In the last article, we explored how marketplace lenders could attract Basel III type rules. Staying on the subject of Basel III, we believe that they are the very rules that are in fact fueling alternative finance such as peer to peer and marketplace lending.
In this article, we look at things from the other side – from the banker’s perspective. We look out into the disruptive competition that banks now face from new age marketplace disrupters.
Banker Bashing
It is quite fashionable (and maybe with good reason because of he financial crisis), to “bash” bankers for not lending to small and medium sized businesses (SMEs) and individuals with supposedly lower quality credit rating. Banks have come under increasing scrutiny in this area, even by Government who have been publically critical of banks unwillingness to lend and the need for more competition in the banking sector.
The void left by banks gave birth to alternative forms of finance, provided by new players who leveraged innovation in financial services, technological development and a new age consumer, to develop an industry that now potentially threatens banking as we know it. Hard to believe that banks who dominated the financial services sector for hundreds of years are now facing disruption, maybe at unprecedented scale.
Despite the criticism and the threat that banks face, they are still (to this day) reluctant to lend to SMEs and higher risk individuals. So why is this the case. In fairness, this subject hasn’t really received much attention – well…. because its just fashionable to bash bankers!
So lets take a closer look at what is driving this reluctant behaviour by banks.
Basel III Rules Drive Bank Behaviour
We know that the Basel Accord introduces a risk based capital adequacy framework. What this means is that banks have to measure their risks and using a complex formula laid out in the regulation, work out how much capital they need to keep to buffer these risk in the event of their failure.
The more risk that banks take on the more capital they need to keep. Capital “sitting around” to buffer risk, can’t be deployed by banks to earn a margin. So cost of capital goes up, putting significant pressure on margins, and this doesn’t make shareholders very happy.
So naturally, banks look for less risky loans to back. Know the interesting thing is that the Basel III rules play a big part in deciding what type of loans / investments are risky.
So for example, one of the problem with the Basel III rules is that they favour government debt over corporare borrowing. So more of the bank’s deposit flow to sovereign debt instead of reaching more “risky” (according to Basel III rules) SME’s and first time home buyers.
Prior to the credit crisis the Basel Accords attributed the least risk to government debt. As a result, significantly less capital was required to be held against such loans (practically a 0% risk weighting). By contrast, corporate debt was largely considered to be at the other extreme, requiring significantly more capital to be held against such exposure, especially for corporate debt with poor credit ratings or no credit history (as in the case of SMEs).
So whilst government and regulators were critical of banks unwillingness to lend, it was their very rules (of course created at an international level) that drove banks away from the riskier segment of the economy. The results, banking rules were designed to divert money away from SMEs and to government.
The Euro sovereign crisis highlighted the weakness in the assumption that Government debt is risk free in any way, and the rules were tightened in Basel III.
However, Basel III rules still continue to create a a huge (and growing) demand for investments in government bonds (through, for example, short term liquidity ratio requirements). Banks are also driven to accept government debt as collateral to back other forms of debt.
Now to the credit of banks, they have awoken to the need for diverting more of their deposit base towards the SME sector, however, how can they, when the rules make it prohibitively expensive for them to do so.
Regulatory Arbitrage
At the other end of the spectrum, alternative finance providers face a very light touch regulatory framework that allows them to either facilitate lending, or lend themselves. This light touch approach to regulation allow alternative finance firms to take on high levels of risk, with significantly small amounts of capital backing the risk exposures. Under current rules in the UK, peer to peer lenders are only required to retain a minimum of £20,000 of capital, which will rise to £50,000 in 2016.
Clearly this creates regulatory arbitrage. If banks want to now venture into alternative lending, they would have to do so outside their current structures, and establish a completely separate entity to be able to capture market share at the riskier end of the lending spectrum. Even under such an arrangement, banks may still be caught by Basel III rules under the Group supervisory framework.
We have seen big names like Goldman Sachs create their own online lending platform. Hargreaves Landsdown is another big name financial institution going down this route by creating their on peer to peer lending platform. Its only a matter of time until other bigger players follow the same path.
There are two scenarios that could play out in this competitive banking landscape:
- Big players could crowd out the new disruptive start-ups, because of their financial muscle and regulatory know-how. What big players lack however, is the entrepreneurial culture and innovative approach of the new disruptive start-ups.
- The other alternative is that Basel III rules apply to the alternative finance sector. This will potentially close the regulatory arbitrage gap. However things may go back to the old days where SME’s and higher risk individuals once again experience a finance “drought”. Banks continue to dominate.
The second scenario may well be a possibility. When subjected to scrutiny by the Treasury Select Committee, the Chairman of the Financial Conduct Authority (FCA), John Griffith-Jones intimated that when peer to peer lenders become more like banks, regulators should not allow regulatory arbitrage into the system.
Neither of the above alternative seem to be feasible for the economy as a whole. Either innovation is stifled and the big guys once again dominate and finance doesn’t reach the very segment of the economy where it is most needed.
The only plausible alternative is to rethink Basel III and IV rules to develop a Basel V framework that promotes innovation, disruption and opens up finance to a wider segment of the economy.
About the authors
This article was jointly written by Jay Tikam and Gary van Vuuren. Jay is the managing Director of Vedanvi who spent several years helping banks implement the Basel Accord. He also took on the challenge of implementing Basel II in the South African banking sector.
Gary van Vuuren is a Basel Accord expert, sought after in several parts of the world to teach the regulatory framework and its practical implementation to banks and university students.