The UK banking scene is in the midst of major change. Gone are the days when just a small handful of banks dominated the industry and were able to maintain relatively high net interest spreads without fear of new entrants.
And, with the government and regulator apparently encouraging so-called ‘challenger’ banks to be born and succeed, it could be argued that the outlook for long-term incumbents could be somewhat difficult.
In fact, the likes of Virgin Money (LSE: VM) and Aldermore (LSE: ALD) are making excellent progress. They have both reported very satisfying results in recent months, which shows that they are increasing market share, increasing their loan books and driving through rising profitability.
Virgin Money is expected to increase its earnings by 13% in the current year and by a further 34% next year as it becomes increasingly popular among consumers. Similarly, Aldermore is forecast to post a rise in its earnings of 36% this year and a further 20% next year. Both banks, therefore, could see investor sentiment improve — especially since such strong growth rates are rare not just in the banking sector, but in the FTSE 350 as a whole.
Of key significance to the success of the likes of Virgin Money and Aldermore is that they appear different to the more established banks. Consumers still have a deep mistrust of bankers and their supposed wrongdoings of recent years and, as a result, are very open to the slick marketing of challenger banks, which have successfully positioned themselves as being more transparent, more customer-focused and, crucially, different to their peers.
Of course, the better-established banks still have a major advantage over their peers. Certainly, the business models of Virgin Money and Aldermore are working well in a low interest rate environment where an improving UK economy and rising wages (in real terms) are causing consumers to spend, borrow and then spend some more.
However, when monetary policy tightens, the economy’s performance is less impressive and the outlook for the banking sector is less appealing, the likes of Lloyds (LSE: LLOY) are likely to prove more stable, more resilient and better able to generate increasing profit in the long run.
Furthermore, Lloyds and its more established peers still have a major size and scale advantage over challengers such as Virgin Money and Aldermore. They have huge scope to cross-sell their products to existing customers, have greater resources to adapt to technological change and, with switching banks still being relatively unpopular, have large customer bases that tend to be fairly loyal.
Furthermore, Lloyds continues to trade on a hugely appealing valuation. Certainly, its growth prospects may be significantly less impressive than either Virgin Money or Aldermore — Lloyds earnings are forecast to increase by just 4% this year — but its price to book (P/B) ratio of just 1.18 indicates that its shares could move significantly higher.
As a result of this, plus its size and scale advantages, Lloyds appears to be the best buy of the three, although more adventurous investors may wish to buy a smaller amount of Virgin Money and Aldermore to go alongside Lloyds at the present time.