Non-bank finance
Filling the bank-shaped hole
Europe’s banks are shrinking. What will take their place?
Dec 15th 2012 | from the print edition of The Economist
OF THE things you expect to encounter in a financial firm nowadays, hope is not high on the list. Panoramic views, insincere receptionists, plates of uneaten biscuits, yes. Optimism, no. But this is a time of huge opportunity in finance—as long as you are something other than a bank.
Take one of British finance’s minnows. MarketInvoice is a start-up that runs an electronic marketplace in which small firms sell their unpaid invoices to investors at a discount. This lets credit-starved businesses get hold of cash faster than they otherwise would, and gives the buyers a return on the invoices they snapped up. Small firms have received £40m ($64m) via MarketInvoice since it was launched in 2011. Anil Stocker, an ex-Lehman banker and one of the firm’s founders, says his big problem is controlling growth, so as to maintain the quality of the invoices.
A lot of “peer-to-peer” platforms like MarketInvoice have sprung up in the past few years, their fortunes buoyed by the retrenchment of the banks. This week’s investment in Zopa, Britain’s biggest such platform, by Jacob Rothschild is thus a sign of the times. And on December 7th Britain’s Treasury recognised the fledgling industry by announcing that it would be regulated—which may, by encouraging users to trust it, allow it to grow faster.
In the City of London, where the buildings are swankier than around MarketInvoice’s HQ a few kilometres north-east, and the pots of money bigger, a similar sense of purpose is on view. The 30th floor of the “Gherkin”, perhaps the most stylish skyscraper of all, is home to Ares Capital Europe, an investor that specialises in the debt of European middle-market firms. The firm’s American parent opened a London office in 2006 on the basis that a financial system dominated by banks that were highly leveraged and mispricing risk was unlikely to end well. A team of 25 professionals now sifts through some 350 possible private-debt investments a year. Other private-debt funds are also busy. Intermediate Capital Group, an asset manager, is in the process of raising the largest-ever fund in Europe for mezzanine debt, which sits between senior debt and equity in a company’s capital structure.
Band of others
Close by the Gherkin are the London offices of an even bigger beast. BlackRock, an American asset manager that has close to $3.7 trillion in funds under management, has just launched a European infrastructure-debt division to lend clients’ money to infrastructure schemes. Matt Botein, head of BlackRock’s alternative-assets business, calls it an early start in a market that could see assets worth hundreds of billions of dollars move off banks’ balance-sheets and into institutional investors’ portfolios.
Banks everywhere are under pressure from regulators, creditors and shareholders to refashion themselves into safer, smaller entities. Non-bank finance companies are turning the travails of these shrinking banks to their advantage. Nowhere are their opportunities greater than in Europe. European banks have long been more reliant on wholesale funding than their American counterparts; they are now trying to rely more heavily on deposits. They were more aggressive in taking on long-dated assets in areas such as property and infrastructure; now they prefer shorter-term assets, which are easier to fund and worry regulators less.
Retrenchment by European banks is creating problems round the world: French and Spanish banks provided 40% of trade credit to Latin America and Asia last year, according to the World Bank, and analysts at Morgan Stanley reckon that since June 2011 foreign lending by French banks has shrunk by 20% (or more than $650 billion). But the banks’ difficulties are also felt acutely at home. Another big difference with America is that banks dominate Europe’s funding landscape.
In America banks are responsible for an estimated 25-30% of lending; the rest comes from a variety of other sources, including the capital markets and investors in securitised assets. In Europe the picture is reversed. The banks account for the bulk of corporate-financing activity (see chart 1). There is €8 trillion ($10 trillion) of corporate debt on European bank balance-sheets, for example, and only €1.3 trillion in the bond markets. As the banks retreat, other forms of funding are sorely needed, which is why companies of all shapes and sizes, from MarketInvoice to BlackRock, are bullish about their prospects. The worry is that, despite their best efforts, the shortfall will be too big to fill.
For some borrowers that previously relied on the banks for a loan it is no great hassle to switch to the capital markets. Issuers and assets that boast an investment-grade credit rating find it particularly easy to issue bonds. Such is the hunger for assets that offer a yield, though, that markets are quite happy to fund issuers with lower credit ratings as well.
European property firms, generally bank-bound in the past, are poised to issue a record amount of bonds this year. Europe’s high-yield market, though small, is also headed for a record year (see chart 2). Many borrowers have headed across the Atlantic in order to tap America’s well-developed private-placement market, in which debt is issued directly to a handful of creditors. Retail-bond markets are becoming an increasingly popular way for household names to raise capital from individual savers. “The direction of travel in Europe is clear: the incremental replacement of banks by the capital markets,” says Simon Samuels, an analyst at Barclays.
