Challenge the status quo – Secure Trust Bank and BBA

11 December 2015

Increasing competition in the UK financial sector is seen by many as a key step towards reducing the dominance of the ‘big five’ banks and their status as ‘too big to fail’. Challenger banks are central to achieving this balance, but their future growth appears threatened by a new 8% banking surtax due to come into effect in 2016. Sarah Williams speaks to Paul Lynam, CEO of Secure Trust Bank and chair of the BBA’s Challenger Bank panel, and Cyrus Ardalan, chairman of OakNorth Bank, to find out more.

As Chancellor of the Exchequer George Osborne announced plans for a new 8% surcharge on British bank's UK profits in his mid-year budget speech, he declared that the changes would make the country "a more competitive place to do business". The bank levy will meanwhile be reduced over the next six years, he said, because the current system has "worked" in raising revenue and increasing the stability of balance sheets "but now it risks doing harm unless we change it".

The competition to which Osborne referred was of course that of international competitiveness. A competitiveness that banks such as HSBC (which threatened to relocate its company headquarters away from the UK) were keen to highlight before the election as being at risk from the higher bank levy and new 'ringfencing' rules.

While some therefore welcome Osborne's planned reduction to the bank levy, the new surtax is the subject of accusations that a different kind of competitiveness is now under threat; namely competition within the UK's own banking industry.

While the bank levy only applied to the biggest banks in targeting large global balance sheets, the new 8% surtax will affect all UK banks large and small, provided their UK profits meet the £25-million threshold.

The change, effective from 1 January 2016, is therefore likely to limit the ability of challenger banks to grow and prosper, undermining efforts to lessen the dominance of big banks.

Maximum capacity

The lending capacity open to UK consumers and businesses is also likely to be affected, according to Paul Lynam, CEO of Secure Trust Bank. As chair of the Challenger Bank Panel at the British Bankers' Association (BBA) Lynam is an outspoken advocate for a fairer system for challenger banks and the customers they serve.

"The very frustrating thing is that when you look at the aggregate balance sheets of the large banks between 2012 and 2014, on average those banks shrunk their customer lending by 3%," Lynam says. "By contrast, the challenger banks at aggregate were growing at nearly 10%, and some of the challenger banks, including Secure Trust, have been growing at 30-40% a year, so you have a situation where the large banks have been shrinking the amount of lending, sucking credit out of the economy and arguably prolonging the downturn, and the smaller banks have been doing what the government have been looking for all banks to do - which is to lend to consumers and SMEs."

While challenger banks want to be able to continue to do this, Lynam says, the demands of paying 40% more tax (the increase from the standard 20% to the 28% rate including the new surcharge) on profits above £25 million will mean less capital retained to support new lending. The amount of incremental new lending that challenger banks will be able to offer will be directly impacted by this increase in tax, Lynam says, a reduction he forecasts will deny SMEs around £6-8 billion in lending over the length of the current parliament.

"One of the things just to bear in mind is that the challenger banks lend disproportionately to SMEs, so we reckon that the challenger banks are lending around £1 in every £5 to SMEs, despite the fact that we add up in aggregate to less than 10% of the overall market," Lynam says.

Overcoming the obstacles

This willingness to lend comes in spite of the multiple hurdles challenger banks face compared with their bigger rivals. One of these is the much greater proportion of capital new banks and challenger banks must hold as a 'buffer' compared with large established banks, because of the perceived risk they pose through their shorter track record. This means that the cost of lending, in terms of the capital banks must hold to offset that loan, can be more than double that of big banks.

The rates at which the biggest banks can borrow also constitutes an implicit subsidy, Lynam argues.

This willingness to lend comes in spite of the multiple hurdles challenger banks face compared with their bigger rivals.

"We have a quite bizarre situation where the larger banks are going to have their reduced tax subsidised by the smaller banks that are supposed to be competing with them, at the same time as their funding costs are being subsidised by the taxpayer because of the fact that the wholesale lending markets deem them to be 'too big to fail', and therefore they lend to the big banks at UK sovereign risk rating and sovereign risk interest rates, instead of the stand-alone ratings of these banks," Lynam says. "So it's a very disadvantageous situation that we're being put in for reasons that ultimately are for the benefit of the larger banks."

