U.K.’s Upstart Lenders Face Brexit Shock in First Downturnby
Concerns weigh on smaller banks’ shares in run up to vote
Analysts predict rising bad loans in event of a recession
Investors contemplating how London could look outside the European Union have already identified some potential victims: fast-growing British lenders that might have to face their first economic downturn as public companies.
Billionaire Richard Branson’s Virgin Money Holdings UK Plc and small lenders like OneSavings Bank Plc have ridden the recovering economy of recent years to help them win market share from the nation’s entrenched players. With the U.K. Treasury and some analysts predicting that a British vote to leave the EU on June 23 could cause the worst drop in house prices since the financial crisis, the banks could see their progress reversed as they’re saddled with bad debts.
“I’m still hoping common sense will prevail and we’ll remain in the European Union,” OneSavings Bank Chief Executive Officer Andy Golding said by telephone. “I’m not necessarily certain if anyone knows what the result will be of an exit. But I am pretty certain it creates a slowdown in economic growth and creates less demand for new property.”
The J.C. Flowers & Co.-backed lender is financially secure enough to withstand a downturn, but would “not grow at the same rate,” Golding said. “If growth slows, we’ll find it harder to keep growing.”
Chancellor of the Exchequer George Osborne is warning a vote to leave the EU may cause a “DIY recession” with rising unemployment and an 18 percent drop in house values. Share prices of five of the so-called challenger banks have dropped an average of 14 percent in June, as polls showed increasing support for a Brexit.
Shawbrook Group Plc fell 4.3 percent to 229.7 pence at 10:32 a.m. in London trading, bringing the company to its lowest value since its April 2015 initial public offering. Virgin Money was 2.8 percent lower, while Aldermore Group Plc and OneSavings Bank lost 4.6 percent and 2.3 percent respectively.
Home prices have already fallen in central London, according to the Royal Institution for Chartered Surveyors. Even at bigger banks like Royal Bank of Scotland Group Plc, Chairman Howard Davies has noted a slowdown in loan demand he attributed to the referendum.
To be sure, pro-Brexit campaigners say EU rules are stifling the British economy and that local companies will fare better if they’re severed from the continent’s requirements. And not every challenger is certain that they’ll be hurt by a vote to leave.
“I don’t think this Brexit is going to have an impact on us,” Metro Bank Chairman Vernon Hill told analysts on a first-quarter results call. “There’s such gigantic market share to take, I don’t think we’re going to be affected by any macro event like that.”
Started in the ashes of the financial crisis, some of Britain’s challenger banks are built on the remnants of lenders that failed, while others were created from scratch. Their executives are typically former senior bankers with experience at firms such as RBS and Barclays Plc.
Until now, the challengers have enjoyed a robust housing market with Bank of England’s key interest rate at a record low. Lending increased by 32 percent last year for a group of the smaller banks studied by KPMG LLP in a report last month, compared with 4.9 percent fall for the country’s five-largest banks. That has led to higher profitability, with an average return-on-equity of 19 percent for the five smaller firms that traded publicly last year, which could be derailed by an economic downturn.
The challengers have “neither gone through a full credit cycle nor had their books fully seasoned,” analysts at Citigroup Inc. led by Ian Sealey and Andrew Coombs wrote in a note to clients last month. “This is likely to put upward pressure on loan losses.”
While Britain’s largest lenders and global investment banks in the country have said they may relocate staff elsewhere in Europe in the event of a Brexit, the challengers, typically focused on the U.K., lack such diversification. None have more than 40 billion pounds ($58 billion) in total assets, a fraction of Lloyds Banking Group Plc’s 807 billion-pounds.
“Big banks are more able to withstand volatility compared to the challenger banks, especially those who do not have diverse products and more mature, substantial balance sheets,” said Richard Iferenta, a partner at KPMG LLP.
Brexit may lead to higher prices for customers on loans and less certain business investment, Virgin Money CEO Jayne-Anne Gadhia told analysts last month. Executives from other challenger banks from Shawbrook to Aldermore have said the potential effects are unclear.
Many of the smaller banks have focused on buy-to-let lending to landlords, a sector under close scrutiny from the Bank of England and U.K. government over fears that the market could be overheating.
“Impairments are at record-low levels, and they will rise,” said Jonathan Goslin, an analyst at Numis Securities in London. “It’s just a matter of when and who’s got the right controls in place. That will be the real test.”
Asset quality for most challengers is stronger than lenders had in previous cycles. Virgin Money’s average loan-to-value is about 55 percent, indicating house prices would need to fall 45 percent before most borrowers were in negative equity. OneSavings Bank, has the highest average loan-to-value ratio among challengers at 66 percent. That compares with 56.3 percent at Lloyds, Britain’s largest mortgage lender.
“They are very, very differently positioned to banks that failed in the past,” said Ian Gordon, an analyst at Investec in London. “Even if Osborne does crash the economy, the consequences for the challenger banks with their prudent positioning of their portfolios, relative to the likes of Lloyds and RBS going into the 2008 crunch, puts them in a far, far better place.”
Banks have also tightened lending criteria. Gadhia said Virgin Money “pulled back a bit’ from buy-to-let lending while OneSavings Bank’s Golding said his bank started asking landlords to show higher levels of rental cover on borrowing at the end of last year.
“Credit standards are high generally,” Nigel Terrington, CEO of specialist lender Paragon Group said in an interview. “We would rather prioritize credit and pricing, and if that means sacrificing volumes then so be it.”
A recession coupled with rising loan impairments could make it harder for U.K. lenders to access wholesale market funding, compounding potential market volatility in the wake of a Brexit vote. Many lenders front-loaded their annual funding requirements to protect against tougher conditions, with Virgin Money selling two tranches of mortgage-backed securities to raise about 1.3 billion pounds of funding.
The challengers predominantly finance their lending from consumer deposits, which are more resilient in a downturn than wholesale market funding. Virgin Money, Aldermore, OneSavings Bank and Shawbrook had an average loan-to-deposit ratio of 102.9 percent at the end of last year, compared with 322 percent for Northern Rock before it collapsed in the financial crisis. Still, their reliance on housing loans could weigh on their profitability.
British “banks are exposed to U.K. property to varying degrees, so yes they would be impacted if there was a downturn in the U.K. property market,” said George Barrow, an assistant fund manager at Polar Capital in London, who helps to oversee about $10.4 billion. “That would be inevitable.”