also lack the fixed costs of branch feared a stalling or reduction in the small Challengers.
networks and high-maintenance growth in the Challenger bank sector
legacy IT systems. in the event of a downturn, whether
Both the larger Challengers and the prompted by Brexit or not.
Big Five have maintained margins, But there is little evidence of a
despite the reduction in the Bank of slowdown in their growth, with the
England base rate to 0.25 percent small Challengers growing their
in August 2016, with net interest balance sheets by £8.6 billion, up
margins for the large Challengers 22.5 percent over 2015. The large 1 Provident Financial has been excluded,
reflecting its different funding structure
stable at 1.9 percent. Challengers have accelerated compared to the other members of the ‘smaller
Challenger’ segment.
The smaller Challengers, excluding balance sheet growth from 2015, to
Provident Financial1, maintained 7.8 percent. Challenger banks and 2 Cost of risk excludes Provident Financial,
reflecting the different structure of its lending
their net interest margin (NIM) their investors will be asking how book compared to the other small Challengers.
at 4.3 percent, in line with 2015. they might best deliver growth and
3 Average CET1 excludes Handelsbanken, for
Despite small improvements in cost manage credit performance if the UK which no CET1 ratios are available for the the
of funding, the smaller Challengers economy dips. UK business.
Technology:
the great
leveller
Although the large incumbent banks are investing
heavily – and often very successfully – in new
technology, we’ve continued to see Challengers
of every description create new opportunities
with their own digital expertise and willingness
to experiment.
Customers and driving Maintenance and security: Platforms: the evolution of
cost reduction were new costs an ecosystem
The past three years has seen cyber Open APIs are also driving banking
the twin objectives attacks on Lloyds, RBS and HSBC platformisation. Consumers
of Challenger tech as well as Tesco Bank – but the truth expect the same all-encompassing
is, like every significant organisation, experience in financial transactions
investment in 2017. banks are being tested daily by that they get from Amazon or Apple,
hackers. As the Challengers’ profiles and tech-driven platforms allow
The past year has also seen artificial
increase, the need for good cyber deeper partnerships between big
intelligence (AI), automation and
security simply redoubles. banks, Challengers and FinTech
algorithms play increasingly important
providers to ensure they get it.
roles in Challenger thinking. One Challengers accept that convenience
of the most notable examples in banking must not come at the cost Data-driven tech giants like Facebook
saw Nouveau Challenger Revolut of security. It’s high on the agenda and Google are well placed to develop
partner with Trussle, a London-based for many consumers thinking about true ‘marketplace’ banking. Partnering
startup, to provide AI-powered changing banks, or even just at their with a tech giant means a relatively
mortgage services. current bank. After the Tesco breach, it is small Challenger could access a large,
increasingly important that Challengers growing customer base while tapping
Underpinning it all is data. From raw
take their security measures beyond into the trust consumers have for the
transactions to softer behavioural
compliance considerations. likes of Apple or Amazon.
analysis, it’s data that is helping
Challenger banks transform from New technology such as machine However, both tech giants and
offering a point-in-time service learning can help identify and address the Challenger banks have a tricky
to providing lifestyle experiences new attack vectors and we expect to problems to address. They must
around financial products. OakNorth, see renewed investment in this area have the technology in place to on-
for example, are now investing in in the year ahead. board customers properly; reliable
data analytics to free up employees and secure APIs; compliance with
for other areas in the customer Open Banking: the big shift Know Your Customer rules; and a
pathway. Their aim is to improve The strategic ramifications of host of other regulations. Failure on
customer experience. imminent Open Banking are any of those scores risks massive
clear: this is nothing less than a reputational damage.
Larger Challengers and the Big Five
are increasingly emulating digital decomposition of the banking value Contemporary Challengers such as
banks. CYBG, for example, has chain. In fact, the question is not Fidor already offer an Open Banking
launched new digital banking services. whether the technology is viable – platform onto which third parties
Virgin Money is building a personal open APIs are inevitable – but will can plug in services. Note that Fidor
finance management app, Virgin customer behaviour change? And has been bought by French giant
Red. Yolt (which describes itself as will third parties win their trust for BPCE, and has also done a deal with
‘a FinTech owned by ING’) is a new banking transactions? Protecting Telefonica to offer banking via the O2
platform consolidating bank accounts, and improving the experience of the mobile network. Its new alternative
credit cards, utilities and even media consumers should be a priority. investment marketplace Finance
subscriptions in one app. But if the Open Banking endgame is Bay also features a partnership
