Challenger banks OneSavings Bank (LSE: OSB) and Virgin Money (LSE: VM) are not only giving the big banks a run for their money on the high street, but I think they are also better investments.
Indeed, when comparing the smaller challenger banks to the likes of Standard Chartered (LSE: STAN) and HSBC (LSE: HSBA), the smaller banks come out on top, simply because they are much easier to understand!
Tangled web
Terry Smith used to be one of the City’s top banking analysts, but today he won’t touch the sector. Why? Because banks have just become too complicated — even for some of the City’s top analysts.
Complex credit derivatives, high levels of leverage opaque accountancy practices have made it almost impossible to analyse the balance sheets of larger banks. For example, HSBC has a balance sheet with nearly $2trn of assets. So, it’s not possible to correctly assess every risk the bank is exposed to.
On the same note, few analysts predicted Standard Chartered’s recent set of problems, as the bank’s huge exposure to risky credit was hidden away from many analysts.
Standard has been hit by its exposure to the Chinese and Indian resource sector, where falling commodity prices have pushed many smaller miners into liquidation. During the third quarter Standard reported a bad debt charge of $539m, up from $250m as reported during the second quarter. The total value of Standard’s impairments year to date is $1.6bn.
On top of risky, complex balance sheets, the larger banks are also being forced to fork out billions in fines for mistakes made in the past. These multi-billion dollar fines are forcing banks to dig into capital cushions to fund the payouts.
A simple solution
On the other hand, OneSavings and Virgin are relatively simple to understand.
OneSavings, which reported a fourfold increase in underlying profit before taxation during the first half of this year, has total equity and liabilities of only £4.2bn, with a balance sheet that can be understood by many of the bank’s investors. What’s more, due to the small size of the bank, it is able to get to know its customers, so impairment losses are small.
Only 22 customers were three months or more in arrears on their mortgage payments during the first half of the year. Total impairment losses only came to £4.7m during the first half, that’s 0.29% of One Savings’ total loan portfolio.
Similarly, after reading through Virgin’s half year report, you get the feeling that you know and understand the bank. In particular, the company lays out its mortgage portfolio, showing the quality of loans and stating that the average loan-to-value ratio of the portfolio improved to 58.7% in June 2014.
Once again, conservative lending criteria helped the bank keep the volume of mortgages over three months in arrears low, at only 0.32% of the mortgage book at the end of the first half, compared to the industry average of 1.5%. Virgin’s balance sheet is slightly larger than that of OneSavings, with loans in excess of £21bn.
What to do?
So, the simplicity of Virgin and OneSavings make them better investments than HSBC and Standard. As a quick comparison, One’s half year report is around 42 pages long — HSBC’s half-year report weighed in at a staggering 300 pages!