For Cyrus Ardalan, Chairman of OakNorth Bank, the very fact that banks of different sizes do have different associated risks should itself make the case for regulation that reflects these differences. Ardalan, who joined OakNorth Bank in July 2015, is no stranger to the regulatory environment faced by larger banks, having previously worked as Barclays' vice-chairman, public policy and government relations.

Given that the current regulatory environment stemmed from a response to the financial crisis and the large global financial institutions that were a cause for concern, care must now be taken to ensure regulation is appropriate, he argues.

"That whole environment was created for those very large institutions and yet it is being applied virtually line by line to small financial institutions like [OakNorth], and clearly the risks associated with running a bank like ourselves are very different than they are for very large institutions," Ardalan says. "And so I think you really need to look at the whole regulatory environment and see to what extent we need to make it somewhat more proportional to the needs, requirements and risks associated with smaller financial institutions."

Ardalan also raises the point that besides reducing the capital a challenger bank has to reinvest in its growth, the 8% tax also threatens future funding sources in sending a negative signal to potential investors.

"You've got private equity firms; you've got entrepreneurs like Rishi [Khosla] and Joel [Perlman] who set up OakNorth; people like that looking at coming into the sector will say, 'Wait a minute, you have a sector that not only pays tax but there's a surtax - because it's a tax over and above what other corporations pay - to come into this industry, so what impact does that have on the potential returns on my investment?'" Ardalan says.

"And the third aspect is that it creates uncertainty that again has an impact in terms of the external investors, who will say, 'Here is an industry that is being singled out in a way by the government for an incremental tax, could there be other things coming down the road?'"

For Ardalan, this uncertainty has characterised the industry in recent years - the changing regulation and the doubt over what fiscal burdens banks will face next - and has been a barrier to further investment; one that must be overcome in order to nurture competition.

The absorption game

Compared with countries such as Germany, France, Austria and the US, the UK has a much smaller number of financial and credit institutions. A market even more concentrated in respect of the dominance of the five largest banks: Barclays, HSBC, Lloyds, RBS and Santander.

But while recent history shows a marked lack of competition, this wasn't always the case, as Lynam is eager to point out. "Historically, there have been huge amounts of competition in the UK," Lynam says. "If I go back to even as recently as 1 January 2000, so 16 years ago, you would have names like - just off the top of my head - Alliance & Leicester, Abbey National, Bradford & Bingley, Bristol & West, Halifax, Bank of Scotland, Woolwich, NatWest. All of these were stand-alone competitor banks and financial institutions on the UK high street."

With such institutions absorbed over the subsequent years into what are now the big five banks and Nationwide, the government therefore found itself in a position in 2007 where a rescue of HBOS was essential, Lynam says, because of the impact its failure would have had on the UK financial services industry as a whole.

"Therefore, where I think the economy and the government needs to get to is back to where we were 15, 20 years ago where there was much more choice and much less concentration of market shares, which means you can get away from this too-big-to-fail problem," Lynam says.

Get competitive

As well as providing a more stable financial industry, more competition within the sector could also better serve diverse customer groups with individual needs, Ardalan claims.

As well as providing a more stable financial industry, more competition within the sector could also better serve diverse customer groups with individual needs.

"To have a successful economy, you need to have a diverse ecosystem in the financial sector, which provides a variety of different types of financial product and services," he says. "And in our case, what we're doing is we have a bank that is very focused on doing one thing, and that is essentially providing capital lending to medium and small-sized growth companies and entrepreneurs; a sector that we think historically has not been particularly well served in the UK because it falls a little bit between the cracks. The requirements are quite sophisticated, but the entities are relatively small."

At the time of the interview, Ardalan is optimistic that the government will take steps to amend the current regulation and allay some of the concerns of challenger banks.

"I think all the indications are that they're really taking a hard look at the proposed regulatory environment, and seeing to what extent it needs to be adjusted and adapted to the current realities to make sure that it's not running counter to the government's other objective; mainly to try and promote growth, employment, SMEs and the economy in general," Ardalan says.

Lynam, for his part, professes that the 8% surtax itself is not an unacceptable premise - as long as challenger banks are also allowed to operate on an even standing with their larger rivals.

"As a cohort, the challenger banks have no objection to being taxed on the same basis as the large banks, provided we're able to compete on a like-for-like basis" Lynam says. "And at the moment we're not, so therefore we think it's fair that either one of two things happens: the playing field should be made level immediately or there should be a differential tax regime that recognises the real economic and financial benefits that the too-big-to-fail banks benefit from."