Framing New Futures: Annual Challenger Banking Report

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

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

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 50 institutions have been granted a banking licence in Nouveau Challengers tailor their services to customers in underserved the UK – there were 13 applications to the Prudential markets, around cutting-edge Regulation Authority in 2016 alone. technologies or with services that 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 A significant proportion of these new platforms and apps. These businesses past few years. players exploit underserved niches, reduce competition by creating “blue 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 Many Challengers argue that the will be in raising brand awareness free of legacy conduct issues and challenge has already taken place, and winning over customers to new building resilient, trusted brands. and that the label is now redundant. ways of thinking about money as a 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.

© 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG netw ork of independent member firms affiliated with KPMG International Challenger banking annual report 5 Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Brand Technology A diverse and crowded market We’ve seen many Challengers Five key means consolidation is inevitable. focus on technology that allows Brand differentiation and strength them to plug into external will be a critical component services, such as investing or towards high levels of customer shopping. Platformisation is here drivers engagement to ensure survival. to stay. We expect significant additional 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.

6 © 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. 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.

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.

8 © 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. 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 We continue to watch for potential the agenda for many Challengers. long been a competitive advantage impacts of Brexit. As yet, there’s We expect to see more deal for Challengers, although that may be no visible impact on the financial activity – whether in mergers and narrowing a little as they mature and performance or valuation of acquisitions, less rigid partnerships some enter new markets and layer Challengers. This may change as or platform sharing – as the market on functionality. negotiations unfold. evolves. Consolidation is clearly one potential endgame. Regulation: Customers: scale and experience There are deep currents at work as a critical year ahead the market strives to maintain enough In our Challenging Perspectives: CEO The regulatory landscape is shifting flexibility to adapt. 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.

10 © 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. 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.

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.

12 © 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. 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 to 0.8 percent, reflecting both the banks as they become sector remain strong. Smaller age of their deposit books and their Challengers increased their average more diverse, but we product propositions. continue to watch for CET1 ratio to 15.5 percent in 2016, 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 balance sheet growth from 2015, to Challenger’ segment. The smaller Challengers, excluding Provident Financial1, maintained 7.8 percent. Challenger banks and 2 Cost of risk excludes Provident Financial, their investors will be asking how reflecting the different structure of its lending their net interest margin (NIM) book compared to the other small Challengers. at 4.3 percent, in line with 2015. they might best deliver growth and manage credit performance if the UK 3 Average CET1 excludes Handelsbanken, for Despite small improvements in cost which no CET1 ratios are available for the the of funding, the smaller Challengers economy dips. UK business.

14 © 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. 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 reputational damage. Larger Challengers and the Big Five clear: this is nothing less than a 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 with the Nutmeg online wealth As we all know, banks don’t stand uncertain for now, we can say that many management platform. still. People talk about a tsunami of Challenger banks, with newer, more 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.

16 © 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 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 approach to operational risk for banks. how can regulators set more reactive that proactive towards 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.

18 © 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. 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.

© 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG netw ork of independent member firms affiliated with KPMG International Challenger banking annual report 19 Cooperative (“KPMG International”), a Swiss entity. All rights reserved. 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 net interest margins. Conclusion: 02 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 natural be prepared for the pitfalls. 03 evolution Technology is set to play an increasingly important role, with artificial intelligence (AI), Over the past few years, Challenger banks have automation and algorithms successfully made their mark in the financial 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 04 use and personalised services have been set by the 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.

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 Cooperative (“KPMG International”), a Swiss entity. All rights reserved. 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

Richard Iferenta Head of Challenger Banking [email protected]

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