Hit hard by regulation and declining revenues, banks have been forced into scaling back their operations, leaving a gap that their non-bank counterparts have been quick to fill.

While the banking sector has contracted, its shadow has lengthened. A barrage of regulation, plunging revenue streams and ever present cost-cutting drives have savaged Western financial institutions, forcing them to scale down or withdraw completely from numerous business lines and activities.

Meanwhile, their non-bank counterparts have expanded to take their place, moving from clients to competitors and transforming themselves into formidable financial powerhouses the likes of which Wall Street has never seen before.

BlackRock's solid growth

There is no better example of this rise of the non-banks than BlackRock, unarguably one of the financial sector’s biggest post-crisis winners. From humble beginnings in 1988 when Laurence Fink and Robert Kapito left First Boston to found an asset management firm, the New York-based company now boasts a total of $3500bn in assets under management as of the end of 2011. Its BlackRock Solutions arm, which provides risk management, investment management and advisory services, caters to client portfolios totalling about $10,000bn.

But BlackRock boasts more than sheer scale. It has effectively become instrumental in managing the US government’s financial sector bailout. It supervises the $130bn portfolio of toxic assets that Washington inherited from AIG and Bear Stearns, has a crucial advisory role in the $1200bn Federal Reserve scheme designed to kick-start the foundering US housing market, and monitors Fannie Mae and Freddie Mac’s balance sheet.

BlackRock also recently announced plans to launch a bond trading platform allowing asset managers to trade directly with each other. It is a move that Moody’s Investors Service has warned could be “extremely detrimental” to global investment banks, and has indeed led to much consternation among the major capital markets players – not that they would publicly admit it, of course.

BlackRock may be the most prominent, but it is not alone. Citadel and Man Group, to name but two, have been underwriting loans for some time, and asset managers with external fund administration and custodial facilities are not unheard of. Concerns have even been voiced over non-banks themselves becoming too big, or as Edward Kane, professor of finance with Boston College, puts it, “too complex and difficult to unwind” to fail. In fact, Mr Kane, a former president and fellow of the American Finance Association and founding member of the Shadow Financial Regulatory Committee, warns that funds may be keen to expand swiftly in an effort to benefit from the insulation from potential downside that such all encompassing operations would create.

Filling the gaps

Currently, the two most striking areas of expansion for non-banks are in the complex world of structured products and in lending to the real economy, both of which have seen a dramatic increase in activity from asset managers since 2008. It is not hard to see why these developments have taken place. For various reasons, banks have scaled down operations significantly in both areas, and for non-banks, filling in where the banks have retreated is both an opportunity to pick up new business and a necessity in providing their clients with services that are harder to come by through more traditional channels. 

Nevertheless, banks would be forgiven for feeling at least a little uneasy as firms that were once wholly reliant on their expertise and services begin to disintermediate them and operate in the kinds of arenas and business lines that were previously their exclusive preserve. Most, however, remain unwilling to discuss the issue. When contacted for the purposes of this article, even the British Bankers’ Association, which describes itself as “the voice of banking and financial services”, said it was still discussing the issue with its members and declined to comment beyond a brief written statement that welcomed competition between banks and non-banks, and stressed the importance of defining the term “shadow banking” and of regulating institutions on a case-by-case basis.

Regulatory concern

Banks are not the only ones with misgivings about the sector’s development. The massive increase in non-bank activity in certain areas of the market has not gone unnoticed by regulatory bodies. A recent European Commission (EC) green paper on hedge funds and private equity argued that every part of the vaguely defined parallel banking sector should be subject to the same degree of regulation as its banking counterparts. The EC's aims, a spokesperson told The Banker, were to “ensure a level playing field between market operators undertaking the same activities, mitigate systemic risk, including by discouraging irresponsible behaviour, and to do this through effective regulation but without imposing any burdens that are not necessary”, because “there shouldn’t be regulatory arbitrage among different institutions doing the same things".

