A snapshot of the corporate lending market

Answer

Should you be interested in becoming a corporate lawyer, you will inevitably have to demonstrate a solid grasp of how businesses finance their operations.

Although retained earnings still constitute the most important source of long-term finance for UK businesses, your corporate clients will most likely seek to raise finance externally, by issuing debt or equity securities or by taking loans, for example.

Since this readership will likely be familiar with debt already, whether by way of overdrafts, student loans or indeed by having watched "The Big Short", we shall focus on debt financing in this article.

Commercial banks

These are understandably considered traditional lenders, since the first iterations of modern debt finance in Europe derive from the merchant banks of medieval Italy.

As with any industry sector subjected to strict regulation and reliant on economies of scale, commercial banking has developed into an oligopoly in virtually every large economy. In the UK, the ‘big four’ banks comprise Barclays, HSBC, Lloyds and the RBS group.

Note that commercial banks are to be distinguished from investment banks, with the former primarily engaged in lending to businesses and the latter playing largely an advisory, book-building and underwriting role for large-scale, high-risk projects, such as flotations or mergers and acquisitions.

The modus operandi of most commercial banks can be summarised as follows:

1. Accumulation

Commercial banks take deposits from a large number and wide variety of depositors. In fact, it is the depositors who act as the ‘real’ lenders in a loan market. The money which banks advance is sourced either from their depositors or from depositors of other banks which lend on the interbank market.

2. Re-packaging

Such deposits are then re-packaged so as to align these in volume and term with the needs of the bank's borrower customers. In this way, banks are able to perform so-called ‘liquidity transformations’ by using large numbers of smaller, short-term deposits to provide large facilities over extended periods.

Naturally, borrowing ‘short’ but lending ‘long’ exposes a bank to market risk, which liquidity crises, such as the run on Northern Rock in 2007, illustrate candidly.

3. Investment

At this stage, banks act much like any other investment manager, in that they use the expertise and experience of their staff to identify profitable lending opportunities, while achieving risk reduction through diversification.

The above should clarify why banks are referred to as financial ‘intermediaries’, as it is rarely a bank's own capital that is advanced, but rather re-packaged tranches of depositors' money.

The global financial crisis

The 1980s ushered in an era of market stimulation, the foundations of which lay in lifting the separation between retail and investments banks. Margaret Thatcher's ‘Big Bang’ and the US Gramm–Leach–Bliley Act allowed investment banks to finally access and invest millions of people's personal savings, deposited with retail banks.

An ambitious assortment of further regulatory changes and monetary policies paved the way to disaster, such as prolonged reductions in interest rates, deregulation of derivatives and a relaxation in capital maintenance requirements, coupled with a blind eye turned on due diligence, with rating agencies and asset managers alike replacing the truth with wishful thinking.

And as residential real estate – the trustworthy backbone of secured private debt – became leveraged by the world's largest financial institutions beyond eye-watering proportions, all it took was a critical mass of mortgage defaults to trigger a chain reaction of global systemic collapse.

In the aftermath, banks switched from speculation to risk aversion almost overnight, a sentiment which, in a more nuanced form, rings true to this day.

Of course, regulators felt vindicated in reverting back to old principles of prudence by re-instating the separation between retail and investment banking, achieved in the UK by the Banking Reform Act 2013, together with various secondary legislation and Prudential Regulation Authority rules.

A further measure was the imposition of far more stringent capital maintenance requirements, the Basel Accords being a prime example. Battered by the most severe financial crisis since the Great Depression and with little appetite for investment, banks were busy re-setting their business models and regulatory boundaries. The time was ripe for a new entrant.

Alternative lenders

Largely to be understood as any form of non-bank lender, ‘alternative lenders’ filled the vacuum left by mainstream banks' zero-risk policies.  

Given their far greater market share, we will focus on the larger end of the alternative lending spectrum, the so-called ‘institutional investors’. These can largely be categorised into institutions engaged in contractual savings and investment funds which are not.

The former category mainly comprises insurance companies and pension funds, since both are in the business of entering into contracts with their customers, under which customers render upfront payments over specified periods, in return for such institutions meeting their future liabilities in the event of materialised insured risks or retirement.

The latter category includes any investment funds falling outside the above business model, such as investment trusts, unit trusts, private equity funds and hedge funds, among others. What these share in common is that they pool money from a wide range of investors and manage that money on their behalf.  

While there is an on-going debate as to whether active portfolio management is able to not only ‘beat the market’, but also to recoup management fees, many investors nonetheless prefer to leave their money in a ‘safe’ pair of hands.

The label ‘alternative’ might be somewhat misleading, as we are certainly not talking about a small side-kick to commercial banks. Alternative lenders comprise institutions trading in positions large enough to cause such severe supply and demand imbalances, that their trades can affect the value of the underlying assets.

One of the key features of alternative lenders is that they are generally subject to less stringent regulation. This is likely to remain the case, as key financial regulators in the UK (The Bank of England, FPC, FCA and PRA) have proven hesitant to impose requirements similar to those imposed on the banking sector, so as not to stifle the UK's economic recovery post-Brexit. I imagine covid-19 will be yet another continuation of this story.

Such regulatory freedom has allowed alternative lenders to provide a more customer-friendly offering. By not being subject to strict capital maintenance and risk management requirements, alternative lenders can generally give credit approvals and make management decisions faster than banks can.

Also, alternative lenders have more leeway at the negotiation table. Should a borrower require flexibility in the structure of its facilities, such as more accommodating financial or information covenants, alternative lenders are more likely to oblige.

However, alternative lenders have also been known to charge higher interest rates than banks, in an attempt to capitalise on corporate borrowers' lack of funding alternatives post credit-crunch. Also, it remains to be seen whether a lighter regulatory approach proves sustainable long-term or whether we are headed for yet another financial crisis.

Nevertheless, the rise of alternative lenders in the corporate lending space is likely to continue.

FinTech

While the success of online banking and so-called ‘challenger banks’ is undeniable (although their profitability is not), the automation of lender/borrower interactions is somewhat confined to the retail banking sector.

This is because when lowlifes like you or me look for a term loan, such as a mortgage, or an on-demand facility, such as an overdraft, we will inevitably move within the confines of heavily standardised facility agreements. This is partly due to our very limited bargaining power on the one hand and the regulatory straightjacket imposed on retail lenders on the other.

Given such high levels of standardisation, it is no surprise that retail banking operations are susceptible to automation. However, corporate lending paints a very different picture. It is unlikely that any prudent corporate finance manager will ever conduct loan negotiations using only a mobile app.

Nevertheless, artificial intelligence is making some headwind in corporate lending, primarily in data analytics. For example, the numerous and highly complicated financial and information covenants given by corporate borrowers can be monitored by lenders much more efficiently when relying on machine learning.

Not only would this lead to cost reductions, which could ultimately be passed down to corporate borrowers, to the extent corporate lending markets operate efficiently, but it would also result in more sophisticated risk management by way of early warning systems, allowing lenders to anticipate borrower defaults much earlier than usual.

The future?

I believe that the precarious economic position which the UK currently finds itself in will provide ample reason for keeping the regulatory status quo, thereby allowing alternative lenders to continue their ascent.

While FinTech will improve operational efficiency in the background, it is unlikely to shift business models as fundamentally as it has in the retail banking sector.

Phil Cerny is a trainee solicitor at Taylor Wessing.