uncertain for now, we can say that many with the Nutmeg online wealth
As we all know, banks don’t stand
Challenger banks, with newer, more management platform.
still. People talk about a tsunami of
change, but we think it’s more like flexible systems, are likely to be able to While many in the sector see
global warming, where the seas rise adapt quicker to new levels of market platformisation as a threat, there
at an unnoticeable pace. If you stand transparency and consumer control. are opportunities to be grasped
still you’ll still drown. But most of the Open Banking also highlights the in increased collaboration, cost
banks are facing shore and walking up importance of guarding data use. The efficiencies and more efficient use of
hill. Success will be with those that General Data Protection Regulation data. The knock-on effect is improved
walk the fastest. (GDPR), due May 2018, will set the customer experience.
ground rules. While GDPR affects
numerous sectors, financial services
firms will be hit hard if they fail to
become compliant, not least because
of longstanding scrutiny of customer-
related conduct risks.
Capital ideas:
avoiding
inertia
When it comes to capital requirements, newer,
nimbler players operate at a disadvantage to the
incumbents. New rules and business models are
posing questions for both banks and regulators –
with big implications for customer outcomes.
The Internal Ratings Capital rules: the The most contentious requirements
PRA and beyond are the application of a capital floor
Based (IRB) approach: and the shift to a single standardised
In the past, the PRA has tended to be
how can regulators set more reactive that proactive towards
approach to operational risk for banks.
a level playing field for firms seeking IRB approval. But in But neither incumbents nor
the past 18 months, it has noticeably Challengers can avoid preparing
Challenger banks? changed its modus operandi. for change elsewhere in the rules.
For standardised approach users,
The PRA has changed course The PRA has set out a staged
there are new requirements for real
to provide more help to support process to getting to IRB, with a
estate transactions, with increases
Challengers but its still too early focus on earlier discussion and
in risk weights for exposures where
to tell how this will impact capital interaction, and a series of gates
repayment of the loan depends on the
requirements in practice. to provide more clarity for firms
income generated by the underlying
on how they will interact with the
Regulatory capital requirements property – a significant change for
regulator during their IRB journey.
pose a problem for Challenger Banks many Challengers.
It has also issued clarifications on
because most apply the standardised
what firms can do with limited data There may be new restrictions on
approach for credit risk capital
for probability of default (PD) and when IRB can be applied to different
calculations.
loss given default (LGD) model portfolios, and parameter floors
The IRB approach used by most development, and it’s made clear the have also been proposed. Firms
incumbents (and some larger requirements of the use test and the using internal models would have to
Challengers) generates capital experience requirement. calculate a floor based on standardised
requirements depending on risk approach to limit the benefit from
Good news for Challengers? Many of
parameter inputs determined by the internal models such as IRB.
them have made positive noises about
bank which in general (and particularly
the PRA’s shift. But we shouldn’t get In short, then, Challengers need
for low risk residential mortgages)
carried away. The procedural changes to make the most of their fleet-
leads to fewer capital requirements
are welcome, and the new attitude footedness in adapting to new
than the SA.
shows a willingness to engage with regulatory realities around capital,
Many Challenger banks argue this banks. But until we see how the and ready themselves for new
incentivises them to lend to slightly regulator applies these new practices, opportunities as those rules bed down
more risky customers rather than it’s too early to call this a turning point. and their options develop with support
in the prime space (especially in from the PRA.
mortgages), where they struggle to Basel accords: What
compete given the differential on Challengers can expect
capital required.
Furthermore, the shift to IRB might
IRB status is understandably hard to not be as attractive as it has been in
achieve. Younger banks, in particular, the past. At the time of writing, 2017
don’t have the required data (up to has seen numerous disagreements
seven years worth) to support the between members of the Basel
development of robust internal credit Committee, creating uncertainty for
models. Many won’t even have the both big banks and Challengers alike.
three years of experience using A crunch meeting to finalise global
their models to demonstrate how capital rules for banks has been
well they’ve integrated them into postponed, with no decision on when
business processes. the next talks will take place. Not only
has ‘Basel IV’ been delayed, but the
full implementation of Basel III in 2019
is somewhat becalmed.
Conduct and
customers:
the edge
Challenger banks all have unique strategies, but ask
CEOs about the overriding priority, and they agree:
it’s customer experience. That focus is serving
them well in shaping their approach to conduct risk,
new data regulations and strategies for growth.
