As banks find their margins squeezed on traditional lending and payments activities, nonbank credit and financing—supported by technological innovation—is growing exponentially.
Alejandro Cosentino, CEO and founder of Afluenta, sends a clear message: Using big data and new technology, Argentina’s first peer-to-peer lending (P2PL) firm says it connects borrowers and lenders better than banks. It lends at lower rates and rewards investors with higher yields. Everyone—except traditional commercial banks—is better off, including Afluenta—which takes a 6% fee.
Launched in 2012, Afluenta has facilitated 1,300 loans for a total of $4 million. Each loan amounts, on average, to $3,000, and it is usually split among more than 120 lenders who share its risk. The Argentine group is small, compared to P2PL firms in the United States, but its business model is similar.
Since its launch in 2007, San Franciscobased Lending Club has facilitated over $7.6 billion in loans, including $1.4 billion in the last quarter of 2014. The group, which counts US former Treasury secretary Larry Summers as a board member, made its stock debut in December 2014. Lending Club defines itself as the world’s largest online marketplace connecting borrowers and investors. The outfit is focused on gaining size—it has announced a flurry of partnerships with firms around the world, from Google to Chinese e-commerce retailer Alibaba.
From Latin America to the US, Europe and China, peer-to-peer lending is growing, and it is just one of the many ways in which credit is expanding outside the realm of regulated banks. In P2P lending, individual borrowers are given a risk score (which generally is based on their credit score from traditional scoring firms and their application—and which the software evaluates and spits out in a matter of minutes), and their rate reflects that. Investors include individuals and institutions.
But P2PL is just the latest incarnation of shadow banking. Traditionally labeled as shadow banking for its hidden nature, it comprises the extension of finance and credit to individuals and corporations through nontraditional, nonbank channels. It includes all the players engaged in credit provision that are not subject to regulatory oversight, along with financial activity of more traditional intermediaries that is not subject to oversight.
It incorporates everything from lending between individuals supported by peer-to-peer lending sites to the explosion of asset-backed bonds and other credit products to corporations and to fund long-term infrastructure projects, where financing is provided by institutional investors—such as insurance companies and pension funds. As the availability of banks loans and of public finance is shrinking, more financing for infrastructure is being provided by institutional investors, either directly or indirectly.
Paul McCulley, US economist and former managing director at global investment management firm Pimco, coined the term “shadow banking” when the securitization of home loans made up a large part of the assets packaged and sold to nonbank investors. It came to represent one of the many deficiencies of the financial system ahead of the financial crisis. Since then, increased regulation in the US and in Europe have helped dismantle most of what was once considered shadow banking. But other forms of nonbanking credit are emerging, this time supported by technological innovation.
The Financial Stability Board (FSB), which runs a yearly study on 20 jurisdictions plus the euro area, has a very wide definition of shadow banking, including all nonbank financial intermediation in aggregate. The board defines it as the Monitoring Universe of Non-Bank Financial Intermediation (Munfi). The 2013 amount of Munfi was $75 trillion, up over the previous year by $5 trillion, or 120% of total global GDP. Munfi hit a record high at 124% of GDP in 2007 and fell to a post-crisis low of 112% in 2011.
Worldwide, peer-to-peer lending is growing, and credit is expanding outside the realm of regulated banks.
“What happened,” says Laura Kodres, chief of the Global Financial Stability Division at the International Monetary Fund, “is that other types of shadow banking expanded—in particular, the use of investment funds that are now supplying credit to small enterprises, leveraged loans [loans to companies or individuals that already have high debt levels], and project finance.”
For example, the nonbank share of leveraged loans as a percentage of all leveraged loans in the US has grown from about 20% to 80%, she says. “A lot of that credit activity is now taking place outside of banks, for instance among credit-focused mutual funds.”
Regulation imposed on banking after the financial crisis, such as capital constraints from Basel III regulations, are setting limits on the activity of traditional banks and spurring other forms of credit. “Lending is actually a more expensive activity for the traditional commercial banks, and nonbanks see this as an opportunity to be able to provide credit at lower cost, in part because they do not have to follow the same capital requirements and they do not have to follow the same liquidity requirements that traditional banks do,” notes Kodres.
INSTITUTIONAL INVESTOR INTEREST
Pension funds, hedge funds and mutual funds are, for example, buying bonds to finance investments that require long-term funding, such as bridges, motorways and other infrastructure. The FSB report shows that one of the most dynamic Munfi subsectors in 2013 were trust companies, which grew at a rate of 42%.
A Goldman Sachs study published in March estimated that more than 7% of US banking profits are at risk of leaving the banking sector in the next five years as a result of disintermediation by nontraditional players. The study, which sees both regulations on the banking sector and new technologies as the engines of shadow banking, said that around $11 billion out of $150 billion in 2014 could leave the sector.
“Since the financial crisis, commercial banks are much less interested in long-term loans for regulatory reasons. This leaves [openings] for others, mainly insurance companies or other investors such as pension funds. For these investors, who are seeking long-term opportunities with steady returns, investment in infrastructure is the ideal opportunity,” says Daniel Berger, director of insurance at BearingPoint in Zürich. Berger says that this is the case in Europe, but similar trends are common around the world, from the development of shadow banking in China to the funding of infrastructure projects Latin America.
The emergence of shadow credit can help support economic growth, but it also comes with its own risks. “It is important to recognize that shadow banking in itself is not a bad activity,” says IMF’s Kodres. “The potential downside of that is that people do not understand the risks that they are taking or that there is too much overall generic credit being extended out there—whether it is in shadow banking or in traditional banking—that is not priced properly and hence is not taking into account the true underlying credit risk of the borrowers. That is when we usually run into difficulties.”
