UK challenger banks may be more vulnerable than established banks to an economic downturn and Brexit-related risks, Fitch Ratings says.
Several challenger banks have grown fast in retail mortgage lending, often to niche borrowers, or in asset classes that perform less well in a stress, to gain a foothold in the market.
Fitch views sustained above-market-average growth as a potential risk to a bank's credit profile because it may indicate under-pricing of risk or a loosening of underwriting standards to generate volume. Rising interest rates and unemployment could also trigger significantly greater losses on banks' mortgage portfolios, with falling house prices exacerbating the impact.
Fitch's assessment comes just weeks after the The Bank of England warned that fast-growing lenders with a limited track record may be underestimating the potential losses on their loan portfolios during a downturn, and overestimating their ability to mitigate losses through business growth or capital-raising.
Says Fitch: "We think some challenger banks may be required to set aside more capital, possibly by way of increased Pillar 2 capital requirements, in light of the Bank of England's analysis."
Challenger banks may also be more exposed to funding pressure in a downturn given their reliance on online retail deposits with short-term fixed rates, and deposits from SMEs and corporate clients, says Fitch. These sources of funding are more price-sensitive and less stable than current accounts, and could become more costly to attract and retain in the event of rising interest rates and financial pressure on consumers.
Fitch placed the Long-Term Issuer Default Ratings of all rated UK banks on Rating Watch Negative earlier this year, reflecting uncertainty about the ultimate outcome of the Brexit process and the risk that a disruptive no-deal Brexit could damage banks' earnings, asset quality, liquidity and funding.
"We believe that less diversified banks or those focused on niche or highly cyclical sectors are more vulnerable," says the ratings agency.
Indeed, challenger bank applications for banking licences are coming under closer scrutiny from the Prudential Regulation Authority (PRA), which approved just four applicants in the last year, down from 14 in the previous timeframe.
The figures come in the wake of a letter from the PRA to chief executives of challenger banks in mid-June, which outlined the regulator’s concerns about their risk management.