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New Entrants Aim to Shake Up U.K. Retail Banking

The U.K. retail bank sector is in a state of flux. A clutch of new entrants are hoping to take advantage of this.

Vernon Hill II is the very picture of privileged ease. Wearing his trademark double-breasted blue silk suit, the billionaire sits back in his spacious London office and looks around for Sir Duffield, his Yorkshire terrier. But the American-born banker quickly makes clear that he means to shake up the establishment, not defend it. Over the past two years, Hill has raised £251 million ($392 million) to launch Metro Bank, the first wholly new entrant on the U.K. banking scene since the days of King George IV.

“Ours is a transformational model. It’s unlike anything bank customers have been getting so far on the high street,” Hill tells Institutional Investor. “As our slogan says, ‘Join the Revolution!’ ”

Hill’s timing seems anything but propitious. The loathing of bankers has become a staple of popular culture in the U.K. since the financial crisis, which forced the government to effectively nationalize Royal Bank of Scotland Group and spend billions propping up Lloyds Banking Group. And the market is dominated by just five giant banks. But Hill believes those factors will work in his favor. He plans to roll out 200 branches — or stores, as he calls them — across southeast England by the end of the decade. The Philadelphia native points to his track record in the U.S., notably with Commerce Bancorp, which he developed over more than 30 years before selling it to Canada’s TD Bank Financial Group in 2007 for $8.5 billion. “I’ve built four banks from scratch, so I know what it takes,” he says.

Hill is not alone. Over the past three years, several new entrants have appeared on the British banking scene, pursuing everything from niche lending strategies to full-service operations. Other potential contenders are lurking on the sidelines. Although their strategies vary, all are convinced that there is money to be made in one of the most maligned, and concentrated, industries in Europe. “It’s a once-in-a-generation opportunity to shake up the market,” says David Morgan, head of the London office of private equity firm J.C. Flowers & Co., which is looking for acquisitions in the sector.

The biggest new player is Virgin Money Holdings (U.K.), a financial upstart launched by British entrepreneur Sir Richard Branson and backed by New York–based private equity investor Wilbur Ross Jr. The outfit, until recently an online credit card operation, expanded dramatically in January by acquiring Northern Rock, gaining 1 million customers and £18 billion in deposits at a stroke.

Another potential heavyweight is supermarket operator Tesco. The company provides loans, credit cards and insurance to some 6.5 million customers through a personal finance venture it launched with RBS in the late 1990s. After buying out RBS in 2008 and resolving a series of information technology problems, the rebranded Tesco Bank expects to begin offering mortgages later this year and add current, or checking, accounts beginning in 2013. Tesco isn’t the only retailer eyeing the market. Marks and Spencer plans to launch M&S Bank in July at its flagship store near London’s Marble Arch and will open 50 branches over the next two years. The bank, a joint venture with HSBC, will build on an existing personal finance unit that provides loans, credit cards and savings products to some 3 million customers.

Two other recent start-ups, Aldermore Bank and Shawbrook Bank, are targeting small-business borrowers seemingly ignored by the big banks and steadily building up their balance sheets. Although modest in size, they have some powerful backers. Aldermore’s investors include Goldman Sachs Asset Management and London private equity firm AnaCap Financial Partners, while Shawbrook’s chairman is Sir George Mathewson, former CEO and chairman of RBS. Besides J.C. Flowers, firms battling for acquisitions include investment vehicle NBNK Investments, which is bankrolled by such prominent institutional investors as insurance group Aviva and asset manager Invesco. The firm’s chairman is Lord Levene, former chairman of Lloyds’ insurance market, and its deputy chairman is Sir David Walker, former chairman of Morgan Stanley International. If a revolution is taking place, the grandees are leading it.