This is hardly a controversial position among law-makers, and is a stance that is rooted in the 2009 G-20 summit, following which participants said in a joint statement: "We have agreed that all systemically important financial institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. In particular, we will amend our regulatory systems to ensure authorities are able to identify and take account of macro-prudential risks across the financial system, including in the case of regulated banks, shadow banks and private pools of capital…"  

The potential for an increase in official scrutiny has funds a little jumpy, too. Blackstone’s credit arm, GSO, has grown to become one of the biggest lenders to sub-investment grade companies on both sides of the Atlantic since the crisis, and is active in financing for acquisitions – a prime example of a non-bank that has benefited greatly from a paucity of weighty regulatory requirements. It remains wary of attracting further attention, however. A source within the fund expressed surprise at the media scrutiny it had garnered in recent months and admitted to worries about attracting further regulatory attention.

Lending a hand

Whatever their ambitions, asset managers are also keen to avoid souring relationships with the banks they are still required to do business with, and most stress that much of their activities are, in fact, nothing new. This is true to an extent. The aforementioned fast-growing pack of non-bank lenders has long-standing roots. In fact, before deregulation and the resultant 'big bang' in the UK banking sector, pension funds and insurance providers used to be heavily involved in precisely this kind of activity, while banks chose to lend predominantly within their short-term liabilities. More recently, funds have played a more specialised role within the credit space – typically, mezzanine or opportunistic investors would concentrate on special situations, such as distressed debt and the like.

Post-crisis developments, however, have been on an entirely different scale and funds and other entities are getting involved in various aspects of lending and debt markets more than ever before.

Part of the reason for this is that incoming Basel III capital requirements make it significantly less attractive for banks to lend on a long-term basis. As a result, many are retreating, and everyone from sovereign wealth funds to pension funds, and even corporates with large bank balances, are flooding into fill the gaps (and improve returns on their cash).

“A couple of my fund clients are quite actively picking up debts which banks are having to sell down because they’re no longer able to get favourable capital treatment by holding certain graded debt,” says Mark Shipman, a partner with law firm Clifford Chance’s investment management office. “There’s fundamentally not a lot wrong with the quality of the debt, it just doesn’t give the banks a favourable treatment from their own capital standpoint.”

Holding an advantage

Aside from being unencumbered by banking regulations, the asset managers and funds have other advantages, too, particularly when it comes to maturity transformation. As a simplistic example, depositors place their money with a bank and can then for the most part withdraw that sum in its entirety on any given day. Funds, however, not only have lengthy prospectuses with multifarious disclosures, statements of intent and conditions, but as a rule, only furnish liquidity to their investors on, at the most, a monthly basis and more commonly, quarterly, semi-annually or even annually.

Closed-ended funds keep money locked up for a number of years. Even the open-ended variety, though, will usually have mechanisms in place to suspend redemptions if returning money is not possible, or have the ability to impose redemption gates, where, for example, only 10% of funds will be released on a quarterly or monthly dealing date. These tools and techniques make the possibility of a ‘run on the (non)-bank’ type situation a practical impossibility.

Popular areas include distressed assets, emerging market assets and private equity, says a head of prime brokerage with a large global bank who spoke on condition of anonymity. “Banks can’t be as nimble or don’t have the risk appetite to get involved in these areas, and because of the current regulatory environment it doesn’t necessarily give them the return on equity or balance sheet that they need. Funds seem to be positioning themselves to take over.”

One such firm is M&G Investments, which launched a UK companies financing fund in July 2009 and has since made £830m-worth ($1.32bn) of loans to UK businesses such as house builder Taylor Wimpey and haulage company Stobart Group. It has also launched a social housing fund, which has raised £200m to lend to UK housing associations – potentially a major upheaval in a field where, M&G says, 80% of funding has traditionally come from just five major banks.

