The development of the non-bank finance market in Europe and the opportunity it presents for asset managers
By Pat Wall, Partner & Colin Farrell, Senior Manager, PwC Dublin
Published: 22 December 2014
Europe has been slow to recover from the financial crisis with levels of unemployment remaining stubbornly high in most European countries. This is in contrast to the US which has shown clear signs of recovery. One of the key factors hindering Europe’s recovery is the lack of credit available to fuel business investment, working capital and large scale infrastructure and real estate projects. Banks in Europe and the US are being squeezed by regulators, politicians and investors but the impact in Europe is much greater where business has long been far more reliant on bank funding.
Depending on who you believe, the European funding gap (i.e. the difference between what banks can lend and what businesses will need) is estimated to be somewhere between €2 trillion and €4 trillion over the next five years. Non-bank finance has to play a major role in bridging this gap. The opportunity is huge but a note of caution is warranted. Despite the EU single market and the existence of the Euro, the lending market is still a patchwork of different banking, lending and bankruptcy laws. It is not possible to adopt a one size fits all approach. Asset managers will need to be smart about the sectors and countries they target.
Europe compared to the US
It is estimated that banks in the US account for about 25% of corporate lending compared to about 80% in Europe. This, coupled with the deleveraging of European banks has led to a significant European debt funding gap. As the percentages show, the US has a much more developed non-bank finance market allowing investors to participate in direct lending activity. It is sobering to reflect that the US has an 80-year head start on Europe. The more diverse funding landscape is attributed to the 1933 Glass-Steagall bank reforms following the Wall Street Crash of 1929. The greater flexibility and maturity of the US market has created a virtuous cycle resulting in a well regulated, deep market for loans making them a suitable asset class for both mutual funds and pension funds alike. The secondary market for debt in the US amounts to approximately $400 billion annually. By comparison, the European market is small. But that must and will change, rapidly.
The sword of "shadow banking"!
The need to respond appropriately to the squeeze on bank credit has not been helped by muddled regulatory thinking on so called "shadow banking". However, it appears that the light is beginning to dawn that not all non-bank financing activity is shadow banking and not all shadow banking is bad. In fact, shadow banking activity provides an important financial intermediation function distinct from those provided by banks. The functions can be economically useful and need to be understood and properly regulated.
The term "shadow banking" has acquired negative connotations but to equate non-bank financing to "shadow banking" is dangerously simplistic. Alternative sources of financing cannot be developed if all lending is straight-jacketed into traditional banking rules. It was those very rules and the dominance of bank lending in Europe that has given rise to its current problems, In essence non-bank finance is the process of directly matching investor capital with lending opportunities. If properly conducted, non-bank lending has the potential to eliminate the central problem of traditional banking; the conversion of short term liabilities (deposits and wholesale funding) into long term assets. Non-bank finance eliminates this problem by matching investors and borrowers with similar risk and maturity appetites. It needs to be understood as a separate and distinct activity to traditional bank lending and regulated accordingly. The provision of non-banking funding can be mutually beneficial to investors, borrowers and asset managers alike.
A change in the European mindset
So what is the stumbling block? The fragmented European lending market certainly provides challenges but none of this is unsurmountable. The main stumbling block in Europe to date has been regulatory mindset about the dangers of shadow banking. Thankfully that now appears to be changing. Ireland and Malta have recently introduced regulations to allow investment funds to originate loans and the EU has proposed the introduction of the European Long Term Investment Fund for large scale infrastructure projects open to retail investors.
The growth in the "peer to peer" or "crowd funding" industry in Europe further signifies that politicians, regulators and most importantly borrowers and investors have realised that there is a need and an opportunity in relation to regulated non-bank financing channels.
As the European market in non-bank lending matures, deepens and becomes more liquid, loans as an asset class will be increasingly attractive to Investors struggling to access adequate yields. On the other side of the equation sound business borrowers who risk being starved of credit are increasingly looking to non-bank funding.
The asset management industry is ideally placed to fill the void left by the de-leveraging of banks. This not only creates an opportunity for asset managers but also aids the European recovery and, if properly regulated, builds a more diverse and stable European financial framework for the future.