The allure for all of these players is the sheer size of the U.K. retail banking market, and its remarkably resilient returns. Total sterling deposits in U.K. banks have held steady in recent years and amounted to more than £2 trillion at the end of March, including £660 billion of personal deposits at the top five banks — Lloyds, RBS, Barclays Bank, HSBC and Santander UK — according to Bank of England and British Bankers’ Association data. Underlying returns on equity in retail banking have retreated only slightly from precrisis levels and, for most of the big banks, remain much higher than group ROEs, which have been hit by diminished returns on wholesale and investment banking activities. “Royal Bank of Scotland, Lloyds Banking Group and Barclays achieved a return on equity of 25 to 30 percent in 2011, assuming that their equity was 10 percent of their risk-weighted assets,” Gary Greenwood, banking analyst at Shore Capital in London, says of the big banks’ retail operations. The new entrants aren’t forecasting quite such high rates of return, but most think a healthy 15 to 20 percent is realistic in spite of the intensification of competition.

What makes them optimistic that they can win meaningful market share: Surveys of bank customers consistently reveal high levels of dissatisfaction. The latest annual research by consulting firm Accenture, released in January, found that 40 percent of nearly 4,000 account holders surveyed were unhappy with their banks, only slightly below the level of a year earlier.

Moreover, the big banks find themselves under attack on several fronts. In early July, Barclays CEO Robert Diamond Jr. resigned after the bank paid a £290 million fine over its role in allegedly manipulating Libor. Only a few days earlier, the Financial Services Authority ordered Barclays, HSBC, Lloyds and RBS to compensate thousands of small and medium-size businesses for improperly selling them complex interest rate swaps. Sandy Chen, a banking analyst at Cenkos Securities in London, estimates the banks will have to pay a total of £1.1 billion to £1.4 billion in compensation. Over the past six years, those same four banks have set aside £9 billion to pay fines for foisting loan-payment-protection insurance on unsuspecting customers.

The regulatory environment also favors new entrants in a couple of important respects. The authorities, concerned about the lack of competition since the collapse or merger of several banks in 2008, are encouraging new players. “We need new banks to enter the market to provide consumers with more choice,” Chancellor of the Exchequer George Osborne said in December. He noted the disappearance of HBOS (now part of Lloyds, in which the government holds a 43 percent stake) and Bradford & Bingley, a mortgage specialist whose viable operations were acquired by Santander UK in 2008.

Similarly, the Independent Commission on Banking, which conducted a yearlong study of the industry and recommended major regulatory overhauls, included a call for more competition in its September 2011 report. The commission noted the striking degree of concentration in the industry, in which the Big Five banks controlled almost 80 percent of current accounts, 71 percent of mortgage lending and 60 percent of savings accounts. The commission urged that any disposals, such as the 600 branches that European Union regulators have forced Lloyds to sell in return for state aid, go to small or new players.

In addition, the top five banks all face much higher capital and liquidity requirements under the Basel III agreement, which U.K. authorities are implementing with vigor. As a result, the big banks are slowly pulling back in certain retail segments, as well as in other areas, in a bid to trim their balance sheets and reduce their reliance on wholesale funding. New entrants, which are not of systemic importance, face lower capital requirements.

Some senior U.K. bankers go so far as to admit that they have too many customers. “I think we’ll become smaller over the next three years to become better,” says Steve Pateman, head of U.K. banking at Santander UK, the second-biggest mortgage lender after Lloyds. “From having been a collection of three different building societies, we’re now building a full-service bank, probably one with fewer than the 25 million customers we have now.”

But for all their potential advantages, new banks face a struggle to woo customers. Consumers and small-business owners may grouse openly about their banks, but they remain notoriously reluctant to switch. The proportion of customers in the Accenture survey who had switched accounts in 2011 was just 11 percent, down from 16 percent in the previous year’s poll. Steve Hughes, senior economic adviser to the British Chambers of Commerce, offers one explanation for the seeming passivity of the organization’s 100,000 small- and medium-size-business members. “I’m astounded at the loyalty of businesses to their banks,” he says. “There’s a widespread belief that the banks are all the same, so they’re not shopping around.” 

Add to this customer complacency today’s low interest rates, correspondingly low net interest margins and the sluggish U.K. economy, which officially fell into a double-dip recession in the first quarter, and the prospects for new entrants don’t look bright. These competitors face a long struggle to achieve attractive returns.

