Bank regulators must be sleeping more soundly these days. They have achieved one of their goals. Banks are inherently less risky as they have retrenched markedly from lending to consumers or SMBs. Lending contraction has come at a cost to the economy in the States or in Europe but that issue is for another blog post to address.
The bank sector is less risky granted. Does this mean risk has been taken out of the system? I fear not. Rather, risk has shifted to the non-bank sector. One area where risk has shifted to is the mutual fund industry where corporate bond managers essentially run unregulated and un-licensed entities. Another area is Alt Lending platforms – see my previous post on Alt Lenders, here.
Alt Lenders have so far evaded regulatory scrutiny, other than those platforms focused on consumer lending where the CFPB is nosing around in the US and the PRA and the FCA in the UK to name but two countries. Alt Lenders do not need to set capital reserves, do not need to adhere to certain loan servicing standards, are not shackled, like banks, by rigid frameworks when it comes to originating and underwriting or pricing risk, can use a multitude of data sources in ways they see fit. Basically Alt Lenders are much more nimble, flexible and do not suffer from anything the Fed, the OCC, Basel I, II and III and any other regulator throws at them. Quite the competitive advantage.
Alt Lenders are essentially wholesale banks that finance their activities with “hot” money. By “hot” I mean unstable, non core deposit funds. “Hot” money that comes from hedge funds, speciality wholesale lenders, venture debt providers, PE funds. To be sure, Alt Lenders are racing towards more stable and larger sources of funds such as the securitization markets and banks.
Other than banks, there are no stable sources of funds to finance Alt Lenders growth. Let me repeat myself, none! Except for insurance companies and pension funds, but these are quasi banks I guess. The securitization markets can evaporate as quickly as providers of capital such as Hedge funds and PE funds will.
So we are left with “hot” money. Money that chases yield, that seeks risk, until it finds it and retrenches fast. Hedge funds, PE funds, wholesale lenders. And we all know what happens when the credit cycle runs full circle, when the system gets a liquidity shock. Yes, “Liquidity” that ugly L word. What happens is liquidity vanishes, capital flees and those entities that financed themselves with unstable sources of capital are in a heap of trouble.
As retail depositors funds are not at risk with Alt Lenders and as the space has not yet reached critical mass, so far, regulators have not had to scrutinize and worry. This leaves the Alt Lenders vulnerable in many ways as they have not has to shape up their operations. When the name of the game is growth at all cost, risk and operations management takes a back seat.
I see vulnerabilities in three ways:
1) Lack of stable funding sources: A liquidity shock borne out of interest rate rises will wipe out the most vulnerable Alt Lenders.
2) Lack of quality servicing: This is a hidden achilles heel for all lenders. Build superior servicing capabilities in house or outsource to the best servicer and you are golden. Go with cheaper second rate services because you cannot afford the top tier ones, and you are left with vulnerabilities across your value chain which will become evident once interest rates will rise. I won’t even talk about collections when defaults happen which is a natural extension of servicing. Most Alt Lenders are in growth mode and will not spend top dollars for the best servicers. Draw your own conclusions…
3) Shifting demand equilibrium: Once interest rates rise every platform will be faced with a shifting equilibrium where demand, i.e. borrowers will adapt to the rises by lowering their appetite or shifting their ability to repay and supply will shift their adjusted risk/return expectations accordingly. Many Alt Lenders may not be equipped for such shifting landscapes. Time will tell.
I will give Alt Lenders, in the aggregate, credit for neutral to superior underwriting and credit scoring. Still the above three vulnerabilities leave much to ponder. My assumption is that once interest rates rise, the Alt Lending space will turn into a startup graveyard where you will be able to track tombstone after tombstone of all the weaker platforms that were too young, did not have the most solid capital partners, could only afford average to sub par servicing or could not navigate swiftly enough the changing demand equilibrium.
At R66 we have avoided exuberant investing in the space – partly by accident, partly by design. We are still tracking a handful of Alt Lenders and are focusing on the underlying asset class – the demand for asset classes will behave differently in a rising interest rate environment and one has to chose wisely – are paying particular attention to how servicing will be fulfilled and what type of capital markets eco-system said Alt Lender is thinking of attracting and can in practice attract.
A final parting thought. As the Alt Lending space grows I will not be surprised to see regulatory scrutiny increasing and regulators stepping in. Alt Lenders, especially the marketplace platforms may find soon that they will need to reserve capital against the paper they originate, or that they need to clear certain operational thresholds in a structured and compliant way.
Happy huntings if you invest or operate in the space. These are exciting times as interest rates will rise at some point in the near future.