As banks retreat from lending, innovative financing models are filling the void
HIGH inflation and rising interest rates have reduced the availability of credit around the world. Banks, in particular, are less willing to provide loans. This funding crisis exacerbates the current trend that sees banks adjust their business models – often under regulatory pressure – to a more conservative posture. They have primarily become custodians of client deposits and asset managers charging for a service.
In other words, the traditional banking sector is increasingly bidding farewell to its fundamental role of extending credit to businesses, which is necessary to keep our economies functioning. Hence businesses and projects in need of financing find it more difficult to get loans. They have to look elsewhere.
This industry shift has created space for new types of investment firms that are willing to take the risk that banks are no longer interested in bearing. Private equity (PE) and venture capital (VC) firms, angel investors and family offices have entered the lending space, acting as “shadow banks”. They seek to exercise more control over their creditors than banks. But they are also able to engage in riskier projects and transactions.
Following the failures early this year of Signature Bank and Silicon Valley Bank in the United States and forced sale of Credit Suisse, those types of non-banking institutions will increase in prominence and assume a more important role in our economies. Credit will continue to be critical for economic development, so this new space needs to be well-regulated, with governments behind the idea.
The future of finance
We believe that the future of financing belongs to non-traditional banking. Borrowers can get better conditions than at traditional lenders because the opportunity cost for these investors is different from the banks. But to provide these conditions, PE and VC firms require a certain level of control – not only shareholder control, but sometimes even operational control.
It’s evident that there will be changes for the booming non-traditional lending space. First, because they won’t be able to avoid regulation which will certainly increase for these entities. Ultimately, they have a fiduciary duty to their own investors. Second, because the market will become more crowded, and the growing competition will make life more difficult for them. And third, because many borrowers don’t easily like to cede control of their businesses. They will look for lenders that allow them to keep their autonomy.
Reaching both – autonomy and great lending conditions – is almost impossible for borrowers. At the end of the day, investors need to mitigate and compensate for both the operational and macroeconomic risks. But is it really that improbable?
The alternative approach
If investors can migrate part of the operational and macroeconomic risks to another, lower type of risk, then everyone benefits. Collaterals such as shares have their value directly negatively correlated with the risk of default. Real estate or fixed assets that are not managed properly can lose significant value too. Investors need to seek independent collaterals, such as cash-like assets or bank guarantees that are not affected by operational risks, that can be liquidated immediately. Such collaterals shall be used not only as guarantees but also indirectly, non-dependent of the borrower’s performance, a trigger of remuneration that is hedged against interest rate volatility. Basically, the remuneration from a project needs to have a part dependent on the borrower’s performance and another part triggered by the collateral independently.
Investors that follow this approach, without funds of third parties being managed, will cushion their macroeconomic and operational exposure and will not be impacted as much by new regulation. They will be able to absorb the demand being left behind by retreating banks and grow their market share.
Industries evolve constantly. The financial industry is not immune to the forces of change. It is time to reimagine the financing model.
One doesn’t achieve a different result if the inputs are kept constant. You won’t get better lending conditions if you don’t first change the exposure to investment risks. On the remuneration side, decentralising the dependence on the borrower’s performance is key. It will create a more sustainable financial industry.
The writer is CEO and founder of Ethos Asset Management