“Since Lehman went under, we thought the banks were going to struggle to provide that sort of credit to parts of the UK economy,” says a spokesperson for the fund, adding that it expects such operations to expand still further. “We have always said we think this is a structural thing, we think it’s unlikely that banks are going to return to provide long-term finance to this market in the foreseeable future, so if this goes well, we’d like to pursue the idea of further funds.”

Corporate action

It is not just asset managers dabbling in credit. Engineering group Siemens, which is Europe’s largest industrial conglomerate and has long had a sizeable financial services arm, set up banking operations in 2010. This was a move that helped it to safeguard itself against counterparty risk at the height of the eurozone crisis when it stashed as much as €6bn with the European Central Bank. However, it now operates quite extensively in small and medium-sized (SME) lending, as well as project finance, and in contrast to the broader banking sector, Siemens financial services itself has expanded staff numbers by 50% to 2600 and total assets by two-thirds to €14.6bn over the past five years.

It is not alone in the corporate world. General Electric, for example, also has a colossal financial wing, with a long history of lending to clients and suppliers, while Rolls Royce has also looked at financing suppliers that might not be able obtain funding elsewhere.

This kind of activity may not have banks particularly concerned. After all, they may not be moving out of the space all together, but they are most certainly de-leveraging and de-risking and concentrating on much less chancy lending activity. 

There will, however, always be businesses on the higher end of the risk scale that require financing, and in order to meet client needs, banks may have to embrace a remodelling of sorts, suggests Mr Shipman, whereby they lend to customers that make sense from a balance sheet and capital perspective, and act in an introductory role in others, setting up existing and new customers with alternative sources of financing. Although that does not mean that this process will be entirely consensual, he adds, and there is no doubt that the banks would prefer to do some of that business if they were not being priced out of the market by stringent regulatory pressures.

A quiet welcome

Lawmakers, in some regions at least, have been cautiously welcoming of these developments. In the UK, the government appears to have had an eye on M&G’s UK companies financing fund when it earmarked £1bn of its £21bn Business Finance Partnership credit easing scheme designed to facilitate lending to SMEs, for distribution through fund managers.

This kind of initiative could be threatened by the EC’s intention to regulate banks and non-banks alike, however. It is a delicate balance at a time when just about every Western economy requires additional sources of lending to help boost fragile growth. And asset managers argue that it is preferable that the risk associated with lending markets is borne by professional investors – whether institutional or high-net-worth individuals – who have willingly invested in fund structures.

“The pendulum could swing too far," cautions the head of prime brokerage at the large global bank. "If a huge amount of institutional money starts chasing real economy lending, there will be more credit than there is demand so the price will drop, and at that point the banks might just leave the institutional guys to it,” he says. “Institutional money can be very fickle, though, as we have seen in 2008 and 2009 when certain asset classes turned nasty. I don’t necessarily think a completely institutional backed lending system is a good thing – institutional money can be very sticky but also at times be very flighty and I would be slightly concerned about it all exiting in a hurry if things got tough again.”

Structured credit

The other prominent growth area for large asset managers, then, is structured credit. Banks once modelled, structured, originated, underwrote, traded and restructured these products themselves. But post-2008, their suddenly less-popular structured finance operations were drastically scaled down and for banks, originating new products was not a popular pastime. But collateralised debt obligations (CDOs) and other securitised products did not disappear, and demand, while somewhat diminished, remains. The investor profile has shifted somewhat to encompass more long-term, unleveraged investors, many of which do not have the expertise and sophistication to deal with these products on their own. Enter a fund manager to act as a fiduciary intermediary.

BlackRock Solutions, for example, picked up a number of very experienced ex-investment bankers from the structured credit world, and has been advising on debt restructuring and been involved in services such as helping value large portfolios of structured credit. Another relatively recent entrant to the market is London-based Cairn Capital, which counts among its staff various former employees of AIG Banque. As with BlackRock, Cairn has a large investment business, but it also helps value, and restructure portfolios – precisely the kind of detailed cash-flow modelling expertise that tended to only exist in the banks before, and is now available externally.

