Markets & Economy

Filling the Gap

Filling the Gap
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A perfect storm of tighter regulation and problematic historical loans is putting the crunch on bank lending. This offers an opportunity in 2018 for other non-bank providers to step in, says Alcentra’s Paul Hatfield.

One of the many legacies of the global financial crisis is its impact on the supply of credit. In the decade since 2007, the world’s central banks have kept interest rates at record lows while at the same time experimenting with ultra- loose monetary policy. Meanwhile, in an effort to shore up the banking system, regulators have added to the rule book on loan provision even as they demand ever higher levels of capital adequacy.

The result is twofold. On the one hand, banks are facing unprecedented pressure to trim their current loan books—especially where they do not foresee them being repaid by the original borrower—but they are also withdrawing from the market, leading to a downturn in the amount of available credit.

On the former point, PricewaterhouseCoopers (PwC) estimates there are approximately €2.3 trillion of non-core assets on banks’ balance sheets (almost equivalent to the GDP of France), close to half of which are highly unlikely ever to be paid back.1

For Paul Hatfield, global co-chief investment officer with Alcentra, the outcome is stark. “This is one of the major issues now facing lenders. Regulators are imposing much stricter rules—but banks also face serious problems caused by the poor-quality loans they have made in the past—principally in property and corporate lending. We believe the balance sheets of Eurozone banks and their ratio of bad loans to total gross loans is at an unsustainable level.

“Banks have struggled to solve this riddle and in response have been disposing of noncore operations, cutting costs and, where possible, issuing new share capital to try to strengthen their financial standing. New European banking regulations are also forcing them to clean up their balance sheets. These regulations also constrain them from lending to smaller and medium-sized companies.”

Part of the issue, according to Hatfield, is the problem of yield. By keeping interest rates at historically low levels, central banks have unwittingly pushed investors further and further up the risk ladder. As a result, and in order to find the kind of returns they would like to achieve, investors have taken on credit that once would have been deemed too risky or too illiquid. “Consequently, we’ve seen high levels of very poor-quality companies being given capital finance in areas like the European high yield bond market,” says Hatfield.

With Basel III capital requirements looming, banks now have to address deteriorating returns from these legacy assets and this is adding to pressure to trim loan books. Not only are they selling these loans to other investors, says Hatfield, but they are doing so at substantial discounts to the original value: “At a time when investors are hungry for higher returns, this can create opportunities for other lenders to fill the gap left by banks who have stepped back from the arena. There are also opportunities to buy the impaired loans which banks have made in the past at significantly lower prices than their full face value.” Here, he says, the numbers speak for themselves. The UK, France and Germany completed 199 private debt transactions in 2016 compared to 119 in 2013.

Stronger global growth, particularly in Europe and in the U.S., is adding to the demand. Hatfield notes how smaller and mid-tier companies are keen to tap into the rising economy, as are private equity companies looking to raise finance for acquisitions. Although this is leading to greater competition among the more newly established participants in the direct lending market, he says the flow of opportunities “remains strong,” meaning larger, established managers “can afford to be more selective and discerning in their investments.”

Chart 1

1PwC Portfolio Advisory Group: “Capitalizing on the Acceleration in the Bank Restructuring,” 2016.

Risks

Bonds are subject to interest-rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Management risk is the risk that the investment techniques and risk analyses applied will not produce the desired results and that certain policies or developments may affect the investment techniques available to managing certain strategies.

BNY Mellon holds 100% of the parent holding company of BNY Alcentra Group Holdings Inc., which is comprised of the following affiliated companies: Alcentra Ltd. and Alcentra NY, LLC.

Views expressed are those of the manager(s) stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular investment, strategy, investment manager or account arrangement. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. The Dreyfus Corporation, Alcentra, and MBSC Securities Corporation are companies of BNY Mellon. © 2018 MBSC Securities Corporation, Distributor, 225 Liberty Street, 19th Floor, New York, NY 10281.

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