Britain has seen the emergence of several new banks since the financial crisis, looking to pick up customers as bigger rivals slim down in order to bolster their balance sheets and meet tougher regulatory requirements.

The KPMG report showed new British banks increased lending by 16 percent last year, compared with a decline of 2.1 percent at Britain's 'Big Five' retail players - Lloyds Banking Group (>> Lloyds Banking Group PLC), Royal Bank of Scotland (>> Royal Bank of Scotland Group plc), Barclays (>> Barclays PLC), HSBC (>> HSBC Holdings plc) and Santander UK (>> Banco Santander, S.A.).

KPMG noted, however, that the combined loans of the five largest challenger banks are still equivalent to just 5 percent of lending provided by the 'Big Five' and it is therefore easier for them to achieve higher levels of growth.

The research found that smaller 'challenger banks', such as Metro Bank, OneSavings Bank (>> OneSavings Bank PLC) and the UK business of Sweden's Handlesbanken (>> Svenska Handelsbanken AB) were growing at the most rapid rate, with larger challengers such as Virgin Money (>> Virgin Money Holdings (UK) PLC), TSB (>> TSB Banking Group PLC) and the Post Office showing slower growth.

However, Britain's competition body, which is investigating the industry, has warned moves to improve competition have yet to have the desired effect.

"Although the overall 'challenger' banking sector is growing rapidly and securing greater returns, it is the small challengers who are driving its growth," said Warren Mead, head of challenger banking and alternative finance at KPMG.

The research showed that smaller challengers achieved an average return on equity, a key measure of profitability, of 18.2 percent, last year. That compared with 2.1 percent at larger 'challenger' banks and 2.8 percent at the 'Big Five'.

"If this trend were to continue, as the challengers grow and benefit from economies of scale, it poses an interesting question for the 'Big Five' as to whether too big to fail becomes to big to compete," said Mead.

(Reporting by Matt Scuffham Editing by Jeremy Gaunt)