The banks themselves—or at least the universal banks, which combine commercial and investment banking—are often happy to help this process along. If properly managed it offers them a way to husband capital, as they are being pressed to do, while still keeping a relationship with their clients. Advising on and arranging the raising of capital in the markets can be just as lucrative as extending credit. And banks don’t need to make loans on their balance-sheets in order to make money from ancillary services, like overdrafts and trade finance. This all gives them an incentive to keep working with borrowers.
BNP Paribas, for instance, is still doing short-dated lending of its own. But it is also working with middle-market clients to tell them about longer-term options such as bond markets and private placements. “We’re agnostic about how our clients access credit,” says Martin Egan, BNP’s head of debt origination. “We are bringing our bond and loan activities closer together.”
Other types of issuer and asset face a tougher task replacing the banks. Some firms are just not big enough to make the switch to the capital markets: below a certain level of borrowing, the transaction costs are too high and the liquidity lacking. Securitisation markets provide one answer to that problem but, in Europe at least, they have a poor reputation given their role in the financial crisis and remain largely moribund. Collateralised loan obligation transactions, a way of bundling up the debt of mid-market firms, have been rare as hen’s teeth in Europe since August 2007.
No stopgap big enough
And some assets, such as infrastructure debt, have multi-decade maturities that stretch well beyond the horizons of bond investors. Oliver Wyman, a consultancy, reckons that European banks will need to shed €900 billion of long-dated assets like infrastructure debt, commercial property or project finance; volumes of lending are already down (see chart 3).
In theory, there are large pools of non-bank capital to flow into these gaps. Long-dated assets, for example, appear to be a perfect—and profitable—fit for pension funds and insurers, which have to meet long-term liabilities. Mark Hutchinson of M&G, a British fund manager which has for years invested directly in everything from leveraged loans to social housing to the debt of mid-sized British companies, finds it “extraordinary” that others have not followed M&G’s example and put money into these sorts of less liquid assets.
But there are behavioural, technical and operational barriers in the way of a rapid surge by non-bank finance. Trustees of defined-benefit pension schemes are used to putting money into assets like equities and investment-grade corporate bonds, not privately held debt. Regulators don’t like defined-contribution schemes holding long-dated, seldom-traded assets, such as infrastructure debt, because they are not liquid enough to be marked to market. What Solvency 2, a set of capital rules for European insurers that is being refined at a glacial pace, will mean for firms holding such assets is not clear.
There are other factors that hamper the rise of non-bank lenders at the present time. One is the euro crisis itself: not everyone believes the single currency will be around for much longer, which makes everyone more nervous of lending. Linked to that is the problem that, given the state of the economy, a lot of businesses may be bad bets, so concerns over creditor rights are high. Tripp Smith of GSO, the credit-investing arm of Blackstone, says it took four people four months to structure a $430m loan for Cementos Portland, a Spanish cement firm, because it had to be secured against assets in America.
But the biggest problem is that the historic dominance of the banks means there is only a shallow pool of institutional investors in Europe with expertise in assets that are less creditworthy and less liquid. Earlier this year Morgan Stanley calculated that European banks will reduce their exposures in the commercial-property sector by €300 billion-600 billion over the next few years, but that other providers have only €100 billion-200 billion to put to work in that time. So funding, where it is available, will be at much higher spreads than the banks used to demand; and for marginal borrowers stingy banks will be the only game in town.
Again, a division of labour can help. Banks could find clients and do the initial underwriting of credit, then pass them on to investors with an appetite for the long term. SociétéGénérale, a French bank, and AXA, an insurer and asset manager, are reaching out to mid-market French firms with something along those lines. Such companies are not looking for enough money to be of interest to the high-yield market, but offer enough of a return to be alluring to investors. So SocGen originates the debt, keeps a slice of it on its balance-sheet, and hands the rest to AXA, which then allocates it to its funds. The bank frees up its balance-sheet while keeping its client; AXA gets exposure to assets it would otherwise have been unable to access; borrowers get funded.
