UK challenger banks may be more vulnerable than more established banks to late-cycle and Brexit-related risks, according to Fitch Ratings.

Analysis from the ratings agency pointed out that several digital challengers have grown faster than the market, and faster than GDP, during relatively benign credit conditions in recent years, with performance not yet tested in a downturn.

“A cyclical downturn or a disruptive no-deal Brexit, leading to higher unemployment or falling property prices, could expose weaknesses in their risk management and financial position,” it read.

UK banks' loan books are still performing well, with impairment charges at cyclical lows after a decade of low interest rates, low unemployment and, until recently, strong property price growth.

However, challenger banks may be underestimating the impact of a potential downturn when calculating their provisions, given their short track record and lack of historical through-the-cycle impairment data.

The Bank of England stated this month that fast-growing lenders with a limited track record may be underestimating the potential losses on their loan portfolios under its latest cyclical stress scenario, and overestimating their ability to mitigate losses through business growth or capital-raising.

Fitch noted that some challenger banks may be required to set aside more capital, possibly by way of increased Pillar 2 capital requirements, in light of the central bank analysis.

Several challenger banks have grown fast in retail mortgage lending, often to niche borrowers, or in asset classes that perform less well in a stress, to gain a foothold in the market.

“We view sustained above-market-average growth as a potential risk to a bank's credit profile because it may indicate under-pricing of risk or a loosening of underwriting standards to generate volume,” wrote Fitch. “Rising interest rates and unemployment could trigger significantly greater losses on banks' mortgage portfolios, given UK households' high indebtedness – falling house prices could exacerbate the impact, particularly for banks that have focused more on high loan-to-value lending to drive growth.”

Challenger banks may also be more exposed to funding pressure in a downturn, given their reliance on online retail deposits with short-term fixed rates, and deposits from small businesses and corporate clients.

These sources of funding are more price-sensitive and less stable than current accounts, and could become more costly to attract and retain in the event of rising interest rates and financial pressure on consumers.

Challenger banks have been unable to break the market domination of the UK's largest banks, and their lack of scale limits their ability to generate margins in the highly competitive mortgage market, concluded the report.

“We believe that less diversified banks or those focused on niche or highly cyclical sectors are more vulnerable – many challenger banks fall into this category.”

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