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Fueling the Next Evolution in Nonbank Finance

Date: Nov 23, 2015 @ 07:00 AM
Filed Under: Industry Trends

Since the financial crisis, both the size and influence of the nonbank financial institution (NBFI) sector has grown steadily. Assets held by nonbank financial institutions rose from $60 trillion in 2008 to $75 trillion today, with approximately $25 trillion in the United States and another $25 trillion in Europe. As a result, their share of global financial assets grew to 25 percent.  Today, nonbank financial institutions account for a substantial portion of lending in such vital consumer sectors as residential mortgage, student loans and auto finance. In addition, they are now important sources of financing to small businesses and mid-sized companies.

But this growth has not been without its challenges. As regulators zero in on various sectors, nonbank lenders are evolving, maturing and increasingly looking to niche markets for new opportunities. More than ever, it’s important that nonbank lenders find the right financial services partner with experience navigating this complex environment.

 A Favorable Environment

A number of factors in the years since the financial crisis have helped fuel the growth of the NBFI market. The first is government regulation. Banks are operating in a complex, rigorous regulatory environment and some have pulled back from a number of markets and specialties. This has provided new opportunities for nonbank lenders to fill the gaps. Small business finance is one example. 

The second factor driving the post-recession growth of nonbank financial institutions is the ready availability of capital. With interest rates at historic lows and yield spreads compressed, investors have seen in nonbank financial institutions a way to earn a higher risk-adjusted rate of return that also provides diversification from existing investment strategies. Alternative investors such as private equity firms, pension funds, sovereign wealth funds, high net-worth individuals, family offices and insurance companies have invested in a variety of investment vehicles that can meet the capital needs of nonbank lenders. Large money center and some regional banks have also have become more important financing partners, to a certain extent filling the void left by the contraction of the asset-backed commercial paper markets, which now account for just $200 billion in funding, down from their peak of $1.4 trillion. 

The asset-backed security (ABS) market also continues to be an important source of funding for nonbank lenders. ABS investors are increasingly interested in emerging asset classes and newer issuers. Among established areas of commercial finance, securities backed by auto and equipment finance lending have found a particularly favorable reception.

Finally, for nonbank financial institutions, technology is the great equalizer—and many firms have turned to IT to introduce solutions that reinvent traditional financial services business models. By taking advantage of big data analytics and new distribution channels, new nonbank financial institutions have positioned themselves to fill the market for personal and small business loans.

Catalysts for Change

These three factors— regulation, ready access to capital, and technological innovation—have combined to create fertile ground for the growth of nonbank financial institutions. Today there are thousands of independent nonbank lenders in the United States alone—and new companies are entering this arena at an accelerated pace.

This is not to say that there are no headwinds. The regulators have not forgotten the role that nonbank lenders played in the mortgage crisis, and the growing presence of nonbank lenders in this and other sectors has increased the call for action. The government continues to scrutinize the sector, and any regulations that it is likely to enact have the potential to erode the cost and other advantages that nonbank lenders may have relative to banks. In a survey that Capital One conducted at the 2015 ABS Conference in Las Vegas, 73 percent of the industry professionals polled said that increasing regulatory requirements and associated expenses are the most significant risks they faced.

Access to capital is another issue. Not all nonbank lenders have been successful in this regard. Smaller or less seasoned lenders platforms may lack the sophistication and the financial resources required to tap the capital markets. Reporting requirements for smaller, less frequent issuers often necessitate costly and time-consuming systems and infrastructure development. Some finance companies lack the capabilities to create these systems or prefer not to disclose this information for competitive purposes.

Perhaps the most significant challenge to nonbank lenders is simply a product of its popularity: the growing number of companies entering the market. In the 2015 ABS Conference survey, 68 percent of the respondents said that competition would increase over the course of the year.

The Next Evolution

In response to these changes in the nonbank lending environment, the industry is evolving. Government regulations have discouraged all but the most intrepid nonbank lenders from focusing on mortgages; however, some have been successful in capturing more of the originations and servicing market, especially as many banks have de-emphasized these efforts.

All these firms share a reliance on technology. As we have seen, the more commoditized areas like student and personal loans are especially suited for new technology-focused lenders, who can apply big data analytics to maximize margins and develop more competitive pricing models.

The more traditional nonbank lenders are taking a different tack. In a survey conducted at a specialty finance and asset management thought leadership conference that Capital One hosted in May, they identified emerging niche markets as their single best source of risk-adjusted investment opportunities. The inherent complexity and limited scale of these markets discourages competitors, while their growth potential justifies early investment. These markets include structured settlements, niche residential and commercial real estate lending, and alternative energy finance. The challenge in markets without an established track record, however, is finding a way to generate an appropriate return.

Perhaps the most significant response to developments in the nonbank lending environment is consolidation. Consolidation adds to the lender’s knowledge base, enables access to more diverse sources of capital, and creates capacity to comply with regulatory oversight.  Consolidation also provides a path into new niches. For instance, a number of private equity and alternative asset management firms have been active acquirers of commercial and consumer finance assets and platforms. They hope to expand their lending businesses as banks and others either exit businesses or struggle to meet the challenges of the current environment.

As the market evolves and complexity remains an issue, nonbank lenders will benefit from collaborating with a financing partner who can help them navigate the market and assess new opportunities. Nonbank lenders often work in highly specialized market niches. They need a counterparty that not only knows their sector, but also has experience structuring financing solutions tailored to these unique needs. Nonbank lenders and specialty finance companies should look for the expertise to tailor solutions to the unique needs of lenders and investors and to access to flexible capital.

Ultimately, the underlying factor separating winners and losers among nonbank lenders is the strength of their leadership team. For the last five years, the environment has been relatively forgiving. Going forward, investors will favor investment teams with a track record of working closely together, with ready access to capital, and the skills and creativity to take advantage of the gaps emerging as banks continue to deemphasize their historical financing markets.

1.) See http://www.financialstabilityboard.org/wp-content/uploads/r_141030.pdf?page_moved=1

 

Dave Kucera
Managing Director | Capital One
Dave Kucera is managing director and head of the Asset Backed Finance Group at Capital One, which provides recourse and nonrecourse financing and other services to specialty finance companies and asset managers throughout the United States across a broad range of sectors.
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