Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

If there's one lesson from the British antitrust regulator's recommendations for the country's banks, it's that upstart challenger banks should be careful what they wish for.

After an 18-month investigation into retail banking competition, U.K. regulators have essentially rebuffed calls from small upstart banks to radically shake up what they see as an oligopolistic market.

Nimble Wins The Race
U.K. challenger banks don't look very challenged on the stock market
Source: Bloomberg data

Tuesday's 400-page report proposes to cap fees on customers who spend more than they have, as well as provide customers with more information on service quality and cost. Regulators say this could save customers about 1 billion pounds ($1.4 billion) over five years.

Yet frustrated small banks still decried it as a damp squib -- hardly surprising given some of them had been pressing regulators to break the grip of the so-called big four lenders. HSBC, Barclays, Lloyds and RBS together account for 70 percent of the checking-account market.

Rather than point the finger at lobbying from incumbents or blame regulators for pulling punches, challenger banks need to accept that their own constant drumbeat on a lack of competition is starting to backfire. Regulators have found no evidence of the kind of industry monopoly that would merit a break-up -- and half-way measures like those announced will only serve to make big banks look more secure and transparent to their clients.

With even leaner and nimbler mobile-only banks on the way, the focus for all banks should be on finding the right business model rather than launching antitrust broadsides.

Funding Circles
Average deposit rates are higher for upstarts than dominant banks, meaning higher funding costs
Source: KPMG data for easy access accounts at Jan. 2016

After all, challenger banks might have a stronger case to make if they weren't doing so well. It's true they've had to fight more and spend more to attract deposits than top banks, making their cost of funding structurally higher. But this gap has hardly been crippling. A study this month by KPMG found that challengers both big and small last year reported returns on equity of around 10 to 17 percent, far higher than 5 percent at big banks. The study also found that, over time, challengers were able to cut payout rates on deposits, with bigger brands like Virgin Money and TSB on average pretty much closing the funding gap with incumbents.

And if the U.K. market were an open-and-shut case of oligopoly, you'd think investors would be chasing sharks rather than minnows. But most big U.K. banks -- with the exception of Lloyds -- are trading at a discount to book value.

Small is Beautiful
Investors tend to prefer minnows to sharks, judging by the price-to-book ratios of U.K. banks
Source: Bloomberg data

That's because the incumbents have been struggling to  restructure their business profitably, overhaul their aging IT systems and put an end to misconduct charges that have damped their appetite for cross-selling products to customers.

Meanwhile, Virgin Money, Aldermore, and Secure Bank all trade at a premium to book value. "Small is beautiful," Citigroup analysts say, citing the challengers' superior growth prospects.

With even smaller technology-focused upstarts on the way, competitive pressures are rising, not falling -- and that's what should be a bigger worry for challengers trying to protect their turf. It's not just big banks wooing customers with free, commoditized services: Tech start-ups like Circle and Revolut are also combining free or almost-free services with other products to retain customers.

More rules are on the way that will force banks to open up their technology platforms, potentially offering opportunities for established tech companies looking for a foothold in finance.

Challengers may find themselves out-challenged sooner than they realize.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lionel Laurent in London at llaurent2@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net