Since the global financial crisis, the inexorable trend across the banking industry has been toward more regulation and higher capital requirements. As a result, non-traditional lending has largely shifted into non-bank platforms.
However, the policymakers deliberating additional regulation in the form of Basel IV may be hesitating to move the pendulum much further. Over the long-term horizon, the regulatory environment could reach a turning point, which would have important investment implications.
LENDING MODELS: the devil you know or the devil you don’t
Lending involves risks. And these risks tend to be exacerbated during periods of economic stress. There are three main avenues to manage this:
Facilitate non-traditional lending in the banking sector, which has the lowest funding cost but exposes not just investors but the entire economy to systemic shocks and potential taxpayer bailouts in the event of a crisis. On the plus side, at least you know where the problem lies – the devil you know, as they say.
Have the non-traditional lending occur outside the banking sector. In this environment, risk is more dispersed, and in theory the taxpayer shouldn’t have to step in to bail out the system. However, the risk still exists, and if correlated during periods of economic stress can be just as hard to clean up. This is the devil you don’t know.
Regulate and severely limit the amount of non-traditional lending, but at the expense of growth, productivity and social mobility.
PICK YOUR POISON: the trade-off between lower volatility and diminished lending
Developed world policymakers have been trying since the financial crisis to thread the needle among the options above, leading to three general outcomes:
Banks become more utility-like, focusing on lower-risk lending and fee generation;
Non-traditional lending, to the extent it’s being done, occurs mainly outside the banking sector; and
Regardless where the lending occurs, regulation, in the form of macro prudential policies, aims to temper aggressive lending practices.
Under this framework, the trade-off between a potentially safer, less volatile system is diminished lending to riskier borrowers.
Non-bank vehicles would need to incorporate higher funding costs, compliance costs and a higher return on equity, all of which lead to higher interest rates for non-prime borrowers.
Conversely, most prime borrowers who have access to bank funding now borrow at levels close to historic lows, given where government rates are and how intense the competition is for these borrowers’ business. While reducing risk to the banking sector,
this trend has widened the gap between low-risk and higher-risk borrowing costs, arguably exacerbating concerns about income inequality and social mobility.
Consider two examples in the U.S. First, in the auto lending market, prime borrowers pay mid- to low-single-digit annual percentage rates (APRs) on loans, while subprime borrowers pay well north of 20 per cent.
Second, in the mortgage market, there is now very little risk in private markets, which mainly comprise prime borrowers. But this overall lower-risk environment has come at the expense of a falling home ownership rate and higher borrowing costs for non-qualified mortgages.
Eventually, the pendulum could swing back toward non-traditional lending in the regulated banking sector, as its lower funding costs ultimately win out. However, this will take many years to play out, and it’s not a certainty it will even do so.
Until then, non-traditional lending will remain outside the regulated banking sector, and higher returns will tend to accrue to platforms that have efficient funding models and can navigate the regulatory terrain in a cost-effective manner.
Joshua Anderson is a portfolio manager at PIMCO. The views expressed in this article are his and should not be taken as investment advice, or neccessarily those of AltFi.