As access to bank funding has become harder to obtain, more alternative lenders have emerged from the shadows. These lenders (or shadow banks) are not regulated to the same degree as traditional banks. Could some be a disaster in waiting?
By Tony Kaye
Across Australia’s capital cities, work is underway on hundreds of large-scale commercial and residential property developments collectively worth billions of dollars.
The types of projects are as varied as the developers behind them, ranging from luxury hotels to high-rise CBD apartment buildings, retail complexes, and developments in outer suburban areas.
What is most interesting about these developments is not necessarily what they are, but how they came about in the first place. Traditionally, the funding to get most of them off the ground came from banks or other mainstream lenders.
Increasingly, however, the bulk of the money required is being sourced from so-called “shadow banks” – non-bank financial intermediaries that are backed by Australian and foreign institutional funders and a growing army of sophisticated private investors.
This is a rapidly growing segment of the Australian lending marketplace in an environment where major banks and other financial institutions have significantly tightened their lending screws on investors and home loan applicants to reduce balance sheet risk.
The term “shadow bank” was initially coined in the US, just before the onset of the 2008 global financial crisis (GFC), to describe the risky mortgage-backed securities structures set up by banks to offload unwanted loans from their balance sheets. These securitised loans were repackaged as highly rated investment bonds, even though the underlying assets were often poor.
Shadow banking has come a long way since. These days the term is used more broadly to cover all financial intermediaries that offer bank-like lending activities. However, a key distinguishing factor is that these alternative lenders, although having some reporting obligations, are not regulated to anywhere near the same degree as banks and other authorised deposit-taking institutions.
In the same way as traditional banking, shadow banking generally involves structuring loans around maturities and liquidity, and the use of leverage. Loan interest rates are often competitive with those charged by mainstream banks but can also be much higher. The bonus for investors providing the funding is attractive yields, while larger funders are often able to take a first mortgage over the property as collateral.
Is shadow banking a cause for concern?
When quantified, the numbers around shadow banking globally are mind-boggling.
The Financial Stability Board, an international body that monitors and makes recommendations about the financial system, estimated in a report released in March 2018 that non-bank financing at a global level stood at around US$160 trillion.
In some countries, the level of non-bank debt is causing concern due to the potential risks it poses. For example, the Chinese Government is currently attempting to unravel a US$10 trillion shadow banking ecosystem created by the country’s banks to effectively sidestep regulatory lending constraints, says Wilson Pang FCPA, KPMG China head of turnaround, restructuring services.
Shadow banks currently have access to about A$16 billion in warehouse facilities from large banks, of which A$11 billion was drawn as at June 2017.
Many Chinese banks have used various products and structures to raise capital and on-lend funds to local governments, companies, and hundreds of millions of households. But Chinese corporate defaults, including defaults by government agencies, have risen this year and many experts are very concerned about potential global contagion, says Pang.
“There are certainly risks, but what is most important is how people realise that risk, identify the risk and can mitigate the risk with the right actions and attitudes.”
Pang says this is happening in China right now, with the government actively taking steps to shore up the country’s banking system, financial markets and economy.
“This is the year with the strongest regulation being imposed on all the banks, forcing them to recognise their non-performing loans and encouraging them to speed up the disposal of those non-performing loans,” he says. “That is a way to ensure the stability of the system.”
The potential of a trade war between China and the US may not help the situation, and the US itself – which the FSB says has an estimated US$36 trillion in shadow banking liabilities – is certainly not immune to potential financial spillovers from such a dispute.
Non-bank lending can potentially create damaging long-term effects. The UK, with around £2.2 trillion in non-bank debts according to the Office for National Statistics, and Canada, with around C$1.1 trillion according to the Bank of Canada, could also be affected by any major default spillovers.
For that matter, so could Australia. According to the Reserve Bank of Australia (RBA), shadow bank lending accounts for about 7 per cent of total financial system assets, which is roughly equivalent to about A$500 billion of capital. It is certainly not on a large enough scale to worry the central bank at this point, but that’s not to say the RBA would not become concerned if levels grew to a point where it could damage financial system resilience.
Shadow lending in the Australian residential sector has been small to date, despite the Australian Prudential Regulatory Authority (APRA) further tightening constraints on banks’ lending.