Conduct and culture have become dominant risk Growing pains: the need
factors for all banks. For Challenger banks, this is good for structure
Those kinds of formal structures are
news. With newer, more dependable systems, little likely to remain important regardless
legacy from the back book, and a can-do attitude to of – and perhaps even because of –
the Challengers’ new approaches. The
customer experience, they’re well placed to redefine platform model, Open Banking and
how risk is considered as part of strategy. use of third-party systems could create
unforeseen conduct risks that are not
all within the control of a Challenger’s
Risk: have Challengers Trust matters: where risk own board. There is even a risk that
changed the game? meets culture today’s new architectures could
A dynamic approach to risk Although they have to guard against become the issue-laden legacy
management, allowing faster, bolder any kind of misselling complacency, systems of the future.
decisions in the face of fast-changing Challengers can still influence banking
Many Challengers are focused on
conditions, delivers competitive culture for the positive. This, as
niche markets. That heightens the risk
advantage for any business. FCA chairman John Griffiths-Jones
around clarity on the boundaries of
highlighted in the foreword to the
In banking, risk is also tied up with customer ownership – especially as
regulator’s 2017 business plan, is a
regulatory compliance and reputation. PSD2 mandates open APIs – which
huge factor in delivering the expected
For incumbent banks, scarred by the could create poor customer outcomes.
standards of conduct.
financial crisis and hit with fines for
The regulatory and reputational
long-past conduct failings, this makes This means not only embedding
impacts around the provision of
it a constraining factor. Challengers conduct risk in strategy discussions
advice – not least on the promotion of
have none of that baggage and can – that’s crucial for all banks – but
third-party products – also makes the
define their approach to risk in line also making a positive of risk by
picture cloudier.
with clear market opportunities. combining it with customer and
culture considerations. Every bank Algorithmic approaches to offering
For example, most Challengers have
has to evaluate new products for advice as well as automation of
a very simple product set targeted at
risk and optimise customer journeys processes can create new types of
a defined customer segment. Most
with clear executive accountability. risks around customer outcomes.
large players have many different
Challengers can come at the problem These risks are still poorly understood,
(often legacy) products across different
with an entirely fresh outlook – one and are under review by regulators.
segments, such as mortgages and
many of them are happy to promote
savings accounts. The Challengers In short, then, while we see many
in marketing.
are better placed to use newer, faster, Challengers rightly focused on their
more flexible systems making it easier It’s not all one-way traffic. Having customers and deploying innovative
to test and refresh sales journeys a customer-focused target culture approaches and technologies to serve
quickly, using information gathered is one thing. Complying with the them, their strategies will increasingly
to inform its management of conduct conduct rules is another. Larger rest on how they choose to manage
risks. banks tend to have the resources the operational and conduct risks
and experience to run a standardised those decisions create.
Since much of this advantage is
conduct risk self-assessment process
predicated on technology platforms,
across the firm or develop a firm-
there is a new risk that products
wide taxonomy for conduct risk
and services are properly explained,
types. That’s a stiffer proposition for a
especially to vulnerable customers
who must be shown to be aware of smaller bank.
what they’re buying. This is a potential
conduct risk.
In an effort to summarise our
findings, there are a number of
key areas to reflect upon.
01
The Challenger bank sector is
thriving. We have seen aggregate
return on equity increase and
cost ratios decrease. Many of
the Challengers are now self-
sufficient, and have maintained
Conclusion:
net interest margins.
02
natural
Regulation – in the form of Open
Banking, the Second Payment
Services Directive, and the General
Data Protection Regulation – will
deliver as many risks as it does
rewards. Challenger banks must
be prepared for the pitfalls.
evolution
Over the past few years, Challenger banks have
successfully made their mark in the financial
03
Technology is set to play an
increasingly important role,
with artificial intelligence (AI),
automation and algorithms
coming of age. Underpinning it all
is data.
services industry, but how big will they get?
As the landscape continues to evolve, their
importance will become increasingly apparent to
customers whose expectations of speed, ease of
use and personalised services have been set by the
04
Customer experience and
internet giants. That doesn’t mean categorisation frictionless finance will separate
the winners from the losers.
will be any easier. By 2020, our efforts in this report While brand will play an important
may seem simple by comparison – and that’s no role in this equation, the most
compelling new entrants will offer
bad thing. The ‘challenge’ has just begun. value beyond traditional services.
Notes on preparation assets. Gross yield includes the