Risks aside, this market continues to grow, and other forms of alternative credit are developing, often supported by new technology. A study published in February by the Cambridge Centre for Alternative Finance (CCAF) at the Judge Business School showed that the European online alternative finance market, including the United Kingdom, grew from €487 million ($516 million) in 2012 to €1,211 million in 2013 and hit €2,957 million in 2014, with an impressive average yearly growth rate of 146%. Wide differences, owing to uneven regulation as well as to cultural reasons, are detected among the different countries. The UK is by far the largest market for nonbank credit in Europe, with a total of €2.3 billion in outstanding debt and a 168% year-on-year growth rate, aided by a new dedicated regulation governing the digital alternative financial sector. Other large markets include France, Germany, Sweden, the Netherlands and Spain, while Italy is lagging behind.
“We wanted to carry [out] a benchmark study for Europe and focused on online alternative finance,” said Robert Wardrop, executive director of the Centre for Alternative Finance, adding that the online aspect “is important because there is a social engagement dimension to online finance which distinguishes itself from other forms of shadow banking.”
In the UK the sector is attracting institutional investors. “As a result the growth rate in the UK is outpacing the rest of Europe,” says Wardrop. “You can see it: The London metro is full of advertising for peer-to-peer lenders.”
The CCAF study, co-authored with EY and 14 leading industry associations, showed not only the rapidity of growth of shadow banking in Europe but also the way that growth is shaped by cultural differences between countries. “The Netherlands and Spain have relative and absolute bases of strong growth in rewards-based crowdfunding, which has a philanthropic dimension to the investment decisions,” Wardrop said. The study—based on 255 leading platforms in Europe—is believed to capture 85% to 90% of the European online alternative finance market.
Several factors are driving growth in these new forms of finance, notes Wardrop. He cites low interest rates—which are pushing investors to seek better returns—as well as the “significant loss of trust in financial institutions.”
“But our view at the Centre it is that yes, all of this has possibly accelerated the development, but there is a more fundamental trend going on beneath all of this, and it is a technology-driven trend. At the end of the day technology is the big enabler. And what does technology enable? At a very basic level it helps match providers of funding with users of funding. It enables the disintermediation of incumbent institutions—and this is only the beginning.”
For Latin America and other countries, P2P finance represents a new way to get cheap funding. Cosentino’s Afluenta is raising capital to expand into Peru, Colombia and Mexico.
CHINA’S SHADOW BANKING EMPIRE
According to the Financial Stability Board, around 80% of shadow banking activity takes place in the US, the euro area and the UK. But many emerging countries are experiencing high growth rates. Nine emerging markets jurisdictions had 2013 growth rates above 10%.
“Other countries that are seeing a rapid growth of shadow banking are Mexico (in real estate investment trusts) and some countries in the Far East, some of them in Southeast Asia—like Malaysia and Thailand for example,” notes Laura Kodres at the International Monetary Fund.
China, which has experienced a huge expansion of shadow banking, provides a case study. China’s Total Social Financing (TSF), a statistic calculated by the People’s Bank of China that measures shadow banking, was still climbing at double-digit rates in 2014, although it had slowed down from peaks of more than 35% in 2009.
“Part of the slowdown in recent times was due to government intervention. They realized that the industry had grown too quickly and too fast,” says Winnie Chwang, co-manager of the $1 billion Matthews China fund at Matthews Asia in San Francisco.
“In the Chinese case most of the shadow banking is taking place in the form of trust companies, which are financing specific projects of property companies, energy firms or manufacturers,” Chwang says. Once securitized, these products are sold to high-net-worth individuals.
A cap to interest rates paid on Chinese deposits to investors “is really why the wealth management products in China in the shadow banking system have grown up until today,” says Chwang. “Interest rates in China are regulated by the government, and that has created an opportunity for wealth management products to offer…much higher rates of returns.” Chinese officials have said that they will deregulate interest rates paid on deposits in the future, which should help traditional banking channels. “Shadow banking in China will become smaller than it is today.”
TECHNOLOGY TURNS BANKING INTO A UTILITY
Banks are facing a period of deep disruption as their products become commoditized as a result of new technological advancements. “Technology is driving dramatic changes in consumers’ behaviors and expectations—and that affects all traditional transactions,” says David Edmondson, Accenture senior managing director, North American banking. “In addition to that, the old way to make money on banking does not work as well as it used to, [and that change] has mostly to do with regulations introduced after the financial crisis.”
Accenture estimates that competition from digital players may erode as much as a third of traditional retail banking revenues by 2020, or even before that. Banks risk becoming like utilities as clients’ loyalty fades. In fact, more than 70% of customers now consider banking relations purely transactional.
Traditional banks are under a tremendous amount of pressure, with significant revenue at risk as a result of these trends, according to Edmondson.
In the period before the financial crisis returns on equity were around 20% for the 50 US banks with more than $50 billion in assets. Accenture argues that only nimble banks that adjust to today’s new landscape can go back to those levels (with ROEs between 18% and 25%).
New digital banking platforms will be launched either by large technology providers or by banks with large investments in digital solutions, notes Accenture. For example, Facebook is launching an app in April to facilitate payments between friends using Facebook Messenger. And a survey among banking customers shows that 50% would be ready to do banking with nonbanks such as Apple, PayPal, Square and Costco. That percentage rises to 70% among millennials (adults aged up to 34).
“They’ve established a level of trust with their clients through the use of technology mobility [and] are becoming…a trusted adviser,” says Edmondson. “My children have much more confidence in Apple than in banks. When they [are] in their thirties, they will [still] be more at ease with Apple than with traditional banks.”
Providing alternative services can help a bank recover its relationship with customers. “To create new revenue streams, the banks have to use what is unique to them—such as their secure reputation and partnerships, [which will] enable them to provide a bigger role in their customers’ lives,” says Edmondson.