Bank deleveraging around the world continues to hinder formal channels of credit, which, in turn, is driving the growth of credit through nonbank intermediaries. Such shadow banking, as it’s called, is now a more than $70 trillion industry, raising considerable concern about a revival of systemic risks.
But although much of the shadow banking industry may be rightly labeled as dangerous, I think direct lending by Giants could be quite positive for credit markets. In fact, as I see it, the version of direct lending practiced by some Giants today may be an antidote to the risks posed by shadow banking.
Now, I admit that there’s a rather fine line between direct lending and shadow banking. But I’d like to walk you through, point by point, why I think direct lending could be an awesome way to fill the void left by banks. And I’d also like to explain why shadow banking is problematic. But before I get into this, let’s take a step back and discuss what’s been going on in credit markets over the past few years.
Credit Markets Background
Before the financial crisis, banks and nonbank intermediaries engaged in a furious competition to come up with innovative ways to slice, dice, package and sell credit (e.g., asset-backed securities and collateralized debt obligations). In fact, some of this activity helped drive the great financial crisis of 2008–’09. Regulators responded to the crisis by dramatically tightening banks’ liquidity standards and capital adequacy requirements.
Ironically, this tightening has resulted in an increased demand for alternative forms of credit, and much of it appears to be flowing through the shadow banking industry. Sigh. Anyway, take it as a given that banks today are loath to write the kinds of credit they once did. For example, experts see a funding gap of $100 billion in the shipping industry alone because banks are scaling back their lending. Take this to mean that banks all over the world and independent of sector have had to repair balance sheets and deleverage. And yet the small and medium-size enterprises (SMEs) that used to rely on these banks still need working capital. That means their credit demands will have to be met elsewhere.
As I see it, we can rely on shadow banks to fill this void (bad idea), or we can try to empower direct lenders to step into the void by working directly with SMEs (good idea). To explain why I think this way, let me run through some basics of both shadow banking and direct lending.
Shadow Banking Background
Shadow banking generally refers to nonbank financial institutions engaging in “maturity transformation.” This may sound like a rather fancy-pants thing to do, but it’s actually pretty standard. All banks do this when they take a short-term deposit and then lend the money out over a longer time horizon. The difference between shadow banking and traditional banking, however, is that in the case of the former it’s the financial market (and a plethora of intermediaries) that oversees the credit creation and transformation, rather than a single institution governed by regulation and a variety of checks and balances that holds the loan on its books. Confused? Here’s a useful explanation of how shadow banking works (from “Shadow Banking,” a paper in the December 2013 issue of the Federal Reserve Bank of New York’s Economic Policy Review):
Like traditional banks, shadow banks conduct financial intermediation. However, unlike in the traditional banking system, where credit intermediation is performed “under one roof” — that of a bank — in the shadow banking system it is performed through a chain of nonbank financial intermediaries in a multistep process. These steps entail the “vertical slicing” of traditional banks’ credit intermediation process and include 1) loan origination, 2) loan warehousing, 3) ABS issuance, 4) ABS warehousing, 5) ABS CDO issuance, 6) ABS “intermediation” and 7) wholesale funding. The shadow banking system performs these steps of intermediation in a strict, sequential order. Each step is handled by a specific type of shadow bank and through a specific funding technique.
In tightly controlled and regulated economies, such as China, shadow banking has been widespread. And that’s not necessarily a good thing. In fact, it can be quite negative. Shadow banks ran into trouble during the financial crisis because they had capital providers who wanted liquidity, but they couldn’t access their longer-term loans fast enough to meet this liquidity; that resulted in fire sales. Here’s how Zoltan Pozsar et al., authors of “Shadow Banking,” describe this problem: “In particular, credit intermediaries’ reliance on short-term liabilities to fund illiquid long-term assets is an inherently fragile activity that can make the shadow banking system prone to runs.” If you’re not sure how this would play out in practice, ask your friends who used to work at Bear Stearns or Lehman Brothers. In short, shadow banking is fundamentally risky, and the layers of intermediation make it difficult to assess risk exposures and the potential for contagion.
Direct-Lending Background
Conversely, the practice of direct lending, especially when practiced by Giants, offers a rather different way of filling the credit void left by banks. One Reuters article recently exclaimed, “Yield-hungry pension funds and sovereign wealth funds are stepping in where crisis-hit, regulation-laden banks are pulling back: lending to cash-starved businesses.”
Indeed, pensions and sovereign funds are interested in filling the void left by banks in these “unbanked” sectors. They are doing so because they want the higher yields. But they also like the ability to match liabilities in a tailored and bespoke way; if you’re the one originating the debt, you can set terms that directly meet your long-term needs. For more background, check out this investment memo from the City of San Jose’s Federated City Employees Retirement System describing the opportunity: “Dislocations in the global credit market since 2008 have created an unprecedented opportunity for potential suppliers of capital to companies in need of short- and medium-term liquidity.”
