Lending to businesses has always been a highly cyclical part of banks’ services mix. Unlike consumer lending, with its deep securitisation markets for consumer loans such as mortgages, credit cards and auto loans, bank loans to all but the largest business borrowers are relatively illiquid. As a result, loans to most businesses are held on bank balance sheets until they mature, or in a worst-case scenario are restructured or written off as losses. The financial meltdown and new regulatory environment that emerged from that time has changed the willingness of banks to hold risk assets on their balance sheets.
New US Regulatory Burdens
In response to the failure and near-failure of the largest number of US banks since the Thirties between 2007 and 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 619 of Dodd-Frank, known as the Volcker Rule (named after the former Federal Reserve chairman, Paul Volker, who helped draft the law), restricted US banks from engaging in speculative activities that were considered potentially detrimental to traditional bank customers. More specifically, it restricted them from putting their own capital at risk for such things as trading activities not at the behest of a client.
In addition, larger banks were required by regulators to create detailed plans to wind down activities and break themselves up while preserving customer deposits, should the credit markets again freeze up to the degree that they did in 2007 and 2008. As a result of these regulations, as well as new rules created by other regulators, banks’ reporting and compliance burdens have increased significantly. Some US banks even report that they now have more employees engaged in reporting and compliance-related activities than they have directly interfacing with clients.
The new regulatory burdens shouldered by banks also affected their willingness to make loans to business clients. With the higher level of scrutiny on bank balance sheets, the quality of loan portfolios are being more thoroughly examined with an increased emphasis on safety of the loan portfolio. Regulators have focused more on the loan portfolio in many banks, creating pressure on lenders and credit managers to focus most on high quality assets where the probability of losses are low, and therefore less likely to put depositors at risk. This has resulted in fewer borrowers being approved for loans.
Basel III rules have also affected bankers’ willingness to loan to businesses. While the earlier Basel I and Basel II accords focused more on reserving for potential loan losses, the newer accord forces banks to pay more attention to their overall capital structure and increase capital and reserves for potential losses. This has forced many banks on both sides of the Atlantic to reduce their leverage, thereby reducing the funds available to lend to businesses. As the Basel III standards are put into effect over the next few years, banks will be forced to focus more on creating a sufficient equity cushion and less on balance sheet growth through loan generation.
Growth in Non-Bank Lending
The increased reluctance of many banks to make new business loans has allowed alternative types of lenders to see growth in market share. Borrowers sought out new sources to make up for the banks’ unwillingness to grow their balance sheets with risk assets (loans). The universe of non-bank lenders (lenders who do not take deposits) has seen a growth in demand. In addition, a number of newer types of lender have taken advantage of changes in the marketplace.
The world of non-bank lenders includes a wide range of companies. Everything from a traditional finance company such as GE Capital to its smaller competitors has seen more opportunities with businesses considered too risky or too new for traditional bank lending. This also includes the universe of asset-based lenders, factors and other ‘hard money’ lenders who lend against tangible assets with readily realisable value in case a rapid liquidation of collateral is required. Leasing companies also fall into this universe, with their focus on financing single assets or groups of similar assets.
Hedge funds have also been able to expand their lending business by targeting loans secured by assets that they feel the marketplace may be undervaluing. They also will create loan structures leveraging non-traditional assets, such as intellectual property and other types of assets with cash flow potential. Since the financial meltdown, a number of funds have been raised specifically to lend to small and medium-sized companies, historically banks’ target market.
Private equity funds and venture capitalists have always participated in the lending markets. Loans from these industry players are usually combined with an equity investment and are a way to realise short-term income while waiting for the enterprise value to appreciate.
Potential borrowers can make themselves attractive to a broader universe of lenders by creating an up-to date-financial package of information, preferably prepared by a reputable accounting firm. The firm’s information package should include complete historical financial statements adhering to industry accounting norms. The last thing a potential lender wants to spend time doing is reformatting a company’s financial statements to make them more comparable to others in the industry.
Financial projections are a subject of debate in the lending community. Many lenders will not consider a company’s internally-generated projections. On the other hand, many other capital providers believe that the discipline of creating projections is an important way for management to demonstrate its understanding of the business and its current marketplace.
Most important for finding adequate capital for a growing business is for management to show a full and detailed understanding of the company’s current and historical financial performance. Lenders are most comfortable lending to companies where the management fully understands the financial drivers of the business.
The lending markets continue to respond to changes in banking practices and regulation. Many banks have increased business lending in recent months as their capital ratios have become stronger. Borrowers remain concerned that banks will again move out of the business lending area, should profits fall once more in the future.
Other types of lenders were quick to fill the gap left by banks’ pullback during the financial crisis and have established their presence in the marketplace. As the lending markets continue to evolve for small and mid-sized businesses, new options will continue to evolve to meet market needs.
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