It's no secret that income investors accustomed to banking stocks delivering consistent and impressive dividend yields have been severely underwhelmed since the end of the financial crisis. Indeed, the likes of Barclays (LSE: BARC) still offers shareholders a miserly 1.5% yield after it slashed its dividend in 2016.
However, I think over the long term, smaller challenger banks such as Virgin Money may just prove to be the dividend dynamos their larger rivals once were. This is particularly true of Metro Bank (LSE: MTRO), which is quickly growing its substantial loan book and this morning announced it delivered its maiden profit in 2017.
Last year was another great one for Metro Bank as its loan book grew 64% to £9.6bn and it recorded a 47% uptick in deposits to £11.6bn. Importantly, the bank's loan-to-deposit ratio also grew from 74% to 82%, which shows it is still finding suitable investments to deploy its ever-growing mountain of customer funding.
The management team has also set itself a series of ambitious targets for 2023 that would make it a fairly large and highly profitable lender with plenty of excess cash that could be returned to shareholders. From its current base of 55 stores and £11.7bn in deposits, Metro's management wants to have 140-160 locations in five years with £50bn-£55bn in deposits.
Judging by the pace at which customers are flocking to its expanding online and offline array of services, this isn't a far-fetched target. And due to the increasing benefits of scale, management is aiming for a cost-to-income ratio of 55%-58% by that time with a return on equity (RoE) of a whopping 17%-19%.
This is the level of returns that big banks were delivering before the financial crisis, but with its sole focus being on boring old retail banking, I believe Metro Bank's plans are significantly less risky than those of the old Barclays or RBS. If management hits its targets, I could see it turning into a fantastic dividend-payer over the long term as it kicks off enough cash to cover expansion plans and shareholder rewards alike.
The right strategy?
Compare this with Barclays, which under the direction of CEO Jes Staley is doubling-down on its huge investment banking operations even as it retreats from areas such as its African operations. While this could prove wise in the long term, for now the investment bank is recording relatively low profits that are obscuring the group's highly profitable credit card and retail banking divisions.
In the first nine months of 2017, the corporate and investment banking division recorded RoE of 8.4%, which was lower than the 19.3% of the credit card division and 9.4% of UK retail banking operations. Furthermore, unlike newcomer Metro, Barclays is still weighed down by legacy bad assets and legal issues that sent the group's statutory RoE down to -1.4% in the nine months to September.
While management is doing well to whittle down its bad asset portfolio, I remain unconvinced that pursuing the universal banking business model is still the way to go considering ever tighter regulatory requirements on banks. With a relatively low dividend yield and a lack of compelling growth prospects, I'd easily choose Metro over Barclays for the long term.
Ian Pierce has no position in any of the shares mentioned. The Motley Fool UK has recommended Barclays. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.