Further changes potentially stemming from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, as well as actions taken by the major banks themselves to restrict lending, could push more home loan borrowers into the shadow sector.
For residential mortgage lending, a key constraint is the cost and availability of warehouse financing, which is generally provided by major banks. Data collected by APRA reveals that shadow banks currently have access to about A$16 billion in warehouse facilities from large banks, of which A$11 billion was drawn as at June 2017.
Can shadow lenders spark another GFC?
September 2018 marked a decade since the collapse of Lehman Brothers, the US investment bank that effectively triggered the GFC because of its huge exposure to subprime mortgage lending.
Could shadow banking lead to another GFC? University of Queensland associate professor in banking and finance Necmi Avkiran believes there are risks, especially in terms of some of the lending structures being used by non-banks that lack transparency.
“One of the key challenges for regulators now is to devise rules and standards requiring shadow markets to hold enough liquidity to be sufficiently sensitive to risk,” Avkiran says.
“However, where investors and financial intermediaries fail to identify new risks, it is less likely that the regulators – who have fewer resources – will succeed. Raising capital requirements can limit the capacity of financial intermediaries to expand risky activities, although monitoring overall bank leverage may be better.”
University of Melbourne professor of finance and Australian Centre for Financial Studies research director Kevin Davis says the scale of shadow lending in Australia would be unlikely to cause financial instability.
Davis says most of the issues around the GFC were caused by the interlinkages between financial intermediaries and capital markets, and regulators have since taken numerous steps to reduce potential systemic risks.
“The financial stability risk is not the risk of one institution failing, unless they’re a major player in the system – it’s the extent to which there are interdependencies between the institutions and the failure of one impacts on another one.”
Increased capital requirements on banks and other lenders, and greater financial disclosure, have mitigated system risk, he says.
A growing pool of shadow cash
Other major sources of capital beyond the big banks, such as from the managed funds and superannuation industries, are also emerging to facilitate the activities of shadow banks.
For example, superannuation fund Australian Super is actively involved with Melbourne-based commercial real estate debt and investment specialist MaxCap Group, which to date has managed more than A$4.6 billion of commercial real estate mortgages. The RBA notes that assessing shadow bank lending for property development, rather than mortgages, is challenging.
“Australian law also provides less protection for commercial borrowers compared with consumers because they are thought to be more informed and financially sophisticated borrowers,” says an RBA official.
“It therefore attracts less regulatory oversight compared with residential mortgage lending. The nature of such lending – large loans to a small number of developers – also means that lending is typically arranged bilaterally rather than through a centralised distribution network of brokers that exists for housing lending.
“The way that property development is typically financed also complicates the assessment of credit provision by shadow banks.”
In a bid to address this, in 2017 the federal government announced it would give APRA new reserve powers for regulating the provision of credit by institutions other than banks and other authorised deposittaking institutions (ADIs) where those non-ADIs pose a risk to financial stability. This is being done through the regular collection of data.
In response, Avkiran says good regulations will be the key to systemic stability.
“Regulators need to heed the trends in shadow banking as part of this, to ensure transparency,” he emphasises.
“However, the nature of this sector, the long chains and multiple counterparties with unclear financial obligations, will continue to make the job of the regulator very difficult.”
Should accountants warn clients about shadow lending risks?
KPMG’s Wilson Pang FCPA sees accountants as not just bystanders in the world of shadow banking, but as lead players, with a significant role in identifying risks and notifying their clients.
He urges accountants to be proactive in terms of alerting clients to potential default risks. “Today, I see accountants as having a more proactive role in how to advise their clients to foresee the risks, anticipate the risks and mitigate the risks as much as possible,” Pang says.
“For example, if we know one particular province in China has a higher default rate, then we should be proactive enough to look at our clients’ accounts to tell them what kind of exposure they have.
“Also, if we have the bank data from all different clients, then we should be analysing that bank data to get them some early warning signals so that our clients may be more willing to make appropriate provisions.”
Pang says that, as well as dealing with CFOs within companies, accountants should find ways to communicate with people in other areas of the company. “Our role is not to be a traditional accountant but a watchdog. A watchdog or gatekeeper is really about being active. In this era, I think people should be more proactive [and] we should make use of all the technology, the information, and the bank data.”