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Is this the best niche bank after special dividend announced?

Banking is a no-no for many investors after the Brexit-led crash, but does that make it a good time to look at alternatives in niche areas and at smaller challenger banks? Here are two that are surely worth closer inspection.

Extra cash

While dividends at the big banks are coming under pressure, Arbuthnot Banking Group (LSE: ARBB) has today announced a special dividend of £3 per share to be paid on 18 November — but you’ll have to be on the shareholders register by 21 October.

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The first half of the year saw the sale of Everyday Loans and of a 33% stake in the firm’s Secure Trust Bank, netting a total gain of £217m — and a total first-half profit of £225m. Some £45m of that will be used to fund the latest dividend, which comes on top of a 25p per share payment announced at the interim stage and paid in July.

More of the cash is to be used to accelerate the firm’s expansion, with new premises opening in Manchester and an expectation of having “a further six commercial bankers in place by early 2017.” The “disruption in the larger UK banks” has apparently led some top experts to head in Arbuthnot’s direction.

The firm will see a short-term fall in its net interest margin after the base rate was cut, and the longer term is uncertain, but is Arbuthnot a good buy? Despite a sharp fall after the referendum, the shares have regained their loss to reach 1,648p. With earnings erratic in the short term, fundamental valuations are hard to follow and we’re looking at a 2017 P/E of well over 20 — but the firm’s cash generation and dividends do look tempting.

The new kid

Or how about newer challenger Virgin Money Holdings (LSE: VM)? Unlike the big banks, Virgin isn’t saddled with bad debts accrued during the banking crisis, isn’t constantly looking over its shoulder for regulators wielding notices of fines, and doesn’t twitch every time the phone rings in case it’s yet another PPI claim.

Virgin’s share price tumbled in the days after the Brexit vote, but a steady recovery to today’s 310p leaves it down just 15% overall — and that gives us a forward P/E for this year of 10, dropping to a little over nine on 2017 forecasts. Dividends are low with yields of only around 2% predicted, but they’re strongly progressive, with rises of 18% and 22% on the cards for this year and next, and they’d be very well covered by earnings.

As a small fish in a big pond, Virgin Money has the potential to grow very quickly in the next few years. And the bank’s targeting of the UK mortgage market is a strategy that I think has success ahead of it — at the halfway stage this year, gross mortgage lending was up 19% on the first half of 2015, to £4.3bn, with net lending in the half up 29%.

Credit card and retail deposit balances were both on the way up too, growing 31% and 8% respectively, and in the month after the referendum the bank had seen “no evidence of changes in customer behaviour.

I like the look of Arbuthnot for the long term, but I like Virgin Money better.

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Alan Oscroft 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.

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