By Lawrence White and Emma Rumney
LONDON (Reuters) - Getting together could be the easy bit for mid-sized CYBG and Virgin Money (LON:VM), with breaking the grip of Britain's big four banks an altogether tougher challenge.
The pair are having "positive discussions" about forming Britain's biggest challenger bank, with double the assets of its closest rival among Britain's smaller lenders.
But even that would represent just over a tenth of the assets of Royal Bank of Scotland (LON:RBS), and then face the extra hurdle of years of integration amid stiff competition.
CYBG, which owns Clydesdale and Yorkshire and app-based "B", would be the main bank for around just two percent of high street customers if it merges with Virgin, data from RFi Group shows, compared with around 24 percent for market leader Lloyds Banking Group (LON:LLOY). (https://tmsnrt.rs/2Jcwir8)
"The market has been ripe with opportunities for new players for the past 15 years but it hasn't happened, the incumbents have low customer satisfaction but have been protected by very high barriers to entry," said Ed Firth, analyst at KBW.
However, a deal would leave the combined group better placed to combat the hefty technology spending by incumbent players and fresh competition from nimble digital-only banks, which have put mid-sized lenders under pressure to merge in order to survive.
"There's plenty of strategic logic to it," said a top ten Virgin Money investor, adding that it would create one strong challenger and enable the two to combine technology spending.
But they would need to ensure smooth IT integration, especially after TSB's botched data migration caused customer disruption and landed it in trouble with lawmakers.
"What we would have to decide is... do we want to remain a shareholder in the combined entity, and IT risk would definitely be something that would frighten you pretty substantially," the investor told Reuters.
CONSOLIDATION WAVES
A combined CYBG-Virgin Money would have a market capitalisation of around $5.55 billion, compared with $61 billion for Lloyds and $45 billion for RBS, according to Thomson Reuters data.
For even with efforts to stimulate competition, Britain's banking market is dominated by the four biggest banks after they pursued a series of acquisitions during the financial crisis.
Barclays (LON:BARC), HSBC, Lloyds and RBS have nearly 70 percent market share among their various brands, RFi data shows, confirming a similar finding in a 2016 Competition and Markets Authority report.
Analysts expect a CYBG and Virgin Money tie-up could herald a fresh wave of consolidation among the so-called challenger banks that have risen up since the crisis.
"There is considerable logic in a single player seeking to consolidate the medium-sized mainstream space over time," John Cronin, analyst at Goodbody, said in a recent note.
CYBG-Virgin would start with around 250 branches, compared with 893 for RBS and 1,795 for Britain's biggest bank Lloyds.
That matters less than it has in the past, as customers switch to digital channels and branches become a burden.
"The world is changing and branches which had been the big barrier to entry in the retail market are no longer as important," Ed Firth, analyst at KBW, said.
Analysts expect the two would make the Virgin Money brand most prominent, thanks to greater public awareness through its ties to high-profile entrepreneur Richard Branson's empire.