Should You Buy Lloyds Banking Group PLC And Royal Bank Of Scotland Group plc After Aldermore Pulls Its IPO?

Piggy bank

Despite the government’s best efforts, the UK banking sector remains relatively uncompetitive. Certainly, there is choice for consumers, but it comes in the form of a handful of major financial institutions that remain too big to fail, and too big to bail.

So, it’s clear as to why the government is seeking so-called ‘challenger banks’, such as Aldermore and Virgin Money, to shake-up the incumbents and provide more choice for consumers. It also potentially means less risk for the government if the UK is not reliant on a handful of major banks.

Aldermore’s IPO

Therefore, it’s disappointing on the one hand for Aldermore to pull its IPO. Established in 2009, it has been relatively successful at attracting customers – particularly in the business space – and was aiming to list in the near-term so as to gain an injection of capital with which to grow the business over the medium to long term.

However, with markets falling of late, the IPO has been postponed. It could be argued that this is good news for banks such as Lloyds (LSE: LLOY) (NYSE: LYG.US) and RBS (LSE: RBS) (NYSE: RBS.US), since it means that one of its competitors is being delayed in executing its growth strategy. In reality, though, the progress of challenger banks doesn’t make too much difference to the bottom lines of major banks such as RBS and Lloyds.

Competitive Advantage

That’s because well-established banks have a huge advantage over their relatively young competitors. Their size and scale allows them to offer a range of banking services at little or no cost to the customer, which provides them with a golden opportunity to cross-sell products that are hugely profitable for them.

The most obvious example is current accounts. They are free at banks such as RBS and Lloyds, with the two banks losing money on them, but they provide the opportunity to sell loans, credit cards and investment services to customers – all of which boost the bank’s bottom line.

Challenger banks, of course, find it a lot tougher to justify loss leading activities and, as a result, miss out on the considerable cross-selling opportunities that are on offer. While this doesn’t make them uninvestable, it does mean that their shareholder returns may not be as high as their larger rivals over the long run.

Looking Ahead

While recent years have been hugely disappointing for RBS and Lloyds, both banks are due to return to profitability this year. This is a major step forward for them and, even with the presence of challenger banks such as Aldermore, they seem to be strong buys at present.

Indeed, trading on price to book ratios of just 0.4 (RBS) and 1.3 (Lloyds), they seem to offer great value and have a distinct competitive advantage that could push profit far higher in the coming years.

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Peter Stephens owns shares of Lloyds Banking Group and Royal Bank of Scotland Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.