How Challenger and Specialist banks rebounded since COVID-19

Revenues rebound, but non-interest income falls

Three quarters (76%) of the sector saw an increase in revenues. This reflected that FY21 saw a strong economic recovery compared with economic impact from the pandemic in 2020. The vaccine rollout and the subsequent reopening of large parts of the economy improved business and consumer confidence. Overall, the sector’s revenue grew by 5% year-on-year (YoY) during FY21. 

Other key trends within revenues to note include:

• Digital banks saw a 43% YoY increase in revenues. Whilst they are growing from a lower base, this reflects the accelerated use of digital banking during lockdowns. As branches close, it’s not surprising that consumers and businesses increasingly looked at online banking and chose digital banks, which tend to be seen as having the slickest services. Since 2018, digital banks have seen a compound CAGR of over 700% as they continue to scale up quickly.
• Challenger banks saw their YoY revenue fall by 3% in contrast. Lower consumer activity meant growth was stilted for challenger banks. Specifically, they saw non-interest income fall by nearly a third (28%) YoY. This reflects reductions in the volume of credit card transactions, ATM transactions and reduced travel, all due to COVID-19 restrictions. The average decline in non-interest income for the sector was 12% YoY. Challenger banks have seen a CAGR of -2.2% from 2018 to 2021, reflecting the difficult conditions they have faced since COVID-19 impacted from Q1 2020.
• Specialist banks had better revenue growth, with a 17% increase YoY. This was driven by increases in loan books on the back of multiple government lending initiatives for SMEs and increased activity in the mortgage sector.
• Net interest income (NII) for the segment increased by 9% YoY. With all categories posting a YoY growth (Challenger banks: +4%, Specialist banks: +18%, Digital banks: +56%). The growth in NII was primarily due to an increase in lending volumes and some repricing measures. The median NIM for the sector expanded by 13 basis points (bps) to 2.09% in FY21, driven by prudent balance sheet management, which resulted in a lower cost of funds and a higher yield on loans.

With the UK interest rate increases, banks’ NII growth could witness increased growth. While the loan growth in mortgages and SME lending is expected to moderate, loan growth is expected in consumer and corporate segments due to an uptick in consumer activity with improving economic indicators. However, macro-challenges such as high inflation has created significant uncertainties.

Overall lending balances for the sector increased by 2% YoY 

Key drivers were:

• An increase in SME lending (+9% YoY), supported by government funding initiatives
• An increase in mortgages (+5% YoY), driven by low-interest rates and the stamp duty moratorium
• Unsecured personal lending witnessed a decline (-4% YoY) with banks maintaining a conservative risk appetite and consumers typically saving more during the lockdown

Operating expense – impacted by technology and higher headcount cost

Operating expenses for the sector increased by 1%, driven primarily by an increase in employee remuneration, which increased by 5% YoY for the sector, driven mainly by:

• Specialist banks, which saw a growth of 17% YoY. This reflected increased staff numbers and the release of bonus accruals for many specialist banks. 
• Digital banks saw a 35% increase in compensation expense, mainly driven by increased headcount as they looked to scale up rapidly.
• Challenger banks witnessed a decline in compensation expense and headcount as they streamlined their operations and optimised their footprint to improve efficiency. 
• Additionally, the strong competition for talent, especially in technology, has increased the average cost per employee, adding to total compensation expenses. We can expect this trend to continue as technology skills will continue to be in high demand across financial services.

In absolute terms, non-compensation expenses remained muted for the sector compared with FY20. However, there were increases in non-compensation expenses for specialists (9% YoY) and digital banks (19% YoY) as they continued to invest in their transformation.

We are seeing varied split between compensation and non-compensation contributions to total operating expenses. Some banks benefit from efficiencies, led by the improved use of technology. Others are hiring more people to support the rapid growth of their business. 

Cost income ratio (CIR) – slow but steady improvement

Continued investments in digital along with a solid income growth led to the improvement of the CIR for the sector, which stood at 74% for FY21, from 76% a year ago. This 2% net improvement reflects investment in technology that is both increasing costs in some banks and already driving efficiencies for others. The CIR improvement continues the trend over recent years across the overall sector, with the FY21 ratio 7% better than FY18.

Within that overall sector picture, we also saw:

• Specialist banks remain the most efficient, with a CIR of 48% for FY21, below even their CIR for FY18.
• Digital banks have seen their overall CIR gradually declining over the last few years, indicating that, profitability, which was once a distant dream for these digital natives, is now within reach. Their high absolute CIR reflects that digital banks are continuing to invest in growth and scaling up.
• CIR has also fallen for challengers but remains stubbornly high at 85% for FY21. We expect to see an increased appetite for transformational change, powered by technology, to reduce costs and improve their digital operations and service.

Release of provisions sees return on equity increase

The significant decline in provisions drove profitability for the sector. The overall provisions for the industry declined by 64% YoY during the year.

Once lockdown measures were eased, the easing of provisions reflected the more positive economic picture. Default rates have also tended to be lower than expected. However, the disruption from geopolitical events, higher inflation and a cost-of-living crisis, including significantly higher fuel costs, is likely to change that picture in the future. 

The rolling back of provisions saw the median ROE for the sector improve to 10.7% in FY21 from 7.1% in FY20. It also meant that the net income grew by 13.5% YoY in absolute terms in FY21.

The sector remains resilient

Banks continued to remain well capitalised, with levels well above the minimum required. The median common equity tier 1 (CET 1) ratio for them stood at 17.4%, leaving enough scope for any growth expansion plans in the future. 

Risk weighted assets (RWAs) witnessed a median decline of 2% YoY. This likely is due to several factors, including:

• The gradual improvement in the economic environment post-COVID, which reduces the risk weights on most assets
• Loans extended under the stimulus were typically assigned the lowest risk rate since they were under government guarantees.
• Some banks had also changed their asset mix, including portfolio sales, to improve returns on regulatory capital. 

Challenger banks witnessed the median RWA decline of 10% YoY, whilst specialist and digital banks witnessed a median RWA growth of 3% YoY and 5% YoY, respectively.

Liquidity

Banks continued to garner customer deposits with specialists driving the growth (in absolute numbers). Although starting from a smaller base, digital banks reported the fastest deposit growth driven by the pandemic. The sharp increase for digital banks reflects the growing demand and increased confidence in digital banking, accelerated by the pandemic. As interest rates rise, more customers may look to deposit funds, though that may be tempered by high inflation, making cash savings less attractive in ‘real’ terms.