Specialist lenders lead the UK challenger profitability pack

Nerves have been tested in the banking sector by a series of high-profile collapses this year. The UK’s first so-called challenger bank, Metro Bank, narrowly avoided such a collapse when it received a last-minute rescue in early October, a £325m capital raise by Jaime Gilinski Bacal, a Colombian billionaire who has secured a majority stake in the business.

Many UK challenger banks have struggled to make a profit since inception. For example, Kroo Bank saw a $19.7m loss, while Monzo Bank made a loss of $140.2m (as of February 28, 2023). And Atom Bank, which reports at the end of March, recorded a loss of $12.5m in 2023.

While profitability has so far eluded many, those offering targeted lending to traditionally underserved customers have been consistently profitable, some even within their first year of operation.

Challenger banks in the UK can broadly be divided into three groups: digital first app-based ‘neo-banks’, smaller, relatively newer players that operate branch networks, and finally lenders that serve specialist customer bases.

Profitable challengers serve customers underserved by incumbents 

OakNorth Bank lends to small and medium-sized businesses (SMEs), and was cashflow break-even within 11 months of receiving its full licence. It has been profitable every year since 2015. Its initial goal was to provide £1bn of lending to SMEs. To date its lending has surpassed £10bn, with £152.3m in pre-tax profits.  

“The incumbents weren’t interested in SMEs. They didn’t want to throw the resourcing on them. They couldn’t make the economics work on those smaller loans. But we spotted the fundamental opportunity to industrialise large company lending and apply it to smaller companies,” says Rishi Khosla, founder and CEO of OakNorth.

This November, the bank released an expanded set of business banking services tailored to the specific needs of varying businesses. Specialist lender Allica Bank has also achieved profitability. Serving SMEs with loans including a range of commercial mortgages, it was launched at the beginning of the pandemic in 2019. The bank has just been named the overall winner and fastest growing fintech in this year’s Deloitte UK Fast 50, an annual review of high-growth UK companies. Crucially, after hitting the £2bn lending milestone soon after publishing its 2022 results, it also confirmed a £6.9m net operating profit.  

Allica CEO Richard Davies says the SME sector is massively underserved. “SMEs are viewed as a backwater by the major banks. Multiple times in my career working for big names, I was told to ‘go into large corporations’ because essentially only the village idiots do the SME stuff, which I find deeply offensive,” he says. 

“No one talks about the problems for SMEs. SMEs are missing £7.5bn in interest. That’s around a third of the SME financing gap each year. We’re here to fix this.” 

Lender confidence remains high 

Mr Khosla is confident that OakNorth’s models account for almost every possible eventuality. “What we’ve done is that we split the economy into 274 different industries. For each of those industries we have our scenarios. We have our base case scenario, and then we have our stress scenario and our stress scenario actually combines all the worst of everything that you can imagine,” he says.

He points to the fact that while the affordability of debt has changed, and for some SMEs the outlook is “definitely chilly”, he believes that many are leaner as a result of the Covid-19 pandemic and the bank’s models can detect pinch points even before many of the businesses can. As for banks, the rise in rates have lifted a lot of their earnings. 

Higher interest rates came at just the right time for some

According to Mr Khosla, this has come just at the right time for high-volume retail-focused neo-banks, which are primarily deposit takers rather than lenders. “Suddenly, there’s a massive lift, because they have all these deposits, where they can earn a spread on them.” 

Until recently these high-volume deposits did little for the balance sheet, but now, for neo-banks with customer numbers in the millions, even a small margin adds up to healthy returns. “Now interest rates are higher, without doing anything, they’re able to make money from deposits so they’re generating more profit, or at least fewer losses,” says Simon Low, partner, retail banking and wealth management at Oliver Wyman.

Now the question is: how much of that earning unwinds as rates come down? And what is the plan for sustained profitability?

“Specialist lenders make very good returns, and pretty much always have done from very early in their evolution,” says Mr Low. 

However, Mr Low cautions that while these specialist lenders are buoyant they have not been tested in a downturn. “They are profitable now, but as the credit cycle has turns, how strong will their balance sheets be?”

Expect more challengers to ramp up their lending 

Mr Low expects neo-banks to ramp up their lending capabilities. “Good lending is profitable, and to move into sustained long-term profitability there’s not many ways around it other than to build, then scale your lending.” 

Neo-bank Kroo, which secured its full banking licence in 2022, has plans to do just that. Kroo made a loss of £14.9m for the year to December 31, 2022, but recently launched overdraft and personal loans for its current account customers. Lending was always in its plan.

“I think every other digital bank has, at some point, realised that if you want to be a bank and if you want to be a profitable bank, you need to do lending. I mean, that has been part of our vision from the very, very beginning. Some other banks took some time to realise that,” says Andrea de Gottardo, CEO of Kroo. 

Could Kroo move into other sorts of lending, such as mortgages? “It’s a product that I personally really like because I see a lot of space to improve that market, but it will take time,” says Mr de Gottardo. “So it’s not on the roadmap for now, but personally, but we aim to get to that in the future.” 

Mr Low believes that the higher rates have bought the neo-banks time to get their lending books in order. “I think two or three years could be enough time for investors not to lose interest,” he says. “The big danger, where less can be made from deposits and the situation we had a couple of years ago, is that these became loss-making businesses that burn through investors’ capital with no clear view as to how to become profitable.”