Within the financial analysis section of the impact of income recognised on an
report, the banks are classified as follows: effective interest rate basis from
portfolio acquisitions.
– The Big Five banks: Barclays plc,
HSBC Holdings plc, Lloyds Banking –– Net interest margin: the NIM for each
Group plc, The Royal Bank of Scotland sub-division of Challengers is calculated
Group plc and Santander UK plc. as total net interest income divided
by the average of the total opening
– Larger (Classic) challengers: CYBG and closing interest-bearing assets.
plc, Svenska Handelsbanken AB (publ) NIM includes the impact of income
(UK division), Paragon Banking Group pl, recognised on an effective interest rate
The Co-operative Bank plc, TSB Banking basis from portfolio acquisitions.
Group plc, Virgin Money Holdings (UK)
plc and Bank of Ireland (UK) plc. –– Cost-to-income ratio: the CTI ratio for
each sub-division of Challengers is
– Smaller (Contemporary) calculated as total operating expenses
Challengers: AIB Group (UK) divided by total operating income.
plc, Aldermore Group plc, Close Separately disclosed costs relating to
Brothers Group plc, Metro Bank plc, stock exchange listings are excluded
OneSavings Bank plc, Shawbrook from total operating expenses.
Group plc, Provident Financial plc,
Cambridge & Counties Bank Limited –– Cost of risk: Impairment charge on loans
and Secure Trust Bank plc. and advances to customers divided by
the average of opening and closing loans
Banks with consolidated total assets of and advances to customers.
in excess of £10 billion in their 2016 year-
end annual financial statements have –– Standardised Approach (SA): the
been classified as ‘larger Challengers’. default approach to the determination
of regulatory capital requirements for
Information has been obtained from credit risk where a firm does not have
published 2016 year-end annual regulatory approval to use internal
financial statements (including results models. Under this approach, banks
presentations and accompanying analyst allocate exposures to a series of
packs) and company websites. Where regulatory prescribed categories and in
total numbers are presented, it is the most cases use external credit ratings to
total of the sub-division of the banks as determine the risk weight to be used.
described above.
–– Internal Ratings Based Approach
We have taken the following approach to (IRB): an approach used for the
calculate each of the measures used in determination of regulatory capital
this report. requirements for credit risk, where
– Return on equity: profit before the firm has obtained regulatory
attributable to the shareholders, permission to use internal models to
divided by the average of opening derive risk parameters for its portfolio
and closing tangible equity (excluding exposures which are then used in
non-controlling interests for the Big regulatory prescribed formulae to
Five banks). ROE for the smaller determine the risk weight to be used
Challengers does not include AIB for the exposure.
and larger Challengers does not HSBC present their results in US dollars
include Handelsbanken, as these are ($). These have been translated into
segments of larger groups and do not sterling (£) using the relevant period end
disclose capital figures. or period average rate. Where percentage
– Gross yield: the gross yield for changes are presented for HSBC, these
each sub-division of Challengers is are based on the dollar amounts disclosed
calculated as interest income divided by the banks, rather than on the sterling
by the average of the total opening translation of those amounts.
and closing interest-bearing
Contacts
Richard Iferenta
Head of Challenger Banking
richard.iferenta@kpmg.co.uk
The information contained herein is of a general nature and is not

intended to address the circumstances of any particular individual
or entity. Although we endeavour to provide accurate and timely
information, there can be no guarantee that such information is
accurate as of the date it is received or that it will continue to be
accurate in the future. No one should act on such information without
appropriate professional advice after a thorough examination of the
particular situation.
© 2017 KPMG LLP, a UK limited liability partnership and a member

firm of the KPMG network of independent member firms affiliated
with KPMG International Cooperative (“KPMG International”),
a Swiss entity. All rights reserved.
The KPMG name and logo are registered trademarks or trademarks

of KPMG International.
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Framing

Challenging definitions ..................................... 4

Challenger bank financials: plain sailing?......... 12

Technology: the great leveller.......................... 14

Capital ideas: avoiding inertia.......................... 16

Conduct and customers: the edge.................. 18

Conclusion: natural evolution .......................... 20

Richard Iferenta, Head of Challenger Banking

Contemporary Challengers need to

Five key A diverse and crowded market

drivers will be a critical component

We expect significant additional

In the short-term, we expect

Great customer experience and

Areas to watch to capitalise on customer use

The information contained herein is of a general nature and is not

© 2017 KPMG LLP, a UK limited liability partnership and a member

The KPMG name and logo are registered trademarks or trademarks

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