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June 17, 2014 6:20 pm
Warren Kanders can stop a bullet. He finds it harder to get a bank loan.
The chief executive of Safariland, a Florida-based manufacturer of body armour and riot helmets, says trying to get bank financing has become painful. “There’s a lot of people out there that could use money for productive purposes but the banks can’t lend the way they used to,” he says. “Personally, I think it’s a big reason why our economy isn’t doing as well as it should be.”
It is a common complaint: in an extended hangover from the 2008 crisis, banks are reluctant to lend because their balance sheets are too fragile or because regulators have constrained them.
Into this void have stepped a variety of “shadow banks”, less affected by the new regulations and free to grab business.
Whether they are structured as asset managers, insurance companies or online peer-to-peer lending platforms, these groups are all finding ways to take investor money and use it to extend credit to the real economy.
Mr Kanders eventually found funding to expand his business from Franklin Square, a so-called “business development company”, a breed of non-bank financing that is growing in popularity as banks rein in their risk-taking.
BDCs raise funds from retail investors and use it to invest in middle-market corporate debt – they can juice their returns with debt but are capped at only one times the equity compared with about 15 times at a bank.
The growth of these alternative financiers is forcing complex choices on the traditional banking system. It has to compete directly with shadow banks for clients and top staff, and the banks, who are now constrained by tougher capital rules and bonus caps, often find that they lose.
But there are also important opportunities for co-operation. More and more banks are cutting deals with hedge funds and insurance companies that allow the banks to offload risky assets and redeploy their capital toward additional business.
In recent weeks, about 2,500 companies that borrowed more than €11bn from the German bank Nord/LB have had the main risk of their loans transferred to a hedge fund based on New York’s Fifth Avenue. None of these companies know this has happened.
Warning from traditional banks
The confrontation surfaced first. Gary Cohn, president of Goldman Sachs, gave full voice to that attitude at the 2011 World Economic Forum meeting of policy makers and business leaders at Davos, as he warned that there was trouble ahead.
“You are asking for a new shadow banking system to grow bigger and bigger,” he said. “Risk is risk, whether it sits in a regulated entity or not. My concern is that we are pushing it more and more from a regulated to a less regulated, more opaque sector.”
Since the financial crisis, all kinds of new companies have sprung up, particularly in London, to take on the banks directly.
Hayfin Capital Management has raised €2bn for a new fund to lend money to European midsized companies. It has already lent to dozens of companies, including luxury yachtmaker Sunseeker and meat-free meal producer Quorn.
M & G, the investment management arm of the insurer Prudential, has invested £2bn in private placements – lending structured as privately placed bonds – and helped to finance companies including Caffè Nero, the coffee chain. Earlier this year, Legal & General, the UK’s biggest pension fund manager, said it planned to follow suit and start lending to medium-sized UK companies.
There is an active debate as to whether this shift makes the system safer or riskier.
Dan Zwirn, chief executive of Arena Investors, a US hedge fund focused on lending to companies which do not have access to bank loans, says: “It’s better for this to be pushed off of regulated balance sheets.”
You are asking for a new shadow banking system to grow bigger and bigger
- Gary Cohn of Goldman Sachs in 2011
But the bankers argue that regulators are forcing them to withdraw from vital risk-taking and leave the real economy dependent on more fickle, market-based alternatives that proved unreliable after the 2008 collapse of Lehman Brothers.
“There will be shadow banks,” Jamie Dimon, chief executive of JPMorgan Chase, told investors in February this year. “But the difference with JPMorgan is that after September 17 2008 we were rolling over middle-market loans. We were lending billions of dollars to cities, schools, states and hospitals, whereas the [funding] markets were not. The markets ran.”
For good or ill, the shift from banks to shadow banks can be seen in the booming market for leveraged loans – or loans made to low-rated companies – where regulators have cracked down on the ability of banks to undertake the riskiest types of lending.
