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In Praise of Non-Bank Finance

Patrick Jenkins, the banking editor at the Financial Times, recently wrote an article that identified a number of problems associated with the rapidly growing peer-to-peer (P2P) lending sector ("Why peer-to-peer lending remains inherently unsafe", FT, 22 July 2013).

According to Jenkins, the current returns on offer to investors do not accurately reflect the inherent risks of P2P lending. There is an absence both of stable long-term default rates and of transparent underwriting processes and, while lenders are being offered attractive rates of return, Jenkins argues that these probably do not accurately reflect the risks they are taking. In addition, the enthusiasm that the government has shown for the fledgling industry creates the illusion of public support, when in reality there is no publicly funded protection for these loans. Jenkins concludes: "Banks might have done themselves and the world a lot of damage in recent years, but they are still better judges of lending risk than the average investor".

This defence of the traditional balance-sheet model of bank lending is not new: it was made in the US in the 1980s, in response to the rapid growth of money market funds (MMFs), which are, in many respects, precursors of the P2P lending companies. The belief that, for all their evident failings, banks are better at making loans than other financial institutions is widely held, but it is not obvious why this should be the case. The underwriting skills needed to make sound loans are learnable; they are also portable. You can take the experienced loan officer out of the bank without also taking the banking experience out of the loan officer.

P2P lenders are one of many new groups of players in the non-banking financial system, all looking to increase their market share. In recent years the UK has seen significant growth in sub-prime lending companies - such as payday lenders and home credit companies - a renaissance of the pawn-broking industry, and the slow but steady growth of not-for profit lenders such as credit unions and community development financial institutions (CDFIs). These lenders provide credit in a variety for forms - sometimes secured and sometimes unsecured - for personal consumption, for entrepreneurs and start-ups, and for small and medium sized enterprises (SMEs).

In addition, there are a range of investment vehicles available to institutional and retail investors that provide finance to large companies, including MMFs, corporate bond funds and exchange traded funds (ETFs). A number of European countries are looking to expand the opportunities for private investors to lend to companies outside of the banking system, either mediated though loan participation schemes, or directly in the form of loan origination. The Breedon Report, Boosting Finance Options for Business, was commissioned by the UK government and published in March 2012; and the Central Bank of Ireland is currently consulting on the possibility of allowing investment funds to source assets directly via loan origination.

Why are European governments keen to expand the scale of non-bank finance for business? First, because in Europe the vast majority of loan finance is provided via banks, which means that SMEs lack the benefits of a diversified range of sources of finance. Less choice tends to mean higher costs. This is in stark contrast to the US, as Mario Draghi, the President of the European Central Bank has noted: "in the United States 80% of credit intermediation goes via the capital markets. In the European situation it is the other way round. 80% of financial intermediation goes through the banking system" (2 May 2013).

Second, because banks are currently suffering from a shortage of capital there is less money available for businesses to borrow. Again, the situation in Europe is worse than in the US: earlier this year McKinsey estimated that the bank funding gap in Europe (the gap between demand for loans and the supply of deposits) stood at over 1tn. With many bad debts remaining on their books, and regulators demanding higher levels of capital to support existing lending, the ability of the banking sector to cover this funding gap remains in doubt for the immediate future.

All lending - whether provided by banks or non-banks - is risky, and those risks need to be understood and managed, both by lenders and borrowers. If there is one lesson that should be learned from the financial crisis of 2007-09 it is that improvements in the quality of financial risk assessment are needed: among bankers, borrowers, regulators and policy makers. That having been said, there is no inherent reason to prefer the bank balance sheet model of business lending. A flourishing economy needs multiple sources of finance for existing and new businesses: some from banks, some from investment funds, some from specialist credit providers, and some from P2P lenders.

The emergence of a diversified non-banking financial sector is a development to be welcomed. There is no reason why the banks' market-share should not be reduced by successful new entrants who add to the diversity of funding sources. New lenders with new lending-models, competing among themselves for business, should reduce the costs of capital and produce better service for customers. That would be good news for SMEs and good too for economic growth.

© Mark Hannam 2013