"There are certainly non-bank institutions seeking to perform the role which has traditionally been the focus of the investment banking community,” says Cairn’s CEO, Paul Campbell. However, he adds that the firm’s focus has not been on originating and distributing structured credit. “We are not in the business of making markets between institutional investors, rather providing independent asset and risk management services and advice.”

As with BlackRock's work in Washington, DC, the kind of roles that some non-bank operators have been taking on include helping governments or banks value large portfolios of structured credit. Or perhaps acting in an advisory role when a third-party pension fund or insurer wishes to transact liquidity swaps – whereby a bank borrows gilt-edged securities or US treasuries from a pension fund or insurer and in exchange provides overcollateralisation for certain illiquid assets. In order to do that, typically the pension fund or insurer will want a sophisticated asset manager with a thorough understanding of how the transaction operates, and of how to deal with counterparty default, etc..., to help them price and structure the deal up front.

From a debt perspective, customers often turn to these specialist asset managers rather than the investment banks. “In the past you might have appointed Morgan Stanley and Merrill Lynch to do that job, whereas today you’re going to appoint a BlackRock Solutions or a Cairn Capital,” says Robert Gardener, founder and co-CEO with investment consulting firm Redington Partners.

This too may not be all downside for the banking sector, he adds. In fact, it might help those that still need to further de-leverage their balance sheets. Doing so requires a willing end investor to purchase these products, and end investors are only likely to do that if they feel they have a sophisticated party in their corner on examination and modelling duties.

In the balance

For now, the relationship between banks and non-banks will be, in some ways, a slightly uncomfortable one, but there are potential benefits on each side, as well as to the broader economy, at least judging by the UK government’s encouragement of non-bank lending. However, some level of competition in both the lending and structured finance arenas is inevitable. "I think a natural consequence of more market participants is heightened levels of competition,” says Mr Campbell. “Taking direct lending as an example, non-banks will be a feature of the market going forward, but banks will remain very significant market participants."

It seems likely that there is more to come from the non-banks. Bankers admit that an expected institutionalisation of hedge funds has not progressed at the pace they have feared it might since 2008. “We half expected a number of the larger funds, which were taking on a lot of long-only beta play money, for example, to really embrace the institutional asset management industry and evolve into some form of broker dealer or investment bank-type platform. But they haven’t really moved full into the whole institutional banking side of the service industry,” says a senior investment banker who spoke on condition of anonymity. Although that is no guarantee that their fears will not eventually be realised.

The future of the biggest asset management players and their relationship with banks hangs in the balance. If more non-banks follow BlackRock’s lead, investment banking’s stock could be severely dented by an influx of new players taking them on at their own game. On the other hand, regulatory crackdowns could make asset management giants think twice about getting too involved in bank-like operations if it means they would be subject to the same stringent requirements. Many operators already complain that talk about further regulation for the fund industry is excessive, given the requirements they already have to meet, including the European AIFM Directive and aspects of the US Dodd–Frank Wall Street Reform and Consumer Protection Act.

Others may feel they are stretched a little too thinly and consider selling certain business lines off because the cost of continuing to operate certain services is too cumbersome to carry. Man Group, for example, recently put its banking unit and equity research division up for sale after a series of high-level departures.

The only current certainty is – to resort to a grossly overused cliché – uncertainty. But there is no doubt that in some sectors, changes have been enormous and perhaps irreversible. Recent years have seen banks flinch from the universal provision of services, as they concentrate instead on areas that can best be tackled at the lowest capital cost, and deploy money only where it is most optimal. Once their balance sheets have downsized to the point that they can once again pick the markets and business lines they would like to enter, however, banks may find some areas look very different, with the shadow cast made real, and no guarantee there will be room for them in the markets they once dominated.

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