FILE PHOTO: The Federal Reserve building is pictured in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie/File Photo
Regulators such as those at the US Federal Reserve say they are alive to the risks of a rapid unwinding © Reuters

Craig Reeves knew the banks were in a lot of trouble the day his Dad dropped in to a branch of Northern Rock, shortly before the UK lender became one of the earliest victims of the global financial crisis. People were queueing down the street, waiting to close their accounts. But his father was still offered a big buy-to-let mortgage on a flat in London.

“You could see that fundamentally, things were broken,” says the head of Prestige Funds, a non-bank lender he founded in late 2007. “There was an opportunity there.”

Mr Reeves’ firm — based in a narrow alley just off Oxford Street, in the middle of London — is among thousands that have sprung up around the world since the crisis, seeking to take advantage of a radical reshaping of the financial system. As big banks have been squeezed by tougher rules and more vigilant regulators, forcing them in many cases to pull back from lending, alternative lenders have stepped into the void.

But to some, the rapid growth of the industry has brought new risks. Prestige and its ilk are not banks, so they do not pay into mandatory insurance schemes that encourage depositors to leave their money where it is. If investors suddenly want their money back, many fund managers will have to return it, potentially dumping assets to do so. A lot of small and medium-sized enterprises — the engine of any economy — could be left in the lurch.

Prestige says it has done more than £1bn of small-business loans over the past decade or so, handing out net annual returns of between 5 and 7 per cent to investors including pension funds, sovereign wealth funds, hedge funds and family offices.

“We have an incredibly diverse investor base, from Miami to Malaysia and everything in between,” claims Mr Reeves, who used to trade futures, and then ran a hedge fund-of-funds, before turning to lending. “What they’re all interested in is the capacity: how much more cash can you take?”

Big banks are not coming back, says the head of one of the biggest “direct lending” funds in Europe, speaking on condition of anonymity. Before the crisis Royal Bank of Scotland or Lloyds would do a single mid-market loan of up to £200m, he says. Now both are “nibbling at the edges”, down to about £20m-£40m per deal while his fund is writing cheques for £300m.

“We used to think the market opportunity across Europe was €400bn-€500bn. Now we think it’s more like €1.5tn,” he says.

Regulators say they are alive to the risks of a rapid unwinding. Randy Quarles, the top bank supervisor at the US Federal Reserve, for example, was grilled a few months ago by Elizabeth Warren, the Democratic Senator from Massachusetts, who asked about a surge in lending across America to already heavily-leveraged companies. “The amount itself is not what’s critical,” Mr Quarles replied. “What’s critical is are they being held in ‘runnable’ structures; do we understand how this system is evolving? And that’s something we’re looking at very closely.”

Big banks around the world have undergone fundamental changes since the crisis. On the liabilities side of the balance sheet, they have much more equity funding to absorb losses. But less well appreciated is the transformation of the asset side: vast amounts of liquid instruments such as cash and government bonds, which the banks could sell quickly to cover any sudden outflows of debt funding, such as deposits. The risks of another classic run like Northern Rock, on paper at least, seem much reduced.

But non-bank lenders do not always have big pots of cash sitting around to meet potential redemptions. And investors are often free to pull their allocations any time they like, once they are past an initial lock-up period. As such, the vehicles have “features that make them susceptible to runs”, as the Basel-based Financial Stability Board put it in a thick report this week.

Some structures seem sturdy. At Hermes Investment Management’s direct lending funds there are no redemptions at all; investors’ money is locked up for an initial three years and then up to another seven, depending on when the loans repay. Patrick Marshall, head of private debt, says he seeks an “illiquidity premium” from borrowers — a slightly higher interest rate, in exchange for an assurance that the loans will never be sold.

But others look a little wobbly. An investor with £10m in a Prestige fund, for example, could be out entirely within about six months, including a 60-day notice period, if it maxed out monthly withdrawals of £2m-£3m.

So far the non-banks have performed a vital role, keeping credit flowing to parts of the economy big banks have been unable or unwilling to reach. But the fact remains: we go in to the next downturn with no idea how dependable they will be.

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