5 February 2014

Banks’ leading role turns to supporting cast

The word lending is entrenched within the definition of a bank. After all, what’s the point of a bank if it doesn’t lend? But with recent economic and regulatory changes buffeting financial institutions, this particular area of business has taken a blow.

This news was first published on Dialogue Online
 
Since 2008’s shock to the system, banks have been working to rectify their balance sheets, driven in no small part by Basel III’s revised capital and new liquidity requirements. As a consequence, they have reduced lending to small- and medium-sized enterprises (SMEs).

The issue has hit European corporates more than their US counterparts, as the latter have relied more heavily on capital markets funding.

According to a European Central Bank report, bank lending to non-financial companies dropped from 15% in Q1 2008 to 2.8% in Q2 2009, before turning negative and bottoming out at -2.1% in Q1 2010.

Lending has increased over the past two years however, with Ernst and Young expecting a modest increase of 1.6% in Europe in 2014, below the initially forecast 3.8%.

Steven Lewis, global banking and capital markets lead analyst at Ernst and Young, says the upcoming asset quality review, part of a broader European Central Bank examination this year that includes stress tests, will also have an impact.

“We will see more balance sheet changes and a further increase in provisions as that review process gets underway.” But Lewis says the dearth of lending isn’t only an issue of supply of loans, but also of demand, with corporates increasingly sitting on large piles of cash.

According to Deloitte, the 975 non-financial members of the global S&P 1200 index held US$3.2 trillion at the end of 2012, a 62% increase from 2008’s level of US$1.95 trillion.

Funding alternatives

Despite the corporates’ large coffers, many smaller, potentially more risky businesses have still been in need of funding. And as a result of the credit crunch in recent years, corporates have turned to securities.

David Wright, secretary general of the International Organization of Securities Commissions (IOSCO), says with banks retreating from lending, the only way to finance the gap is through the capital markets. “There is a lot of interest in making the corporate bond market bigger, more transparent and more liquid,” he says.

In addition to the large over-the-counter markets, a number of exchange-based bond markets have emerged since the financial crisis. In December 2012, Nasdaq OMX launched First North in Denmark and Sweden, and this month has extended to Finland. Spanish exchange Bolsas y Mercados Españoles launched a multilateral trading facility in October last year, targeted at institutional investors wanting to buy corporates bonds in mid-tier firms.

SMEs also now have access to alternative, i.e. non-bank, sources of supply chain financing such as Platform Black – a service that allows firms to auction invoices to institutional investors.

Louise Beaumont, co-founder and chief sales and marketing officer at Platform Black, which launched 18 months ago, says underfunded SMEs need financing to keep production lines running. “Our solution allows these businesses to get access to the finance they need now more than ever.”

With 600 SMEs and investors participating, Platform Black works with a large corporate, for example Hewlett Packard, to help access funds for smaller companies. If a supplier “delivers on time, on budget and on quality”, Platform Black places the SME’s invoice for auction on its platform.

“Our investors then compete down the cost of finance,” Beaumont says. “The SME is genuinely getting access to competitive finance.

“The money is advanced, minus the finance fee. And at the end of the 90-day finance term, Hewlett Packard pays the invoice, and the advance goes back to our investors.”

The debt can range from 90-, 60- or 30-days, and even though the finance fee is on the SME, the credit score and strength of Hewlett Packard determines the cost.

Corporates have also turned back to the traditional initial public offering (IPO) to raise funds. The London Stock Exchange’s IPOs reached a six-year high in 2013. A total of 105 companies made their debut on London markets, raising £15.7 billion.

The repo market is an attractive means to raise funds as well, with corporates increasing their presence for short-term borrowing. But with these changes comes an increase of responsibility, IOSCO’s Wright says.

“Central bankers and leading policy makers do not want to see a shift into much riskier instruments in the shadows, because it could create systemic danger,” he says. "There is a parallel effort underway to make sure the shadow banking system is constructed in a responsible way.”

The European Commission last week released proposals for tighter oversight of the repo market, putting limits on rehypothecation of assets and collateral re-use.

Taking time

Banks won’t stop lending to corporates any time soon, according to Lewis, but with time their role will continue to evolve.

“What will be interesting is the extent to which you start to see alliances developing between asset managers, who have the funds to lend, and the banks, who have the credit risk expertise, but don’t want to keep loans on their balance sheet to maturity,” Lewis says.

“There is an opportunity there for a greater degree of formal partnership,” he says. “The banks would be intermediary, connecting a lender with somebody who wants to borrow.

Lewis says banks weren’t necessarily happy about the new landscape, but given the economic circumstances, it was a pragmatic way forward for banks to service their customers.

“I would be surprised if we revert to the status quo. Business of different sizes have recognised that there are other opportunities for funding.”