METRO BANK, FOR ONE, SAYS IT IS IN THE BUSINESS for the long haul. It is the most distinctive of the new players, befitting a bank that in 2010 was the first to be granted a completely new banking license in the U.K. since 1830, when the Duke of Wellington was prime minister. Metro raised a fresh £126 million in June, effectively doubling its equity capital. Its investors include New York–based property group LeFrak Organization, hedge fund firm Moore Capital Management and Fidelity Worldwide Investment, the overseas arm of the Boston mutual fund giant, as well as London-based billionaire real estate owners David and Simon Reuben.

Hill and his team have opened 12 branches so far, which are open seven days a week. The interiors, designed by Hill’s wife, Shirley, are bathed in bright red, white and blue, as are the uniforms of the well-drilled staff. The formula is similar to the one Hill pioneered successfully at Commerce Bank, but the U.K. had never seen anything like Metro’s American-style razzmatazz. The bank opens every branch with a celebratory flourish that includes jazz bands and stilt walkers, free popcorn and sweets, and even shoe shines and manicures. Staff hand out lollipops to children and biscuits to dogs. The informality and facetiousness — one slogan on display proclaims “Dogs rule at Metro Bank!” — are sometimes overly insistent, but the overall effect underscores Hill’s effort to make branches more friendly and to challenge the assumption that all banks are the same.

Harrison LeFrak, who has invested an undisclosed amount in Hill’s venture, recalls the splashy arrival of Commerce Bank in the New York market a decade ago, with a high-profile advertising campaign featuring TV personalities Regis Philbin and Kelly Ripa. “You can laugh at the campy marketing campaigns, but he built a tremendous banking franchise, and the service more than meets expectations,” LeFrak says. He is confident that Hill can repeat the trick in the U.K. and says his organization would be comfortable holding its investment for ten years.

Hill spends half his time in the U.S. and the other half in the U.K., in the latter as vice chairman of Metro, which he co-founded with chairman Anthony Thomson, a former public relations executive who founded City Financial Marketing and sold it to France’s Publicis. Hill, a graduate of the University of Pennsylvania’s Wharton School and onetime Burger King franchisee, is the biggest shareholder in the bank, with a 20.6 percent stake, and affectionately proprietary about the upstart operation.

When a small-business or retail customer comes into Metro, “there is always a banker he can talk to on a one-on-one basis,” says Hill. “Retail service in this country is shockingly bad. Whereas the other banks no longer have traditional branch managers, we have a local director in every store who can sign off on loans of up to at least £500,000, plus a store manager who looks after smaller SMEs and retail customers. Our model is based on providing the best service rather than the best rates on deposits.”

James Reuben, son of David Reuben and a nonexecutive director at Metro, says the bank hits customers with fewer charges than its rivals do. “There are no overdraft fees on debit cards, and we don’t charge anything extra if you use your card abroad, for instance,” he says. Such so-called hidden charges, especially on overdrafts, are a big consumer issue in the U.K. In November, Financial Secretary to the Treasury Mark Hoban rebuked the banks for their “unfair” overdraft charges and announced a new, voluntary code of conduct under which banks promise to explain their charges more clearly and waive charges for customers who exceed their limits by only a few pounds.

“We offer community banks — banks that feel local and serve a particular community,” Hill says. He points to a large photograph on the wall of the Holborn branch in central London showing the area as it was in the early 20th century. Every branch will display a similar piece of local history, he says. This community feel may be difficult to achieve in central London, where several branches are based, but it could work in the more suburban branches that are beginning to spring up. Metro is taking time to train staff hired from other U.K. banks in higher standards of customer service. Only one local director is from the U.S., although the training is typically carried out by Americans.

Hill’s focus on the personal and human aspects of retail banking is well chosen. In its September report the banking commission cited the need for improved customer service by banks. “The relationship between SMEs and the banks has broken down,” says the Chambers of Commerce’s Hughes. Most banks no longer have experienced staff at their branches, and loan decisions are often made by distant, ill-informed divisional executives, he says. Service standards declined in the years of easy credit before the financial crisis, when branch-based staff weren’t expected to make big decisions, merely to process applications. Now that the flow of credit has dried up, banks have been slow to reorganize themselves. According to research consulting firm BDRC Continental’s “SME Finance Monitor,” in the fourth quarter of 2011 some 12 percent of 15,000 businesses interviewed needed finance but didn’t even apply to their banks because they believed they would be rejected.