Reliance on alliance
Such alliances are now being formed in lots of different areas. According to Kenneth Gray of Norton Rose, a law firm, pension funds and insurers are banding together to put money into funds originated by banks which can take on structured debt, for example for financing aircraft or infrastructure projects—a practice already dubbed “syndicate to originate”. In the world of infrastructure finance, institutional investors and banks are discussing ways for the banks to fund the riskier, construction phase of big projects and then pass debt over to other investors once the revenues are flowing.
This sort of model favours universal banks. Pure commercial banks do not have the capital-market capabilities required. Pure wholesale banks lack the necessary relationships with pools of smaller domestic customers. The drawback is that a system in which the banks originate assets and then spin them off to investors has jarring echoes of what went on in the crisis, when subprime mortgage-backed securities made their way from careless lenders to hapless investors.
Skin-in-the-game requirements, whereby banks retain a slice of the risk—as SocGen does in the deal with AXA—or agree to take a first-loss position, are the favoured answer to the problem of bad incentives. Investors can take comfort in the quality of assets from the banks’ own exposure to them. But that may not reassure everyone. So the biggest investors are keen to beef up their own credentials. As well as its new infrastructure group, BlackRock has a capital-markets group that lets issuers and banks know what size and type of debt it has an appetite for and then works with them to get a deal. Allianz, a German insurer, formed an infrastructure-debt unit of its own in July and is also increasing its direct-lending activities, including to companies.
Start of the peer show
Small companies will find it far harder to attract this sort of institutional money. Their cash flows are much less predictable than their bigger brethren’s; they suffer higher rates of default through the economic cycle. Their difficulties in securing funding have long worried politicians, and there are ideas aplenty to try to diversify their sources of capital. NYSE Euronext this month announced plans to set up a pan-European exchange where small and medium-sized companies could raise equity. Policymakers are interested in the potential for securitising small-business loans, bundling the debt of lots of borrowers up into a single security that thereby diversifies credit risk. Many believe that a government guarantee would be needed to get the market off the ground, however.
So far the running has been made by an entirely new set of non-bank firms: peer-to-peer lenders. These firms do not extend capital themselves but provide a marketplace in which individual borrowers and lenders (ie, savers) can come together. Some deal in debt; others let ordinary investors put equity into promising start-ups; others, like MarketInvoice, provide a market in receivables. Some are geared towards small businesses; others are aimed at consumers.
Many are growing at a rapid clip: Zopa was launched in 2005 and has just notched up £250m in total lending on its site; across the Atlantic, Prosper, an American peer-to-peer lender which was launched in 2006, is expecting to do $150m in loans in 2012, more than double last year’s total. Business models are maturing fast. Some equity crowdfunding sites, like Britain’s CrowdCube, are about how much money they can raise for entrepreneurs; later arrivals, like Symbid and Seedrs.com, which are based in Rotterdam and London respectively, sell themselves on the way they let investors monitor their portfolios after entrepreneurs have been funded. Ratesetter, a consumer-loan platform, has some very bank-like features, like a provisioning fund to cover non-performing loans.
Some regulators have big hopes for peer-to-peer lending: Andy Haldane, of the Bank of England, suggested earlier this year that the upstarts could make conventional banks obsolete. Institutional money is now finding its way onto the more established platforms: Prosper’s biggest investor has $35m on the platform. The site offers attractive returns and access to an asset class that was once the domain of the banks, says Dawn Lepore, its chief executive.
For all its promise, though, the industry is still tiny by banking standards, and untested enough that a high-profile blow-up could wreck its reputation. And despite concerns about how mean banks are being to small businesses, this is an area where the banks are still formidable competitors.
Banks have distribution networks that reach far and wide and they offer services, like current accounts and payment systems, that small companies cannot do without. Deposit insurance is a powerful draw, too. The problem of asymmetric information—the fact that borrowers know much more about their business than lenders—gives banks a particular advantage when it comes to funding small firms. “Critical factors like the quality of management at a small enterprise are very difficult to assess,” says Markus Schaber of the European Investment Fund, which provides risk capital to small and medium-sized firms and is majority owned by the European Investment Bank. “Banks know the entrepreneurs themselves through the branches; it is very hard to replicate on an internet platform.”
The path ahead for European finance is broadly clear. The banks will concentrate more on bread-and-butter lending like mortgages and cut down their exposure to other long-dated assets; a few lucky corporate issuers will be able to pick and choose how they get their capital; everything else will have to rely more on other sources of finance. More firms will turn to the bond markets. Very large pools of capital—held by sovereign-wealth funds, as well as by insurers and pension funds—will do more direct lending, often in partnership with banks. New forms of finance will nibble away at mainstream providers.