News, analysis and comment on the increasing scrutiny faced by the financial sector outside regular banks
Bankers have been warning that the new rules are likely to drive leveraged loans into the shadows and even further away from the control of regulators. They point out that if authorities are concerned about overheating credit markets, then targeting the banks is unlikely to cool overall market activity.
In one recent example, Morgan Stanley had to cede its position as lead underwriter on the leveraged financing of the acquisition of Brickman, a corporate gardening business, to Jefferies, the non-bank broker-dealer, which is not subject to the new regulatory restriction.
“That’s one place where activity is very clearly shifting from banking sector to non-banking sector,” says one US financial regulator. “The challenge is the Fed doesn’t have any authority over private equity.”
Promise of co-operation
For all the grumbling, many traditional banks are reaping benefits from the rise of shadow banking as that sector provides them with customers and co-operation.
“I don’t think [shadow banks] are doing things that are bad,” says James Gorman, chief executive of Morgan Stanley. “The major areas are around private equity and trading distressed assets. They’re doing things that banks are restricted from doing and they’re filling the vacuum. I think it’s healthy for the country.”
While some shadow lenders are competing with banks for the same business, others have fashioned a working relationship.
In the UK, Barclays teamed up earlier this year with BlueBay Asset Management, an alternative lender owned by Royal Bank of Canada, to offer loans to midsized UK companies. BlueBay, which raised €810m for its debut fund two years ago, will fund the riskier part of the loan but get a bigger share of the profit.
Anthony Fobel, head of private lending at BlueBay, says banks do not want to hold all the risk of lending to mid-market companies, “but they are worried about losing that client base to alternative lenders”, given the importance of the ancillary services they provide, such as hedging, cash-management and payroll.
In the US, Gary Shivers specialises in equipment leases, typically competing with banks to lend money to companies wanting to fit out new offices with furniture, phones and computers.
But – as is typical of other non-bank lenders – there is still a bank at the back of the transaction. Mr Shivers, chief executive of Navitas Lease Corp, gets financing from Wells Fargo, the largest US bank by market value, and SunTrust, a large regional bank based in Atlanta. “Five years ago no one was lending to the sector,” he says. “Nowadays a lot of people are trying. We are fairly heavily solicited by banks at this point of time.”
His experience is a reminder that in many cases, the transfer of assets and business to the shadow sector is incomplete and banks remain exposed to at least some of the credit risk. In many of the most prominent examples, banks are sharing – rather than fully selling off – the risk of their loan portfolios with investors such as hedge funds and insurers to reduce their regulatory capital requirements.
The banks can only go so far
- Warren Kanders of Safariland
Jean-Pierre Mustier, head of UniCredit’s investment bank, says such “reg-cap” trades are a useful way for it to “free up capacity” for new lending: “I look at it more as a risk-management exercise to ensure that we have an exposure to a specific sector within the risk appetite we have.”
The US Federal Reserve and the Basel Committee on Banking Supervision are keeping a close watch on the trades. Regulators are still wary because of the way banks made use of legal structures known as conduits and “SIVs” (structured investment vehicles) in the run up to the financial crisis to shuffle assets off their balance sheet and avoid capital charges. When the assets lost value, banks were left without enough capital to cover their losses.
In the build-up to the crisis, SIVs were part of a narrow definition of shadow banking which also included securitisations and the vast “repo market” where banks lent out their assets in return for short-term financing.
Now, with the old shadow banking guard in retreat, a new crop of shadow groups, mostly focused on direct lending, has arisen to fill the gaps. There are plenty of companies, many regulators and even quite a few bankers that are quite glad of that fact.
“The banks can only go so far,” says Mr Kanders who bought Safariland from BAE Systems in 2012 and has since acquired more companies whose products for police and military include “battle-proven bomb suits and robots”.
He says he is pleased to have opted for the “one-stop shop” of a non-bank lender rather than trying to assemble financing from a variety of banks, adding wearily: “Trying to line up your bank loans, your hair can be on fire.”
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