Direct lending would typically involve a senior loan to a company that is fully secured by corporate assets. Despite the relative security of these instruments, investors tend to get high(er) rates of return and can even get warrants or payments in kind. As such, it’s becoming increasingly widespread. For example, Steven Daniels, CIO of Tesco Pension Investment in London, recently said, “Pension funds are the new banks. Everyone sees us as long-term lenders, and that is great. I’m happy to participate. We are the new banks, good banks potentially.” U.S. pension funds committed $2.4 billion to direct lending last year, up from $611 million in 2012, according to iiSearches, Institutional Investor’s investment database. So it’s a space that’s growing quickly — and has lots of capacity for further growth.
Driving Home Why Direct Lending Is an Awesome Way to Fill the Credit Void for SMEs and Why Shadow Banking Is Scary
There are some important differentiators that I want to reinforce when it comes to thinking through the differences between direct lending as practiced by Giants and shadow banking.
* Maturity Transformation: Both direct lenders and shadow banks engage in maturity transformation. When direct-lending Giants loan to SMEs, however, they are generally taking a long-term liability and converting it into something of shorter duration. Shadow banks, on the other hand, change maturities by borrowing money for short-term periods and using that capital to write longer-term loans to SMEs. The former is stable and sustainable, whereas the latter is not.
* Keeping It Real: Direct lenders have to develop internal capabilities to assess companies’ creditworthiness, which roots their underwriting and thinking directly in the real economy. In other words, getting direct lending right means knowing your customer intimately. For shadow banks, however, the most important skill for success is knowledge of how to structure, package and then sell on credit products. Shadow banks rarely have to pierce the blood-brain barrier into the — gasp! — real economy. Their focus is on products and models, not companies.
* Policy Support: There has been some recent public policy support for direct lending in the U.K. and Europe. Conversely, there has been a lot of work done to try to figure out how to control the shadow banking sector and bring many of these mechanisms under the purview of regulators.
* Intermediation: The description of shadow banking above lists seven (!) different financial intermediaries that participate in shadow banking transactions. Each one of these intermediaries has to get paid as well as inject its own biases and agency issues into the credit-writing process. I think that’s a recipe for disaster. Direct lenders, on the hand, are trying to connect directly with SMEs. In fact, they are even cutting banks out of the picture. Direct lending (when done well) has zero intermediaries. How cool is that?
Challenges for Direct Lenders
So I hope I’ve identified some reasons why direct lenders should not be lumped into the shadow banking world. Moreover, I hope I’ve converted some of you into believing that direct lending by Giants can be quite a positive phenomenon, given the retreat of the banking sector. What I imagine I haven’t convinced you of, however, is how pension funds are going to actually do the job of banks. That’s a much harder sell. Why? Because direct lending by Giants is hard. (Yes, Virginia, there is a reason why banks exist.)
For example, direct lending demands building sophisticated in-house teams. More than that, it means breaking down organizational silos so that this new team can sit somewhere between fixed-income, private equity and even infrastructure and project finance groups. This is all very hard to do. What’s even more problematic, however, is the tax issues. For example, the U.S. considers lending a commercial activity, which means an in-house direct-lending program could place pension funds and sovereign funds in a vulnerable tax position (not just for the credit writing but also for the fund’s overall status as a tax-exempt investor). That would be a deal breaker for many Giants. (Note: Policymakers need to move quickly to fix this if they want to attract long-term capital into SMEs. Otherwise, get ready for a lot more of the unsavory forms of shadow banking.)
Given these challenges, some Giants will simply decide that they don’t want to do direct lending in-house, that they’d prefer to participate in an indirect way, via third-party direct-lending funds. And, interestingly, external asset managers who purport to run direct-lending programs are seeing widespread uptake.
But, again, there are pitfalls. Outsourcing direct lending will result in high fees (2-and-20 or more). Also, some direct-lending bets via these managers may get transformed into shadow banking bets. Indeed, some of the managers will look to raise lots of debt so they can write leveraged loans to SMEs. In other words, the managers use your long-term capital to raise more short-term capital and then transform all of this short- and long-term capital into medium-term credit.
I’m mostly down on the outsourcing strategy because it reminds me of what hindered the development of third-party infrastructure funds. Managers sold pensions access to an asset class, but then they used financial structures and leverage that completely changed the nature of the bet that the pensions thought they were making. As a result, big, savvy pensions and sovereigns chose to manage infrastructure assets in-house. And I imagine that’s a likely path for direct lending unless some enlightened asset managers arrive on the scene, which would be fine by me.
In the future, pensions and SWFs will continue to pick off the low-hanging direct-lending fruit, such as long-dated infrastructure loans. But as these Giants hone their capabilities, I’d also expect some of them to become more creative and courageous in their loan portfolios. I also wouldn’t be surprised to see some pension funds forging new and creative relationships with credit underwriters. All in all, I think the direct-lending phenomenon could be great for Giants, SMEs and credit markets. I hope policymakers will recognize this and smooth the path to making it happen.
