TSB Bank Initial Thoughts – 25th April 2014


TSB Background and Initial Thoughts:

Following a state bailout during the financial crisis, EU regulations have forced Lloyds Banking Group (LBG) to slim down as a business. This has led to a number of disposals over the years, with the most recent being 631 of the group’s high street branches that are to form a new challenger bank which will adopt the name of a Lloyds’s subsidiary, TSB.

The original TSB was formed over 200 years ago by Reverend Henry Duncan, who, during a time of economic hardship, wanted to create an institution that would cater exclusively for the poor people of Scotland. The reverend’s model proved a success and within five years, had led to a proliferation of similar organisations across the UK.

The new spin-off has proved the most politically palatable means through which LBG can satisfy EU regulatory instructions to reduce its own scale, while forming a new “local banking” entity to help increase competition within the UK financial sector. TSB Bank began operating as a separate entity to the parent last year and is expected to devolve fully from Lloyds’s ownership over time. The first initial public offering of shares in May this year is expected to reduce the stake of LBG by an amount somewhere between 30 and 50%.


Financials front runners of the recovery

2013 proved to be a vintage year for equity markets as record levels of stimulus drove global indices higher, and the recovery cemented its hold on many developed economies. Some of the frontrunners of the pickup in economic activity were financial stocks that achieved strong gains over the course of the year.

Two of the UK retail focused entities which stood apart from the crowd were Lloyds Banking Group and HSBC Plc, while in the asset management world Hargreaves Lansdown also posted significant gains.

With retail banks highly geared to any economic upturn, and now that growth across developed markets is expected to continue driving the global recovery throughout 2014, the up and coming IPO for TSB bank has garnered much attention from the financial press.

While an in-depth analysis of the bank’s investment prospects is difficult without a prospectus and further documentation, today’s report sets out to provide an overview of the general environment which the soon-to-be-listed entity will be operating within, as well as an indication of how a number of select issues are likely to affect the bank going forward.


A strong starting line up  

To begin on a positive note, TSB Bank does have a couple of things going for it that would often be found lacking in the ordinary “new entrant” to a market. These are the 4.7 million retail account holders and 127,000 small business customers that Lloyds has transferred onto its books that now make it the UK’s seventh largest bank. This provides the new entity with a good position on the starting line which, according to some estimates, will see the bank turning over a profit of £200 million by the close of 2016.

While the head start gained from the existing businesses, and a great deal of media hype, may be sufficient to create an appetite among investors for the bank’s shares over the near term, the competitive environment in UK financial services, customer loyalty to existing brands and the operational challenges of running a large institution are likely to form the real test for management over the longer term.

While the entry of a new “challenger” into the UK banking industry heralds a positive development for the cost-conscious consumer, uncertainties remain over whether it will be quite such a joyful event for investors, particularly those with existing positions in larger institutions who already have a strong presence in the UK retail and business banking market.

Despite the various hands that have helped TSB to the point where its shares are about to float, the bank still faces numerous potholes and potential pitfalls in the road ahead, many of which the bank will have to face while stood on its own two feet.


Challenger bank facing challenges of its own as creaking IT infrastructure presents the challenge of a generation for UK financials

Each of the big six UK banks have suffered costly disruptions to service over recent years because of IT systems which have grown obsolete following years of under investment. This has left the UK’s biggest names vulnerable to advanced cyber-attacks and facing substantial bills for upgrades and improvements.

While macroeconomic issues and regulatory action remain highly relevant, outdated infrastructure and the cost of replacements now poses one of the greatest risks to the profitability and standing of UK banking institutions today.

Updating these is likely to prove the challenge of a generation for many, while the potential impact of a failure upon long term value could also be significant. This is a problem for TSB due to the bank’s reliance upon Lloyds’s IT infrastructure, which is renowned for its aged condition.

Such a relationship also represents a dependency which has already attracted criticism from the Office of Fair Trading for its potential to hinder the bank’s ability to compete. As a result, it is highly likely that TSB will need to develop its own infrastructure over time that will require extensive financial investment and risks distracting management and other members of key staff from growing the business.


Risk and competitive environment: “Local Banking” in overbought territory

The UK banking industry is often criticised for being a close knit club comprised of a small number of institutions who each have the financial resources, and necessary incentives, to ensure that barriers to entry into the market remain high. Although there are certainly other places where competition is a lesser force, the above description is not unfair or inaccurate.

This places TSB in a difficult position given its lack of a differentiated offering. The current value proposition of the bank is that it is a specialist in “local banking”, which in simple terms means it offers basic services to retail and business customers. With this in mind it becomes difficult to see why so many observers seem quite as excited over the up and coming IPO as they do at present.

The group’s debut on the stock market comes at a time when, repentant for their past sins, many of the big six high street forces are emphasising their local connections and history or heritage as part of efforts to rebuild trust with consumers. With the term “local” and all of the PR speak that normally accompanies the description firmly in overbought territory, TSB is without any means of differentiation, from a products and services perspective.

Failure to differentiate itself in a competitive market could see TSB shares left out in the cold over time. In addition to the effects of differentiation upon competition ability, the narrow focus of the bank in terms of geographic locations as well as services further restricts opportunity and leaves the bank’s revenue stream lacking diversification.

