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* Challenger banks' shares down 37 pct
* A recession will squeeze lending
* Some CEOs see opportunities amid volatility
By Sinead Cruise and Lawrence White
LONDON, July 3 (Reuters) - Facing the prospect of theirfirst UK recession, Britain's small specialist lenders couldstruggle to cope with a downturn, especially in the small andmedium-sized business sector that is their lifeblood.
The promises of the so-called challenger banks, many just afew years old, to improve customer choice and challenge thedominance of big High Street lenders are looking shaky afterBritain voted to leave the European Union, some investors andanalysts say.
Challenger banks' ability to take business from lenders HSBC, Lloyds Banking Group, Barclays andRoyal Bank of Scotland relies on healthy bank fundingmarkets and a buoyant UK economy with rising demand for loans.
But as economists slash UK growth forecasts and borrowersand home buyers run for cover, those three factors could beunder threat.
The UK could go into recession in the coming year, accordingto economists and strategists polled by Reuters. Britain last had a recession in 2008-2009, following thefinancial crisis.
"The outlook for the important small-to-medium enterprisesector looks likely to be hardest hit and a credit cycleinevitable. We think it's logical that banks have sold off sodramatically," Matthew Beesley, head of global equities atHenderson Global Investors told Reuters.
Marcus Stuttard, head of the London Stock Exchange's AIMboard which provides funding for small businesses, told agovernment committee it was likely "companies will delay makinginvesting decisions and therefore requesting finance" untilBritain's economic future looked more secure.
Financial sector shares fell sharply after the referendumresult last Friday. Among challenger banks, shares of Aldermore, OneSavings Bank, Shawbrook and VirginMoney have fallen an average 37 percent. Britain's fourlargest banks fell an average of 21 percent in the same period.
The stock price falls of larger rivals, with millions ofcustomers and more dependable revenues from Britain andelsewhere, also offer investors opportunities to buy blue chipstock at rock bottom valuations, detracting from the upstartbanks.
"The scale of the share price movements in smaller bankslooks alarming, they look like what you associate with liquiditycrises or capital shortfalls yet those two concerns are notpresent," said Ian Gordon, an analyst at Investec.
Analysts say banks now are much better capitalised than theywere before the 2008 financial crisis, meaning the focus is moreon the implications of a Brexit for the UK economy.
CHALLENGES, OPPORTUNITIES
Some smaller lenders acknowledge the challenges arising fromBritain leaving the EU, but also put a brave face on theirprospects, seeing opportunities at home.
"The challenger banks are almost exclusively UK only and aretherefore insulated from the distractions that will inflictthose operating cross border," Secure Trust Bank ChiefExecutive Paul Lynam said.
"Some banks may temper their lending appetite whilst theywait for clarity to emerge but in the long run Brexit presentsmore opportunity than threats to the smaller banks," he said.
Rishi Khosla, chief executive of OakNorth Bank, a specialistin loans of between 1 million pounds and 15 million pounds ($1.3-$19.9 million), said two lending opportunities from rivalshad come his way since Friday after nervous blue-chip peerspulled out of the deals.
The unlisted bank, which began taking deposits in Septemberand has 160 million pounds in loans, has also seen deposits riseby 20 percent in the days following the vote as savers spreadtheir money around more banks for safety, Khosla said.
Virgin Money, one of the largest and most diversified of thechallengers, said it felt well placed to manage the uncertainty,pointing to its low-risk lending approach.
The Newcastle-based bank, which provides mortgages, creditcards, current accounts, currency services and pensions to over3 million customers, said it was "business as usual" lastFriday. Its shares have fallen 29 percent since last Thursday'sreferendum.
The finance ministry's recent introduction of an 8 percentsurcharge on bank profits over 25 million pounds is also likelyto compound the outlook for challengers.
The surcharge, which replaced a 0.21 percent levy on bankbalance sheets deemed to present material risk to economicstability, could make it harder for small banks to rewardinvestors, attract talent and recycle capital into new lending.
"After Brexit, a UK recession is guaranteed but a bad loanwon't materialise for around 18 months," Xavier VanHove,portfolio manager at THS Partners said. "For me, challengerbanks are no-go areas because I really don't know how bad thingscould turn." ($1 = 0.7534 pounds) (Editing by Susan Thomas)
