UK challenger banks may be more vulnerable than incumbent banks to late-cycle and Brexit-related risks.
Several UK challenger banks have grown faster than the market, and faster than GDP in recent years. But, argues Fitch Ratings, their performance has not yet been tested in a downturn.
A cyclical downturn or a disruptive no-deal Brexit means higher unemployment or falling property prices. And that scenario could expose weaknesses in challenger banks’ risk management and financial position.
UK banks’ loan books are still performing well. In particular, impairment charges are at cyclical lows after a decade of low interest rates, low unemployment and, until recently, strong property price growth.
However, UK challenger banks may be underestimating the impact of a potential downturn when calculating their provisions. Furthermore, they have a short track record and lack of historical through-the-cycle impairment data says Fitch.
The Bank of England note that fast-growing lenders with a limited track record may be underestimating the potential losses on their loan portfolios under its latest cyclical stress scenario.
UK challenger banks: additional capital may be required
Moreover, they may overestimate their ability to mitigate losses through business growth or capital-raising. Fitch argues that some challenger banks may be required to set aside more capital, possibly by way of increased Pillar 2 capital requirements, in light of the Bank of England’s analysis.
Several challenger banks have grown fast in retail mortgage lending, often to niche borrowers. They are also strong in asset classes that perform less well in a stress, to gain a foothold in the market.
Fitch views sustained above-market-average growth as a potential risk to a bank’s credit profile. This is because it may indicate under-pricing of risk or a loosening of underwriting standards to generate volume.
Rising interest rates and unemployment could trigger significantly greater losses on banks’ mortgage portfolios. This is especially pertinent given UK households’ high indebtedness.
Falling house prices could exacerbate the impact, particularly for banks focused on high loan-to-value lending to drive growth.
UK challenger banks: potential funding pressure
At the same time, UK challenger banks may also be more exposed to funding pressure in a downturn. Specifically, those banks reliant on online retail deposits with short-term fixed rates, and deposits from SMEs and corporate clients.
These sources of funding are more price-sensitive and less stable than current accounts. And they could become more costly to attract and retain in the event of rising interest rates and financial pressure on consumers.
UK banks, including some challenger banks, will need to refinance funding from the Bank of England’s low-cost Term Funding Scheme in 2020-2022. If so, this will also push up funding costs.
Thus far, challenger banks have been unable to break the market domination of the UK’s largest banks. And, concludes Fitch, their lack of scale limits their ability to generate margins in the highly competitive mortgage market.
Fitch placed the Long-Term Issuer Default Ratings of all rated UK banks on Rating Watch Negative earlier this year. This reflects uncertainty about the ultimate outcome of the Brexit process. In particular, the risk that a disruptive no-deal Brexit could damage banks’ earnings, asset quality, liquidity and funding.
Fitch argues that less diversified banks or those focused on niche or highly cyclical sectors are more vulnerable. Many challenger banks fall into this category.
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