The customer-friendly Metro model doesn’t come cheap. A branch can cost up to £2 million to launch, a substantial sum for a company that so far has raised £251 million in equity capital and aims to attract £500 million in deposits by the end of the year. Keeping the branches open seven days a week is also expensive. Most of the bank’s branches are housed in costly locations in southeast England, and they occupy sites that are larger than average, some even providing parking spaces, a rarity in the U.K. “They’re going for the luxury end of the market, as far as real estate is concerned,” says Virgin Money backer Ross. “It’s a very different model from ours.”

Yet Hill insists that Metro’s service will easily generate enough additional business to cover those costs. “After we get to scale in 2020, we’ll be able to make returns on equity of 15 to 20 percent, as we did with Commerce Bank,” he says. “By 2020 we’re aiming to bring in £20 billion in deposits.” The business plan calls for the bank to rely on deposits rather than on wholesale funding. It also includes an IPO in 2014.

Achieving such targets won’t be easy, but Hill says he’s pleased with the current rate of progress. The bank opened 700 new accounts a month in the first quarter of 2012, a faster rate of expansion than Hill knew at Commerce; that bank began in 1973 with a single branch and had expanded to 400-plus by the time he sold it. Metro now boasts more than 70,000 accounts, but it doesn’t disclose the size of its loan book. SME lending is 50 percent of the business. Building this up will be the key to the bank’s profitability and returns.

Unlike Metro, which started from scratch, most other new entrants are building on existing businesses. Newcastle-based Virgin Money previously ran a credit card business with 3 million customers. In January the company paid £747 million to acquire Northern Rock, with its £18 billion of deposits and 75 branches. A mortgage lender that had relied on wholesale funding, Northern Rock suffered the first run on a British bank since the 19th century, in September 2007, and had to be nationalized by the government in February 2008.

Virgin is off to a good start, boosting its number of depositors by 5 percent in the first quarter of 2012, but it has plenty of work to do, beginning with the introduction of a current account under the Virgin brand within the next 12 months, according to investor Ross, who paid £350 million for his 45 percent stake.

The old Northern Rock lost more than £200 million in its last full year of trading, 2010, even after the authorities had hived off the worst of its loans into a government-run “bad bank,” but Ross believes there is huge potential for improvement and growth. “I think we can achieve a return on equity of 12 to 14 percent within two or three years, and in a more normal environment, with interest rates rising, we should be in the high teens,” he says. “Eventually, we should be able to double the deposit base, to around £40 billion.” Like Metro, Virgin plans to fund itself exclusively through deposits and compete on service rather than on pricing. The bank has pledged to lend £45 billion over the next five years, a significant amount for a new player but very modest in a country where mortgage lending is running at a rate of £10 billion to £13 billion a month.

Branson’s Virgin Group, which the goateed entrepreneur started with a single record store in the 1970s and had built into an empire with £13 billion of revenue by 2011, is known for its unorthodox, fun approach to business, and it intends to apply that formula to banking. Virgin Money vows to eliminate glass barriers between customers and bank tellers, and it’s opening Internet lounges in some branches, where customers can use their iPads or browse newspapers over tea and coffee.

Ross knows the Virgin business well, having been an investor since 2010, and he rates both Branson and Virgin Money CEO Jayne-Anne Gadhia highly. But above all, he believes the Virgin brand, built up through everything from the record label to airline Virgin Atlantic Airways, is immensely powerful. “The old Virgin Money won new customers at the rate of 200,000 a year, and now there is a big opportunity to cross-sell, since there’s no overlap of products,” he says. He takes a sanguine view of retail customers’ loyalty to date, ascribing it to the lack of “a significant alternative.”

Ian Gordon, banking analyst at Investec Securities in London, is generally skeptical about the likely impact of the new banks, but he doesn’t rule out the ability of Branson and his team to capture a chunk of the market. “Virgin Money is a wild card; it has a capacity to do something surprising,” he says. “But my initial impression is that it’s perhaps not sufficiently aggressive on pricing.” The bank also needs more branches, he adds.

