The UK’s ‘excessive’ approach to prudential regulation for challenger banks has created an uneven playing field that places heavy burdens on new entrants and limits international competitiveness, according to a new report from Innovate Finance.

The industry body, which represents the UK fintech sector, warned that a suite of existing and incoming rules is causing the UK’s thriving challenger banking sector to stall, undermining what the report says should be a ‘British success story’.

Since 2007/8, some forty new banks have been authorised in the UK, most of them challengers, agile institutions which the report claims are partly responsible for overhauling the traditional banking sector with innovations such as ‘banking-as-a-service’, empowering a new wave of fintechs.

Moreover, the whitepaper argues that with challenger banks now accounting for 60% of all bank lending to the UK’s SME sector, these strict rules are not only constraining the growth of banks but also of the wider retail economy.

Current proposals from the Prudential Regulation Authority (PRA) contain ‘logic-defying’ elements, said the report, with the new regulations set to disproportionately burden challenger banks. 

For example, the paper claims that a rule increasing required capital by treating SME-lending the same as high-risk, wholesale corporate lending, effectively penalises the simplest and most productive forms of business financing.

“Challenger banks play an increasingly important role in the UK economy, driving innovation and competition in financial services,” said Charles Elliott, counsel at Hogan Lovells, which co-published the report.

“Given how important challenger bank lending has become in the SME sector, they are particularly relevant to the UK government’s growth agenda.”

To cut the red tape, the study urges the Bank of England to apply MREL (Minimum Requirement for Own Funds and Eligible Liabilities) more ‘proportionately’, noting that rules that were built for ‘Too Big To Fail’ banks are costly and overly complex for challengers, forcing them to hoard capital for regulatory compliance rather than use it for lending and investment.

It also calls for the PRA and Financial Conduct Authority (FCA) to reassess pay rules so that early-stage fintechs and challenger banks can retain top talent, and urges for ambitious reform of the current anti-money laundering systems, which put undue strain on challenger banks and their customers.  

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Innovate Finance wants UK regulators to adopt a ‘think challenger’ mindset to address the reality that challenger banks face disproportionate burdens that hinder exactly the kind of competition the UK regulatory system set out to foster post-financial crisis.

While last week, the PRA and FCA finalised their approach to remuneration reform, which Innovate Finance said included some positive changes, the report said further refinements are needed for challenger banks, including greater flexibility in how key individuals are remunerated and a lighter-touch regime for low-risk business models.    

“The current approach to prudential regulation risks imposing a disproportionate capital tax on the simplest form of lending, diverting tens of billions of pounds away from SMEs and directly undermining the government’s growth agenda,” said Janine Hirt, CEO of Innovate Finance.

“Regulators must adopt a ‘Think Challenger’ approach to ensure we are supporting innovation.”