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Banking investors who want to look beyond the big four are increasingly spoilt for choice, with a range of challenger banks looking to shake their market dominance. AIM-traded Arbuthnot Banking Group(LSE: ARBB) has its admirers, including my Foolish colleague Alan Oscroft, who reckons it could be on the verge of something special. However, recent share price performance has been patchy, despite growing profitability.

Banking on growth

Today Arbuthnot published its audited final results for the year to 31 December and these look like a decent set of numbers. The bank highlighted "increased profitability as capital successfully deployed," with a 91% jump in underlying profit from £4m in 2016 to £7.7m. Operating income increased 32% to £54.6m.

Earnings per share soared from just 3.7p to 43.9p, although the 2016 figure excludes profit from discontinued operations of £228m. Similarly, while the full-year 2017 dividend per share rose from 31p to 33p, last year's figures excluded special dividend payments of 325p. Underlying net assets crept up from £234m to £236m.

Challenging times

Chairman and chief executive Sir Henry Angest hailed the "creditable milestone of surpassing £1bn in its key business metrics: Customer Loans, Customer Deposits and Assets under Management," and added that with strong capital and a good liquidity surplus, Arbuthnot "is well set for further growth."

City analysts are pencilling in EPS hikes of 76% in 2018 and another 75% in 2019. By then, the yield is predicted to hit 3%. A forecast valuation of 15.3 times earnings does not look too demanding. Recent share price performance has been patchy, but Arbuthnot is rising to the challenge.

Scaling up

With a market cap of just £198m Arbuthnot is small beer compared to Royal Bank of Scotland Group(LSE: RBS) at £30bn. However, the market still does not totally believe in RBS, whose shares continue to struggle, despite finally reporting its first bottom-line profit in a decade for last year.

RBS posted a full-year operating profit of £2.24bn, reversing 2016's huge £4.08bn loss, while profit attributable to shareholders of £752m turned round a massive £6.95bn loss. However, it was flattered by the fact that a multi-billion dollar mortgage mis-selling case with the US Department of Justice was not settled in the period, as this would have pushed the bank into another loss.

Income play

RBS does still not pay a dividend, but that is set to change. This year, the yield is forecast to hit 2.9%, then jump to 5.2% in 2019. When the dividends start flowing, investors might finally start believing that RBS is back for good. It will remain a bumpy ride, with EPS forecast to be flat last year (after 2017's dizzying 385% growth) then rise 12% in 2019.

The banking sector is also exposed to further economic and Brexit uncertainty, and the slowing housing market. Net interest margins, which measure the difference between lending and saving rates, fell five basis points to 2.13% in 2017. However, with further base rate hikes expected, it may have scope to widen this again. The bank's legacy issues are not dead, but they are slowly fading away.

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Harvey Jones has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

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