The Debt Connection – September 2014

Date

In the latest Debt Connection, Clearwater International’s UK Debt Advisory team looks at shadow banking.

Shadow banking is a term that has seen increasing coverage in the press – including an article written by the Bank of England’s governor, Mark Carney, in the Financial Times. International regulators are also focussing on this area of the financial markets, looking into potential risks in the industry.

On the face of it, the term shadow banking brings sinister connotations, but there is more to it. Shadow banking is effectively borrowing and lending that falls outside the regulated banking sector. It includes sophisticated borrowing and lending by banks, debt funds and investors, along with other areas like crowdfunding and peer-to-peer lending.

Lending volumes by the banks reduced globally during the recession, as they looked to mend their balance sheets and deal with the  increased regulation and minimum capital requirements that have been imposed on them by national and international regulators. This led to a gap in the market where there was demand from businesses and consumers for loans that was not being met. The demand has meant more lending supply from other financial services firms, looking to fill the gap, which have fewer constraints than regulated banks.

This growth in alternative and direct lending has attracted increased attention from regulators. The Financial Stability Board, an international group of regulators and central bankers, estimates the shadow banking market to have grown by about $5 trillion (£2.9tn) to $71tn (£42tn) globally in 2012. From 2019, within the UK, banks are likely to have their retail operations, used by the general public, separated from their riskier operations in a process dubbed “ring fencing”.

The key concern of the regulators is that alternative lenders are pumping a lot of credit into the economy, which means bubbles can develop that are bigger than people might have realised, due to a lack of information reporting when compared with regulated banking activities. Hedge funds, for instance, are much less transparent, so problems could emerge where not much is known.

It is important to note not all parts of alternative and direct lending deserve suspicion. Many of the lenders have the same regulator in the UK – the Bank of England – through the Financial Conduct Authority and Prudential Regulation Authority. Also, many of the lenders that are active in the markets are the direct lending divisions of well-known insurance companies or credit funds, where part of their funding has come from governments.

There are benefits that alternative finance providers can offer to businesses. We have seen them actively supporting a range of situations in real estate (commercial and residential), corporates, mid-market businesses, SMEs and the LBO market. Key differentiators of the credit funds and direct lenders are their ability to provide longer term financing with more flexible structures and conditions, than are typically available from banks.

This longer-term financing can be more suitable for the funding of capital or infrastructure projects, such as electricity and water networks, or longer-term investments by businesses. There are also strong arguments that many of these alternative funders are less risky as unlike bank customers, who may want to withdraw deposits at some point, their investors want to make longer-term deals: thereby matching longer term investments with longer term borrowing. A good example is the direct lending arms of pension funds, where they will typically hold investments for long periods of time before they are drawn on retirement.

We expect to see more regulation of these alternative and direct lenders going forward, but there is undoubtedly a demand from the market for them. It is important that this regulation does not hamper their activities unduly, as they provide a viable and more flexible source of funding that helps to support many businesses and their growth.