Loosely regulated non-bank lenders have emerged as among the biggest beneficiaries of the Federal Reserve’s ultra-low interest rates with three specialist categories increasing their assets by almost 60 per cent since the height of the financial crisis.
Such lenders, widely considered part of the “shadow banking” system, have expanded rapidly on the back of investors who are clamouring for the higher returns on offer from financing riskier types of lending.
Shadow banking has been steadily climbing the regulatory agenda, with the Financial Stability Board this summer proposing a package of measures aimed at curbing excessive risk-taking in the sector. The regulators’ concern is that many of these lenders could over-borrow or make increasingly dicey loans as they rush to take advantage of historically low rates, exuberant markets and the retreat of traditional banks from certain businesses in response to tougher regulation.
“Think of it like a pipeline,” says Dan Zwirn, managing partner of Arena Investors, a hedge fund focused on lending to companies that most banks will not lend to. “When you can connect the pipe between a type of asset and yield-hungry investors, then what happens is that issuance grows.”
The amount of assets held by US business development companies (BDCs) , specialist finance companies and real estate investment trusts (Reits) has jumped from $779bn in 2008 to $1.22tn in the second quarter of 2013, according to data compiled by SNL Financial for the Financial Times.
The rapid growth of Reits, which borrow in the short-term financial markets to make tax-favourable investments in longer-term assets such as mortgage bonds, has drawn the attention of US regulators.
The New York Fed probed US banks’ exposure to the investment vehicles earlier this year, amid concern that a rapid rise in rates could trigger a sell-off that would affect larger banking institutions. Last week, researchers at the Richmond Fed said that while Reits had “mushroomed” since the crisis, it remained unclear what risk they might pose to the financial system.
Regulators are attempting to strengthen oversight of the lightly-regulated sector while avoiding measures that would stifle its ability to contribute to the recovery.
Last month, Mark Carney, the FSB’s chair and Bank of England governor, floated the option of opening access to the BoE’s liquidity facilities to non-banks, while adding that this would mean extending the reach of regulation.
Paul Tucker, the former Bank of England deputy governor, warned the same month that regulators needed to “up their game” in overseeing hedge funds and shadow banks. He said it would be “disastrous” if the fragility of mainstream banks were recreated beyond the mainstream banking sector, and called for securities regulators to improve the quality of data they are collecting on non-banks.
BDCs provide capital and loans for middle-market companies, using a tax-favourable structure that is similar to Reits. While the leverage of BDCs is capped under law, they too have experienced rapid growth in recent years, leading to heightened competition.
“Underwriting standards go lower, interest rate risk goes higher,” said Mr Zwirn, adding that many BDCs had sought to boost returns by purchasing the riskiest pieces of collateralised loan obligations or the equity of specialist finance companies that were allowed higher leverage rates than BDCs.
Some such companies that proliferated before the financial crisis are still reducing the troubled assets they collected before 2008, while others have been expanding in fields such as lending to people with flawed credit histories to fill a gap left by retreating banks.
Springleaf, the former subprime consumer lending arm of the bailed-out mega-insurer AIG, has been able to take advantage of a turnround in securitisation markets to repackage its loans into asset-backed securities and expand its business.
“The combination of increased capital requirements and regulatory focus will make it harder for banks to serve non-prime customers,” said Steven Moffitt, who leads the consumer structured finance team at Goldman Sachs.
He estimates that 25 to 40 per cent of bank customers will need to source credit from non-bank entities, potentially leading to further growth for speciality lenders.
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