By Sinead Cruise and Lawrence White
LONDON (Reuters) - Facing the prospect of their first UK recession, Britain's small specialist lenders could struggle to cope with a downturn, especially in the small and medium-sized business sector that is their lifeblood.
The promises of the so-called challenger banks, many just a few years old, to improve customer choice and challenge the dominance of big High Street lenders are looking shaky after Britain voted to leave the European Union, some investors and analysts say.
Challenger banks' ability to take business from lenders HSBC <HSBA.L>, Lloyds Banking Group <LLOY.L>, Barclays <BARC.L> and Royal Bank of Scotland <RBS.L> relies on healthy bank funding markets and a buoyant UK economy with rising demand for loans.
But as economists slash UK growth forecasts and borrowers and home buyers run for cover, those three factors could be under threat.
The UK could go into recession in the coming year, according to economists and strategists polled by Reuters. Britain last had a recession in 2008-2009, following the financial crisis.
"The outlook for the important small-to-medium enterprise sector looks likely to be hardest hit and a credit cycle inevitable. We think it's logical that banks have sold off so dramatically," Matthew Beesley, head of global equities at Henderson Global Investors told Reuters.
Marcus Stuttard, head of the London Stock Exchange's AIM board which provides funding for small businesses, told a government committee it was likely "companies will delay making investing decisions and therefore requesting finance" until Britain's economic future looked more secure.
Financial sector shares fell sharply after the referendum result last Friday. Among challenger banks, shares of Aldermore <ALD.L>, OneSavings Bank <OSBO.L>, Shawbrook <SHAW.L> and Virgin Money <VM.L> have fallen an average 37 percent. Britain's four largest banks fell an average of 21 percent in the same period.
The stock price falls of larger rivals, with millions of customers and more dependable revenues from Britain and elsewhere, also offer investors opportunities to buy blue chip stock at rock bottom valuations, detracting from the upstart banks.
"The scale of the share price movements in smaller banks looks alarming, they look like what you associate with liquidity crises or capital shortfalls yet those two concerns are not present," said Ian Gordon, an analyst at Investec.
Analysts say banks now are much better capitalized than they were before the 2008 financial crisis, meaning the focus is more on the implications of a Brexit for the UK economy.
Some smaller lenders acknowledge the challenges arising from Britain leaving the EU, but also put a brave face on their prospects, seeing opportunities at home.
"The challenger banks are almost exclusively UK only and are therefore insulated from the distractions that will inflict those operating cross border," Secure Trust Bank <STBS.L> Chief Executive Paul Lynam said.
"Some banks may temper their lending appetite whilst they wait for clarity to emerge but in the long run Brexit presents more opportunity than threats to the smaller banks," he said.
Rishi Khosla, chief executive of OakNorth Bank, a specialist in loans of between 1 million pounds and 15 million pounds ($1.3-$19.9 million), said two lending opportunities from rivals had come his way since Friday after nervous blue-chip peers pulled out of the deals.
The unlisted bank, which began taking deposits in September and has 160 million pounds in loans, has also seen deposits rise by 20 percent in the days following the vote as savers spread their money around more banks for safety, Khosla said.
Virgin Money, one of the largest and most diversified of the challengers, said it felt well placed to manage the uncertainty, pointing to its low-risk lending approach.
The Newcastle-based bank, which provides mortgages, credit cards, current accounts, currency services and pensions to over 3 million customers, said it was "business as usual" last Friday. Its shares have fallen 29 percent since last Thursday's referendum.
The finance ministry's recent introduction of an 8 percent surcharge on bank profits over 25 million pounds is also likely to compound the outlook for challengers.
The surcharge, which replaced a 0.21 percent levy on bank balance sheets deemed to present material risk to economic stability, could make it harder for small banks to reward investors, attract talent and recycle capital into new lending.
"After Brexit, a UK recession is guaranteed but a bad loan won't materialize for around 18 months," Xavier VanHove, portfolio manager at THS Partners said. "For me, challenger banks are no-go areas because I really don't know how bad things could turn."
(Editing by Susan Thomas)