SHADOW BANKS TAKE UP THE RUNNING IN RISKY LENDING / THE FINANCIAL TIMES

Inside Business

June 29, 2015 3:53 pm

Shadow banks take up the running in risky lending

Sujeet Indap

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©Reuters

For decades local upstarts and foreign powerhouses have tried to crack the US corporate banking sector, usually resulting in expensive failure (looking at you, HSBC). In the latest offensive, however, the challengers may have an unwitting ally: regulators.

The American agencies responsible for overseeing the banks that dominate risky lending to companies have been cracking down on loans they deem to be loose. That effort has created a lucrative opening for institutions outside the grasp of the new rules. As a result, an unmistakable big three — Jefferies Group, Nomura Holdings, Macquarie Capital — of these “shadow” banks that do not rely on US deposits has slowly emerged.

In March 2013, the US Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation updated their decade-old views on leveraged loans — the financing that backs private equity buyouts or companies whose credit is speculative. They were trying to rein in systemic risk in the financial system at a time when the Fed’s easy money policy was potentially creating asset bubbles.

The new guidance was not intended as a strict test, but banks focused on a provision that expressed concerns about transactions where the resulting leverage would be six times cash flow or greater. This boundary, the agencies said, “would raise concerns” about the borrowers’ ability to repay the loans.

The guidance initially did not restrain risky lending. Leveraged loan volume in 2013 and 2014 continued its post-financial crisis surge. Investors were eager to gobble up floating-rate loans and confusion about or indifference towards the new standards did not stop the big banks from feeding that beast.

But since late last year, the mood has shifted. In November, the bank regulators clarified and reinforced the standards. Their annual audit of lending also said that a third of loans in the previous year “exhibited structures that were cited as weak”. Separately, it was widely reported that Credit Suisse had been rebuked for flouting the leverage guidance.

But the questionable deals have not ceased. Rather, Jefferies and friends have increasingly stepped up to provide big leverage that the banks did not. This has raised both their profile (Jefferies, Macquarie and Nomura are all now in the top 15 of the leveraged buyout finance standings) and the eyebrows of market observers. In one example that has become emblematic, Bain Capital secured a loan from Jefferies for the $2.4bn buyout of Blue Coat Software at well in excess of six times cash flow.

Despite their growth, the big three non-banks’ share of the leverage loan market share still adds up to only 8 per cent, according to Thomson Reuters. The regulated banks still have the heft and expertise needed to lead complex loan assignments. And sometimes they do still push the envelope on risky lending.

One head of a non-bank lender pointed to the recent $5bn buyout of another software company, Informatica, where leverage was seven times cash flow. The lending group featured not only Macquarie and Nomura but also Bank of America Merrill Lynch, Goldman Sachs, Deutsche Bank and Royal Bank of Canada. Still, overall leveraged lending is down by a third this year, at least partially because the big banks have curtailed their underwriting and the unregulated firms have only partially filled the void.

For bankers, the market has become a source of frustration and wounded psyches. They argue that leveraged loans, whether arranged by big banks or entities that do not take deposits, are almost fully purchased by third-party investors rather than retained on balance sheets.

Banks and non-banks alike are mostly functioning as middleman, so why is one subject to constraints when the other is not, they ask. One senior person at a regulated bank complains that the artistry of lending — evaluating businesses and optimising their capital structures — has been unduly seized. A lawyer who works with bankers says that morale has slipped as the sector is buried under a pile of internal compliance memos. A steady exodus of professionals to both the shadow banks and to private debt funds has been noticed.

 

Wall Street believes it has learnt its lessons from poor pre-crisis underwriting. When the next crisis come around, we will find out if they are right, depending on which type of lender turns out to be responsible.