As a result, in the event of a UK economic downturn TSB bank could be hit doubly hard when compared with its larger, and better diversified rivals who often oversee simultaneous, and highly profitable, investment banking, wealth management and securities trading businesses.


Risk and competitive environment: Challenger bank punching above its weight with price competition 

The path chosen by TSB is set to leave the bank reliant upon a narrow stream of revenues which are drawn from products and services that in many cases are likely to lack a qualitative differentiation from those of the bank’s competitors.

This traditionally leaves price competition as the most direct route to success for a business such as TSB; however, this is a tactic that can be employed by any company with the financial firepower to do so.

With this in mind, each of the six UK banks that reside above TSB in the balance sheet league tables becomes more of a concern. If a price war were to erupt in the world of retail banking, and prove effective, each individual competitor has the capability to match any offers made by TSB.

In addition to the above, an attempt at a cost leadership strategy for TSB will mean offering higher pay-outs on savings accounts as well as lower interest charges on loans and other forms of finance.

This will have the effect of depressing the bank’s net interest margin, which is bad for profitability and could mean a slower route to progression for investors in the bank.

It will also have the potential to seriously impair TSB’s ability to pay any form of dividends to shareholders over the near to medium term, which could also make the stock less attractive to a large portion of the investor community.


Risk and competitive environment: Customer behaviour a barrier to competition and entry in the current account market, threatens TSB

Although price competition and other strategies may prove to be effective lures for new customers when it comes to mortgage and loan businesses, numerous surveys and investigations by the Office of Fair Trading (OFT) suggest that they may not be quite such an effective tool when it comes to capturing more of the lucrative current account and business banking market.

While mortgage and loan profitability has improved substantially from a low base since 2008, Personal Current Accounts remain the most profitable line of business for retail banks, accounting for over 20% of revenues. However, the most recent review of this market by the Office of Fair Trading found that competition was muted, switching activity low and that this created a barrier to entry.

Further included in the findings were assertions that much of the low competition and consequent barrier to entry for the current account market is due to the unresponsiveness of consumers to fluctuations in the costs associated with their accounts. This is while the same survey found that satisfaction levels across providers were broadly similar, or within a narrow range.

The OFT cited a lack of awareness relating to costs as the key driver behind low levels of consumer responsiveness to costs. While there is conclusive evidence to suggest that many current account holders are unaware of the costs attached to their accounts, to conclude that this is the reason for low switching activity is presumptuous at best, despite the competition mantra of regulators and politicians.

In greater detail, current account costs are calculated by looking at the interest charges levied on overdrafts and by also looking at the opportunity cost of holding funds within a CA as opposed to a savings account.

Our theory is that for a large portion of the population, the costs associated with traditional current accounts (no monthly fee) are both immaterial and, as a result, often irrelevant. This is because a large portion of those consumers who make frequent enough use of their overdrafts for charges to become relevant are likely to be from low income groups, where both financial literacy and the amounts involved can often be low.

On the other side of the same coin, when it comes to interest credits on current account balances, the majority of consumers will use CAs for regular funds that arrive by deposit and depart by debit or transfer on a monthly basis.

As a result, the interest payable on such deposits is, once again, likely to be immaterial in most cases. This renders price competition in the current account market redundant, meaning that education, awareness and transparency campaigns are likely to be of limited benefit.


TSB trips at the starting line; Gripes over transfer from Lloyds see it labelled “Worst Bank for customer service in 2013”

A large part of the TSB story relies upon the history behind the brand name, and an exclusive focus on the UK, to generate interest in the brand. As a result, public perception of the bank will be integral to its success every step of the way.

With the above in mind, prospective investors in TSB will be somewhat bewildered to discover that within its first year of operation the bank has already been awarded the title of “Worst Bank for Customer Service in 2013” by Moneysupermarket in a poll of 9,000 consumers.

Although this is likely due to the switching of accounts from Lloyds and the way this exercise has been carried out by LBG management, it does not bode well for first impressions considering the proximity of the IPO for TSB.

The survey results also provide an indication of the sentiment toward the switch from those whose accounts were involuntarily assigned to TSB by Lloyds. This could be indicative that an issue with customer outflows may be lurking underneath the surface.



In summary, TSB is due to stand alone in a tough market, which has high barriers to entry, at a time when existing competitors are attempting to repair battered reputations through beefing up their own “local” images. This means that the bank is sure to face stiff competition for both its existing accounts as well as new customers over the months ahead.

Although the soured sentiment toward TSB that came out of the switch in 2013 has the potential to yield disappointments for investors, the total number of accounts that have opted to stay will not be known until the release of a prospectus for the IPO. Over the medium term, the bank also has other headwinds to face.

The combined effects of these, based upon first estimates, are likely to see TSB profitability subdued throughout much of its early life. This is despite the helping hand it has received through the existing branch network it inherited from Lloyds. With this in mind, and given the recent volatility across equity markets, it is most probable that the eventual IPO will see the shares float with an above average discount attached.

This may help the stock to support any early gains, or to at least remain stable for a time; however, if an investment in TSB is to yield any notable return then it will more than likely require both patience and an extended time frame.

For this reason, it is difficult to see a large allocation of shares being made to retail investors when the initial IPO takes place in May.

Overall, the creation of a new “challenger” bank has proved a politically popular move and may eventually prove a positive development for the average consumer. Despite this, the question remains open over whether or not the new entity can meet the bar in proving a good investment opportunity.


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