Non-bank finance in Europe
Embracing the alternatives
Banks are changing. That means other providers of capital must step forward, especially in Europe
Fixing one problem often creates another. The financial crisis has produced a wave of regulation to make the banking system safer. Banks are being required to hold more capital. They are being pushed out of riskier areas of activity. This week regulators in America and Britain gave more details of plans to impose losses on bank bondholders to spare taxpayers the cost of resolving failing lenders (see article). Such reforms are needed. Banks must be better cushioned against losses and it must be possible for them to fail.
But refashioning the banks carries a cost. By making it more expensive to fund assets, both because of higher capital charges and because bondholders will bear more risk in future, the new rules are forcing lenders to be pickier. European banks are under particular pressure. They are huge, accounting for most lending (compared with 25-30% in America’s more diverse system). The Europeans are more reliant on flighty wholesale funding. Before the crisis, they financed a lot of long-term assets such as infrastructure. That has to change: funding such holdings with short-term debt is frowned on, and long-term bank debt is hard to come by. The IMF said in October that European banks could end up shedding assets worth $2.8 trillion. Beyond such enormous numbers, the simple reality is that many borrowers can no longer rely on the banks.
For companies with an investment-grade rating or a big brand name, there is an obvious alternative. The bond markets are hoovering up corporate debt in enormous quantities, in part because investors are desperate for a yield of any kind in an environment of ultra-low interest rates. This year is likely to be the first in which non-financial firms in Europe will have issued more debt than financial ones.
The capital markets are not for every borrower, however. That opens the door to other providers of non-bank finance. At one end of the spectrum peer-to-peer lenders are experimenting with entirely new forms of finance in which individual savers and borrowers are matched in an electronic marketplace. At the other the world’s biggest insurers and asset managers are building up their credit-analysis capabilities so that they can lend money directly to mid-market companies, property developments, infrastructure schemes and the like. The banks are often partners in this process, originating debt and then passing it on to institutional investors.
Light, not shade
The idea that more funding activity will pass from the banks to non-banks makes many people queasy. One lesson of the financial crisis was that systemic risks can build up outside the formal banking sector: think of AIG’s catastrophic derivatives bet. The term “shadow banking” is often used to conjure up this dark world. And anxiety is warranted when the non-banks ape the banks in taking on lots of leverage, or in using short-term liabilities to fund longer-term assets. This newspaper would like to see much tougher regulation of American money-market funds, for example, which promise to pay all their investors all their money back the moment they ask for it.
But plenty of non-bank finance is benign. Insurers and pension funds, for example, have long-term liabilities (such as annuities and pension payments) that make them ideal candidates to invest in longer-term assets like project finance. Peer-to-peer platforms do not use leverage. Private-debt funds lock their investors in for a defined period, which reduces the risk of a run. Firms can put the piles of cash on their balance-sheets to good use by offering finance to their suppliers. And having diversity of supply is a good thing in itself. In America’s financial system risk is spread among many more sorts of lenders, and borrowers can call on a large base of credit-savvy institutional investors.
Given the credit squeeze now afflicting Europe, it would be desirable to speed up the emergence of the good sort of non-bank finance. Europe’s regulators can help this happen. There is a strong case for allowing UCITS investment funds (Europe’s equivalent of mutual funds) to be able to hold loans, for instance. Resolving the uncertainty over new capital rules for European insurers known as Solvency 2 would hasten investment in things like infrastructure.
Replacing the hole left by the banks is bound to be a gradual process. It must not be glacial.