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The rise of non-bank credit: Revolution or evolution? 

Traditional bank lending continues to be constrained by tighter regulation, increased capital requirements and a more conservative approach to risk. This would appear to open up significant business opportunities for alternative sources of credit, but there are a number of factors that may hinder the much-heralded revolution in credit provision. Richard Hinton outlines some critical success factors for aspiring new entrants to the evolving world of primary lending.

The global scale of bank lending is so large that if banks retrench their activities by even a few percentage points, it will open up a significant market for non-bank lenders. But if there are any concerns about a potential explosion in non-bank lending leading to another credit bubble, these should be balanced against the countervailing  constraints: the market is globally fragmented, the barriers to entry can be high and it is hard to identify and implement the right business model for the right market. For example, the differences between Europe, North America and Asia are stark.

Europe

In Europe, the traditional model of bank lending dominates the market – and indeed the culture – of many countries. People, whether in business or privately, are used to going to the banks, which is why, for example, 99 percent of all commercial real estate (CRE) debt in Europe is held by the banks and, despite regulatory pressure to raise capital ratios, so far the expected wave of deleveraging transactions by banks has not materialized.1 At the same time, demand for debt has been subdued as a result of the uncertain economic outlook. The combination of these factors has made it difficult for newer players such as market funds, exchange- traded funds, insurers, pension and hedge funds to expand their primary lending activities significantly.

UK

In the UK, retail and small and medium enterprise lending is dominated by the banks. Access to credit in the UK is perceived to be difficult and, in an effort to free up alternative financing, the government is effectively sponsoring new entrants. For example, through the Business Finance Partnership it is making available UK£1.2 billion to invest through managed funds that lend directly to SMEs. However, other actions have been targeted at the banks. For example, the Bank of England and the Treasury have announced a UK£80- billion ‘Funding for lending’ scheme, under which banks will be granted additional cash on the proviso that they then use it to help provide cheaper loans and mortgages. At the same time, the National loan Guarantee Scheme allows banks to raise up to UK£20 billion of funding, guaranteed by the government, to lend directly to smaller businesses at a lower cost than would otherwise be the case.

North America

In North America, by contrast, there is a mature non-bank lending sector – from community banks to micro-lenders to accounts receivable financing to peer-to-peer or social lending – and it would appear this increased diversity is one of the reasons why the supply of credit is not such an issue in the US as it is in Europe. The diversity also increases the capacity of the credit market to fill any gaps that emerge as the banks come under pressure. There is less of a sense of stress; simply a natural progression as market mechanisms react to changed circumstances. However, it also means the US market is very competitive, with returns being squeezed, so funds are being forced to look beyond  their home market. We see this reflected, for example, in a focus from US investors on  markets such as Spain and Ireland, where they have recently transacted for the first time.2

Asia

With its growing export-led economies, Asia has no lack of local currency liquidity and there is not the same tension as in Europe with regard to retail and SME lending the strategic focus is on funding the big ticket  items like China’s numerous infrastructure projects; and the huge scale of this investment means we are seeing major global firms like Siemens leveraging their balance sheet to offer corporate financial services in the region. However, rapid economic growth has also led to a significant expansion of non-bank lending. For example, China has a huge and varied alternative credit sector, ranging from trust loans to underground banks, micro credit and pawn shops. One estimate suggests that non- bank lending amounts to 25 percent of all the loans made in China by the traditional banks, which makes it a significant source of credit for the real economy.

Opportunity versus complexity

Where does this leave the asset management CEO who can see both the opportunity and the complexity? First, so far as successful operating and business models go, this is not a case of ‘one size fits all’. Close attention has to be paid to regional, even national, dynamics and customer expectations to understand which models work in practice and the direction of travel of both the market and the regulatory environment. A big firm with a highly successful business model in Asia cannot expect to succeed in Europe simply by replication.




Close attention has to be paid to regional, even national, dynamics and customer expectations to understand which models work in practice and the direction of travel of both the market and the regulatory environment. A big firm with a highly successful business model in Asia cannot expect to succeed in Europe simply by replication.



Second, regardless of what business model is selected, from both an operational and a regulatory perspective, there is a fundamental difference in moving from buying a debt instrument to selling a debt instrument. This not only has regulatory consequences – especially in terms of increased scrutiny – it also requires the firm involved to become much closer to its customers.


Third, the substance of any opportunity may be more superficial than real. Uncertainties remain and there are still many questions left unanswered. If it takes government pump priming to create an alternative credit sector, what will happen if and when that support is withdrawn? How will the banks act to protect their position? Will the regulatory bar be raised for non-bank entrants? If non-bank lending is highly competitive, can profitable rates of return be achieved? What types of products do customers want? And what can they afford?


Fourth, there are important differences between banks and some of the alternative providers of credit, which are reflected in their products. The former are large regulated entities that actively manage their portfolios and run treasury departments to oversee assets and liabilities. The latter – funds or insurance entities – are investors who ideally want a stable, foreseeable return. So, for example, banks can lend floating rate debt, hedged, on terms that can be as short as three to five years, whereas non-bank investors in the main want longer-term, fixed-rate debt backed by high-quality assets with penalties for pre-payment. Customers tend to prefer the terms banks normally offer.

Where to focus

All this does not mean that the mechanics of value are fundamentally different from market to market. It does, however, mean that new entrants are moving to a different part of the value chain, possibly in a different geography, so they have to do a lot of homework on where and how to operate and what type of products to offer at what price. The following areas in particular require close attention.


Detailed local regulatory and market knowledge
Because detailed local regulatory and market knowledge – gathered on the ground – is so vital, a move to credit provision cannot be driven solely from the center; it requires local understanding of which business models work best and most profitably in which markets.


Entering a new market through acquisition
Entering a new market by acquiring a loan portfolio – of whatever asset class – does not come without risk. Choosing the right servicing partners or anchor portfolio/platform investment is often critical for future success.


Perceived value
New entrants will have to know where clients perceive value and what their product expectations are – especially with regard  to pricing. Pricing challenges are currently evident in Europe, where there have been gaps between the rates borrowers are willing (or able) to pay and the return expectations  of some non-bank entrants. Similarly, differences remain between what sellers of loan portfolios want and what buyers are prepared to pay. This gap will narrow as the cost increases driven by increased bank regulation become visible and as non-banks become more realistic. But the underlying issue is that it is essential – and difficult – to get the pricing right.


Credit management as a core expertise
larger non-bank firms may feel well placed because they have the risk management and regulatory compliance platforms on which to build their entry into alternative credit.


But a more fundamental issue is whether credit management is a core expertise. For collateralized loan obligation (ClO) managers, used to analyzing corporate credit, it might be a relatively small move to originating corporate credit. But this is much more difficult for, say, equity managers.


Sensitivity to local circumstances
The need for sensitivity to local circumstances and responsiveness to customer requirements ultimately resolves into a single question: How entrepreneurial can your firm be on the ground?

Evolution, not revolution?

We are entering an era of opportunity for alternative credit. Just as in the past we have seen the leasing industry flourish  as firms looked for more flexibility in their use of capital and a securitization boom as banks seized the opportunity to free up their balance sheets, now there is an opening for non-bank lending to achieve a step change. But success for a new entrant is not a given. It will only come from detailed analysis of particular opportunities in the context of a clear understanding of their own business model – and how flexibly it can be shaped to meet the local needs of markets, regulators and customers. In the end, what we may be witnessing is not so much a revolution as an evolution.




By Richard Hinton, KPMG in the UK

Sources:

  1. Global Debt Sales Survey 2012, KPMG 2012.
  2. Global Debt Sales Survey 2012, KPMG 2012

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