My latest business, Select Finance Investments, has been looking to acquire a bank in the Isle of Man and, as has been reported in the press, was in active talks with Permanent TSB to buy Permanent Bank International (PBI), its IoM subsidiary, until the decision to close PBI was announced this week. Being a long-standing advocate for the AltFi sector, it may seem contradictory for me to be looking to take on a banking licence but banks are potentially important in filling the gaps within the alternative finance sector, as much as the AltFi sector can fill the gaps in banking products and services.
Since my first investment in the AltFi sector back in 2012 I have invested in or advised more than two dozen AltFi businesses globally, many of whom have gone on to become major players in the industry. I have championed the notion that the AltFi industry can fulfil a useful role alongside the banks, doing the things that the banks do not wish to or cannot do themselves. Despite many changes in the banking industry in the years since the AltFi sector began to emerge, this will continue to be true in most major jurisdictions in the world.
However, there is a problem within the AltFi industry that presently only the banks can resolve. The problem is one of the spectrum of returns over which investors have appetite. Investors in loans from AltFi businesses continue to be driven primarily by the level of return, rather than the level of risk-adjusted return. This drives the highest level of interest to higher yielding loans, whilst the lower yielding, low risk loans find few investors prepared to buy, despite this area of the market offering some of the best risk-adjusted returns.
This is even more pronounced once AltFi loans are packaged and sold within securitisation vehicles. Leverage is added to an SPV but the total cost of that funding is often similar, and in some cases even as high, as the underlying loans yield. The net effect is that the equity investor in the SPV receives a similar return to that available to an unleveraged portfolio but they have significantly increased their risk. There is a transfer of economic value from the holders of the equity to the providers of leverage. Whilst this may make sense from a short term strategic standpoint (it allows the AltFi platform to write more loans) in the long run it cannot make sense to increase risk for no additional return.
In theory, the gap in funding for low yield, high risk-adjusted return loans should be able to be filled with institutional funding. After all, in a yield-hungry world, pension funds and the like should be falling over themselves to access this type of paper. Here the problem lies not with the return profile but with the liquidity – there simply aren’t the volume of loans to make funding worthwhile, because pension funds need hundreds of millions of pounds worth of paper, and that simply is not available currently.
Hence the necessity for a different type of investor, one looking for low yield but very low risk paper, in quantities that can be originated by AltFi platforms. This brings us to the interest that Select Finance Investments had in potentially acquiring PBI. As a business with roughly £100m of equity and a deposit book of £300m, to make a double digit return on equity you would need to put around £300m of loans on the PBI balance sheet, as PBI has no loans on its balance sheet today. Given much of that loan book would be property-backed, that leaves potential funding for loans originated in the AltFi space in the tens of millions, rather than hundreds of millions. When numbers get down to that type of level, the choice of areas to invest in within the AltFi space opens up considerably.
In terms of the access to further funding for the bank through deposits, the offshore world has an increasing problem finding somewhere to put deposits, due to the ever-decreasing appetite for offshore funding within mainstream banks. A new entrant to the market would not need to seek to displace any current deposit taker, merely to provide further diversification to the market. Some of the conversations I have had with prospective depositors with the bank have even been along the lines of how much they would have to pay to access the capacity that we would have for deposit taking, rather than how much return they would receive.
Whilst the acquisition of PBI was not to be, we will continue to look at providing banking within the offshore world, for the same reasons as I became an early funder of the AltFi space – it’s an area that is out of favour and yet the potential returns are very good, because the gap between the perception of risk and the reality in significant. Just as with AltFi lending five years ago, offshore banking is an area that the more mainstream banks cannot or will not service and that creates the opportunity. To give an idea of the degree to which mainstream banks have pulled out of the offshore world, since 2010 the number of licensed deposit takers has roughly halved, whilst deposits are down less than 15%. Today there are just eight banking groups in the island actively taking deposits, less than a third of the level in 2010. Almost all of those that are no longer active, just as with PBI, were (or still are, since it’s a long process) run off.
Is there not a significant risk in providing offshore banking? In short, not in the modern world, within the top tier of offshore jurisdictions. In places like Guernsey, where I live, or in the other Crown Dependencies of the Isle of Man and Jersey, the Anti Money Laundering and Know Your Customer requirements exceed those of onshore jurisdictions, because it is assumed by international authorities that offshore jurisdictions are more likely to be a target for money laundering, tax evasion and the financing of terrorism.
To illustrate the differences of the offshore world to the onshore one, take the example of setting up a company. Here in Guernsey, an individual such as myself cannot incorporate a company, I must use the services of a regulated fiduciary. That fiduciary will do full due diligence on me, my prospective shareholders, the prospective Directors of the company and if any of the above are corporate entities, full due diligence on those underlying companies is carried out. If I wanted to incorporate the same corporate entity in the UK I would simply go onto the Companies House website and provide three forms of identity, which can be my mother’s maiden name, my father’s first name and the colour of my eyes. I kid you not.
The problem for the larger banks is that it is too much work to distinguish between the better offshore jurisdictions and those seedier backwaters of the offshore world that do still provide cover for illicit activity. This lack of desire to differentiate risk is the same type of dynamic that allowed the AltFi sector to blossom in the UK five years ago.
Starting from scratch (or acquiring a small existing bank whose systems can be replaced) also allows a bank to benefit from a lot of the learnings of the AltFi sector over the past few years. Technology-led solutions to much of the internal operations and customer experience can keep costs down but improve levels of service and allow the bank to adapt to changing market conditions far faster. A platform built today can be flexible and adaptable in a way that the legacy systems of the mainstream banks cannot.
Whilst at first glance it may appear completely contradictory for someone steeped in the history of the AltFi sector to head over to the dark side of banking, in reality it is a logical next step in widening and deepening the same trends that drove me into the world of AltFi all those years ago.