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Is Lloyds Banking Group plc destined to continue underperforming this challenger bank?

Since going public in late 2014, shares of challenger bank Virgin Money (LSE: VM) are up over 10%, while shares of venerable Lloyds (LSE: LLOY) have lost more than 25% of their value. We’ve all heard that Lloyds is the safest of the UK’s big banks, so how to explain these divergent fortunes? And most importantly, will this pattern continue for the foreseeable future?

Both are domestic-focused retail banks, so it’s not down to Virgin undertaking some risky trading strategy or expanding into high-growth developing markets. The biggest reason as I see it is the considerably different growth prospects for the two banks.

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Virgin’s market cap of £1.4bn versus Lloyds’ £39bn illustrates quite clearly how much more room Virgin has to grow than its lumbering rival. We also see the differences in one of the most important business lines for both banks, mortgage lending. While Lloyds originated 25% of all new domestic mortgages last year, Virgin’s market share was only 3.6% in the past half year.

It’s quite obvious then that Virgin will find it much easier to continue growing at a rapid clip while Lloyds’ sheer size will make it hard to grow its already substantial market share for major products.

Going hand-in-hand with top-line revenue growth is Virgin’s ability to rapidly juice profits. This is also a byproduct of its relative size as Virgin has been able to tackle stubbornly high costs at a quicker pace. Over the past half year Virgin was able to bring its cost-to-income ratio down from 68.3% to 58.8% year-on-year. Lloyds, despite embarking on an ambitious cost-cutting scheme was only able to improve from 48.3% to 47.8%.

The reason for Virgin having such high costs is due to its purchase of the former Northern Rock assets from the government in 2011. Cutting the bad bits from these assets has allowed Virgin’s return on tangible equity (RoTE) to catapult from 9.5% to 12.2% year-on-year through the last six months. By comparison, Lloyds’ underlying RoTE in the same period fell from 16.2% to 14%.

Income is key

However, many investors look at banks for income rather than growth. In that regard Lloyds is far ahead of Virgin. As Virgin is still investing heavily in expanding its business, dividend yields at the bank are currently quite low, at only 2%.

On the other hand, Lloyds shares currently provide investors with a very decent 4.3% yield annually. These shareholder returns also have considerable room to grow in the medium term once payments for PPI claims are finally ended. This may be several years away though, so Lloyds is likely to end up shelling out more than the £16bn it already has.

Over the long term though, I believe Virgin Money offers both better growth and dividend prospects, which will undoubtedly play out in its shares continuing to outperform those of Lloyds. Dividends are a function of profits, and if Virgin can continue growing earnings by double-digits while Lloyds’ profits fall then its shareholders will eventually benefit from hefty dividends.

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Ian Pierce has no position in any shares mentioned. 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.