By Gabriella Kindert on 5th January 2017
NN IP’s head of alternative credit Gabriella Kindert reveals her key predictions for the alternative lending space in 2017.
Connectivity and interdependence have increased in most industries, including financial services in the last decade. In the wave of digital transformation, new business models are born.
From the crisis of 2008 to date, €19bn has been invested in fintech companies with hundreds of them newly founded. Though this number may not seem very high in the context of the balance sheets of the entire financial sector (€28trn) or the recent fines some banks needed to pay, there are many aspects that are clearly changing in the landscape of financial services. Customer expectations drive changes in business models. New partnerships as well as methods of connecting borrowers and lenders are born.
Herein I provide my reflection on recent trends and highlight some key predictions for 2017 in the alternative lending landscape in Europe.
1. Banks will continue to shrink their balance sheets and will invest in new business models and partnerships
Europe relies heavily on banks. Therefore, in order to assess the lending ecosystem, I always start with what is going on with the banks. Banks have been shrinking their balance sheets since the crisis. In 2008, the total assets of banks in the Euro region stood at €33trn and declined to €28trn by 2015 (ECB, 2016). Just to put this number into context, the decline is higher than the combined balanced sheet of five major banks (Rabobank, ING, ABNAMRO, Deutsche Bank and Unicredit) as of June 30, 2016.
In terms of profitability, it did not really improve this year. Interest rates continued to be low, capital requirements became harder, compliance rules and penalties remain harsh.
The first 6 months of financials in 2016 indicate declining trends in many aspects, including revenue and deposits. The net interest margin of the top 10 listed banks in the sector further reduced to below 1.5 per cent, which is structurally lower than in the US. Return on equity was 5.8 per cent , which remains below the cost of capital, estimated to be around 9 per cent. The prolonged low profitability is very challenging, especially as it coincided with a low equity base and increasing capital requirements.
Regarding outlook, the quantitative easing program is being extended so any interest rate hike is pushed well into the future. This environment forces banks to be more efficient with all of their key resources: people, branch network, system and their balance sheet. In practice, this implies closing down branch offices, reduction of headcount, further consolidation and tighter balance sheet management.
Since the peak of 2008 till 2016, more than 350,000 jobs disappeared. This seems high, but between 2000 and 2008, almost 1 million jobs had been added to the sector. In this context, there might be still potential for job cuts. (The figures are based on listed banks representing approximately 80 per cent of the total assets of the European sector.)
Banks will further explore alternative lending avenues and strengthen cooperation with institutional investors and Fintech companies. This creates new attractive opportunities for investors or potential partners that may have limited business origination or risk management capabilities but offer balance sheet capacity or more efficient business execution.
2. Political support to alternative lending will strengthen
The funding needs of the European economy remains larger than ever. The sentiment that Europe in terms of economic growth is lagging behind the USA seems more widespread than ever. The need for a more diversified funding source in Europe is more urgent than ever.
I see strong evidence that the conviction among key decision and policy makers in Europe is leaning towards increased lending via alternative sources. Over-reliance on banks made us too vulnerable and constrained our economic development and we need to increase resilience via diversifying funding sources towards the European economy.
This vulnerability of Europe is clearly illustrated by the Basel IV debate in recent months. The proposed legislations, which had been discussed in Santiago some weeks ago, favor a regime shift towards a less risk-based approach for credit risk. These would need to be aligned and inserted in capital requirements of European banks (Capital Directive) with very significant potential impact on the economy, including mortgage lending. Proposals to increase capital requirements for lower risk-weight portfolios, such as mortgage loans are disproportionately hitting European banks (Fitch, 2016).
As the European banking system finances about 75 per cent of the economy, the potential adverse impacts are a lot higher. In contrast, only 25 per cent of the US economy is financed by banks. It is largely capital market-based and long-term residential property risks are covered by government agencies (Fannie Mae and Freddie Mac). This diversification enables the US banks to operate with lighter balance sheets and any new legislation has less impact.
European banks are more sensitive to any regime shift and could be forced to decrease their direct lending to corporations and households. More importantly, any of these adverse changes in lending capacity has a direct impact on the economy. They understandably issued a strong pushback on the proposal.
This illustrates profound vulnerability. As Olivier Guersent, DG for Financial Stability, Financial Services and Capital Market Union at EU pointed out this month, “We have to set the rate of retention in securitization market to make sure that there is a market. Legislations are no use if there is no market anymore.”
This implies a stronger push for support for developing alternative lending channels, securitization market and capital market union initiatives. There is also likely to be more scrutiny and consequently, regulation to ensure consistency and a more level playing field between risks of banks and non-banks and transparency to investors about risks they are taking.
3. Institutional investors will show increasing acceptance to alternative fixed income products (e.g. private debt)
The search for yield remains a key theme in a low-return, volatile environment. Those who can deal with and accept the illiquid nature of the asset class will find a safe haven in private debt. These assets have limited liquidity and mark-to-market pricing; consequently, they “look and feel” stable.
Institutional investors (insurance companies, pension funds, etc.) are inherently more suited to participate in funding the economy because they capture a large percentage of long-term savings. However, the infrastructure to facilitate this remains mostly at the banks and the investments need to be channeled via capital markets and partnerships. The growth of partnerships has been painstakingly slow. There needs to be significant education and convincing done also at supervisory board level at these institutions.
Last but not least, investors seem to have high return expectations from private debt instruments that need to be managed. At the moment, a high percentage of investments are going to the highest risk basket in private debt (e.g., direct lending with return exceptions of 6-10 per cent). The potential private debt universe is a lot larger than lending at 6-10 per cent to sub-investment-grade companies. European banks have about 1.5 per cent net interest margin and lend at an average interest rate of 2.5 per cent . The bulk of the traditional banking products are safer assets and can be an excellent alternative to traditional fixed income products. Some of these new assets classes (like Dutch mortgages) has been favored by many institutional investors recently and a lot of similar product initiatives are likely to come.
4) Fintech: Getting more mature, more regulated with new collaborations
Many companies were formed with a mission to implement a new business model in the financial services industry. 2017 is likely to be an important year for Fintech when many of these business models will be tested on their ability to scale and operate under increasing regulatory scrutiny. The market will understand the significant differences between certain sub-segments of Fintech companies. Payments and blockchain services are likely to cause the most disruption and we will see further diversification of deposits payments from retail clients.
Some new companies will simply run out of money to support their business model. The market is likely to test the real value contribution of “smart algorithms”. With increased interdependence, potential defaults will have negative impact on others in the sector. Fintech companies will further recognize the importance of operating in a regulated environment in order to build trust and scale their business model. Regulations above a certain size is inevitable and unfortunately, extremely costly (systems, KYC, compliance and risk management costs). In contrasts, risk management and compliance are core competencies of banks and the associated costs are already inherent.
Rather than perceiving Fintech companies as competitors, financial services companies will be reviewing avenues to develop collaboration models for mutual benefit and assess to what extent they can incorporate innovative business ideas in their incumbent setup. Many financial services companies (e.g., BBVA, Santander, Goldman Sachs, JP Morgan) have established incubation centers, dedicated VC activities and M&A departments to capture on the most interesting opportunities.
A recent survey conducted by Roland Berger confirms that over 85 per cent of Fintech companies anticipate stronger cooperation with incumbents. The most important reason mentioned was the access to a stronger customer base. The power of this approach is to ensure that business or product innovation can be scaled up in a regulated environment, create a mode of comfort and eventually generate a critical mass.