Virgin and Metro could themselves face a formidable new competitor if Lloyds successfully completes the sale of 632 branches with a total £30 billion in deposits. The European Commission ordered that divestment, which represents 5 percent of the British retail market, under its state aid rules. The leading bidders are NBNK, led by CEO Gary Hoffman, who ran Northern Rock in its nationalized days, and Co-­Operative Banking Group, a U.K. mutual business that has a 1 percent share of the market. But Lloyds has had the business on the block since 2010 and wants at least £1.5 billion for it, according to sources close to the discussions. J.C. Flowers had expressed interest but pulled out of the running over price.

Two interesting new banking entrants are shunning the branch model. Peterborough-based Aldermore and Manchester-­based Shawbrook are targeting the SME lending and mortgage markets from regional offices and relying on independent financial advisers, brokerages and the Internet to sell their savings products. They are keeping costs down and managing to grow their balance sheets, albeit still on a modest scale.

Aldermore started by buying tiny Epsom, Surrey–based Ruffler Bank, with £50 million in deposits, at the end of 2008. Since then it has built up deposits of £1.6 billion, extended £850 million of SME loans and funded £600 million of mortgages. Having broken even in the year ended June 30, 2011, Aldermore says it is now a profitable business. It’s also the only new entrant that consistently wins praise from SMEs, according to the Chambers of Commerce’s Hughes, although this is partly because the bank has been in existence longer than the others. Aldermore CEO Phillip Monks says the retrenchment by Britain’s big banks leaves plenty of space for competition. “The supply of lending has shrunk more than the demand,” he says.

According to a government-­commissioned task force chaired by Tim Breedon, CEO of insurance firm Legal & General Group, SME businesses are likely to need £59 billion in funding from banks between 2012 and 2016, but banks are unlikely to meet those needs because of their own deleveraging. Bank of England figures show that the total stock of lending to nonfinancial businesses in the U.K. declined by £151 billion between December 2008 and December 2011, to £506 billion. In June the central bank and the U.K. Treasury announced plans to inject £100 billion of cheap funding into banks to boost their lending, but it remains unclear how, or whether, that plan will work. Monks also contends that there is pent-up demand for mortgages: “U.K. Council of Mortgage Lenders figures show that total lending last year was only £130 billion — half of what it was in 2007.”

The Big Five banks are certainly creating room for fresh competition in the mortgage market. Lloyds CEO Antonio Horta-Osorio said in May that he wanted to cut the bank’s leading share of the mortgage market from 27 percent last year to 25 percent this year. At No. 2 mortgage lender Santander UK, U.K. banking chief Pateman admits the bank will have to shrink its activities, but he doesn’t specify by how much. “The services we provide to our customers and the returns to our shareholders are more important than market share,” he says.

Aldermore has only nine regional offices, but it has managed to draw in deposits by offering attractive rates, including a fixed 3.25 percent for two-year savings accounts. This is designed to appeal to people who are older than 55, says Monks. Yet Aldermore is destined to remain small for some time. The company expects to have grown its balance sheet to about £5 billion by the end of 2015.

Shawbrook, created by RBS Equity Finance, the private equity arm of Royal Bank of Scotland, runs on a similar model. It has just two offices, in Manchester and in Brentwood, east of London, and recently was offering fixed rates of 3.6 percent a year for three-year savings deposits. Acting CEO Philip George says the bank aims to grow its assets, currently some £600 million, by as much as four times over the next four years and to generate an ROE of about 20 percent. To do so, Shawbrook may take more risks than some of its new competitors. “We’re still in setup mode now, but as the business grows we will be looking at wholesale finance,” says George.

Even if the new banks win market share, it will be a struggle for them to deliver good returns at a time when some of the most successful U.K. banks face a squeeze on margins. Lloyds saw its pretax profits on U.K. retail banking decline by 9.8 percent in 2011, to £3.6 billion, as the bank’s net interest margin fell from 2.31 percent to 2.09 percent. Santander achieved an ROE of less than 10 percent in the U.K., according to Pateman. And incumbents are competing hard for customers. In May, HSBC was offering 6 percent rates to new depositors for the first year on amounts up to £2,500, far above the U.K. base rate of 0.5 percent.

Such challenges aren’t deterring bold and well-financed revolutionaries like Hill and his competitors. But it may be many years before they see their dreams fulfilled.  •  •

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