Since the GFC, bank capital levels and the number of bank regulations have skyrocketed in amount and impact. The unquestionable thrust of Basel III has been for global banks to massively increase capital, reduce leverage, limit risk-taking behaviour, and adhere to a far more stringent set of banking regulations. Almost 10 years on since the GFC, much has been achieved.
These developments are a significant positive for debt investors, as the bigger the equity capital buffer, the more protection for debt investors further up the capital structure. Some offshore banks now have almost three times the capital from pre-GFC levels!
Bank stocks have significantly underperformed the broader market in recent times and much has been written about the persistent fall in return on equity (ROE). Given the increase in capital and limits put on riskier business lines, this is no surprise.
The fallout from the Royal Commission will undoubtedly see a further reduction in risk-taking appetite and yet more regulatory burden placed on the banks, continuing the trend of lower risk, higher capital and lower ROEs.
Winners and losers from new bank regulations
Small and medium sized enterprises (SMEs) are the lifeblood of an economy, but given the changes to bank regulations the sector is increasingly a ‘loser’. In Australia, SMEs employ around 70% of the workforce and produce around 55% of business economic activity. However, two key changes continue to push SMEs out of the bank lending market:
1. Cost - under Basel III, banks must hold higher levels of capital against SME lending, including low-risk loans backed by residential or commercial property. This makes lending to SMEs more ‘expensive’ for the banks, and hence they pass the cost onto the SME borrowers.
2. Time – SMEs often require expedited funding. However, the ever-growing level of regulation and compliance that bank officers must comply with results in turnaround times that are typically weeks or even months. Even the highest quality loan application takes time to go through the process.
For example, if a clothing retailer is offered a 30% discount on the usual price by a wholesale supplier on Thursday, provided they place an order by the end of the week for $100,000, the retailer is happy to draw on say, a three-month loan paying 15%. The three-month interest cost on $100,000 would be $3,750 versus a potential increase in the profit margin of $30,000. This loan may also have security over the company’s assets and have directors’ guarantees or a mortgage over the owner’s home.
These high-quality SME loans (often fully secured) are leaving the banking sector in droves. The burgeoning fintech, peer-to-peer, and non-bank lending sectors are the perfect destination for SMEs. Simple, quick, and transparent processes and ultimately, access to funding in just a few days as opposed to weeks or months is what SMEs desire. And they are happy to pay up for such a service.
Alternatives offer a better customer experience
Changing consumer preferences are also contributing to the transformation. Gen Ys are getting older and spending more. This rapidly growing segment of the economy values speed and ease of finance approval and this is something the traditional banking sector has difficulty providing. Credit card usage is falling with the younger generation in particular preferring alternative payment methods. Advances in technology enable operators to build systems that do all the checks of a bank, plus more, in just a few minutes and provide an approval and appropriate risk-adjusted interest rate almost immediately. With advanced IT systems, these non-bank operators can do an ID verification check, credit check, history check, social media profiling (using approval ratings for services such as Airbnb, Uber, eBay etc.), and produce a decision in a matter of minutes.
SME loans follow a similar streamlined process and while they are a little more involved with directors’ guarantees or property security and charges taken over the underlying business in many cases, the turnaround times are much faster than the banks can provide.
Customers are even prepared to pay a higher rate than they may get from a bank if the decision process is fast. And this does not mean that the underlying credit is inferior. In fact, the opposite is often true. It is the dynamic and well-organized business owners that can see an opportunity and have the required financial information at hand to enable a quick online application and fast approval. The greater the history of online loans and repayment behaviour of an individual or company, the greater the accuracy of the decision-making engines. The fintech sector now has many years of data to back the underlying results.
The rise of fintechs for the supply of loans to SMEs was confirmed at the Royal Commission on Tuesday 22 May 2018. The ANZ's General Manager for Small Business Banking, Kate Gibson, provided numbers showing her division was facing a substantial reduction in loans, down to 114,000 in 2017 from 131,000 in 2014. She said, "There were new entrants into the market by way of fintechs, who were also offering lending options to small business customers."
Non-bank lending small but growing
In Australia, the non-bank lending market is growing rapidly but is still relatively small, with many players fighting for scale. We expect that in just a few years, Australia’s market will be far more developed, similar to the likes of the US and UK, where consolidation has occurred, and there are now a smaller number of strong operators. Access to debt funding for non-bank lenders and fintech operators in these more developed markets can be half the cost (i.e. credit margin) of what is seen in Australia.
In recent months the major banks have been providing the largest of the domestic fintech or alternative lenders with relatively cheap funding in the form of flexible ‘warehouse’ facilities. This access to cheap funding from the banks, in volume, will be a game changer for the Australian non-bank market if it continues to grow and filters down to the mid-sized players.
We are constantly monitoring regulatory changes and the opportunities they create in the fintech, peer-to-peer, and non-bank lending sectors. Likewise, the APRA crackdown on non-resident investment lending is also presenting opportunities in providing loans to international buyers on very attractive terms. With the traditional banks forced out of the market, high quality foreign buyers are prepared to borrow money for apartments (and houses) in Melbourne, Sydney and Brisbane with 40% deposit, 60% LVR (against an independent valuation) and at interest rates of up to 8%. The same loan to a local first-home buyer with a short employment history might be on terms such as a 10% deposit, 90% LVR, and 4.0% interest rate.
The growth of the non-bank lending market is a trend from which we believe investors can profit. Companies like Afterpay, CML Group and Heartland Bank have the operational structures, scale, and funding lines to be leaders in this sector. In the peer-to-peer space, marketplaces such as DirectMoney (listed) and SocietyOne (wholesale investors only) offer attractive rates of returns to investors.
Justin McCarthy is Head of Research at Mint Partners Australia, a division of BGC Brokers. The views expressed herein are the personal views of the author and not the views of the BGC Group. This article does not consider the circumstances of any individual investor.