The Rise and Risks of Lending to Non-Depository Financial Institutions

The following is the next installment in RMA’s Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line.

In 2016, private equity investments in financial technology (fintech) firms exceeded $10 billion across more than 500 companies. As of late 2016, nonbank mortgage lenders accounted for more than half of mortgage loans, and six of the top 10 mortgage lenders were nonbanks. In the wealth management sector, digital and automated robo-advising is growing each year and threatening traditional business models. In its fall 2016 semiannual Risk Perspective, the OCC called attention to loans to non-depository institutions and stated that such loans were up 150% in three years, becoming the fourth largest commercial loan category.

What do these statements have in common? They each reference the increasing importance of nonbanks to all facets of the financial services industry, and the competitive threats they present to traditional banks. While many of these nonbank sectors provide investing, partnership, and financing opportunities for traditional banks, they also create numerous risks, including credit risk.

A broad array of non-depository financial institutions use bank credit, including mortgage, business development, finance and leasing companies, real estate investment trusts, hedge funds, private equity firms, and nonbank consumer lenders, among others. Loan types and structures vary, but typically include warehouse lines of credit, revolving credit facilities, and capital call lines. Apart from unsecured facilities to larger, stronger, and well-capitalized firms (often investment grade), credit to these sectors is generally secured, and frequently with tightly controlled and monitored structures. Borrowing bases are often utilized, tying credit availability to a maximum percentage of the assets being financed.

While credit quality has been strong in these sectors, credit risks can be substantial and can arise from various factors, including:

  • Failure to properly evaluate asset quality in the borrower’s portfolio; for example, lending to a finance or business development company with heavy exposure to highly leveraged businesses. Or financing a real estate investment or mortgage firm with excessive geographic concentrations in declining markets.
  • Underwriting aggressively and outside of industry norms. For example, using advance rates that exceed generally accepted levels or financing asset types that other banks normally exclude.
  • Financing borrowers with very high leverage and little absolute capital, justified by a comfort with their track record and cash flow stability. It’s critical to understand the ability of such borrowers to operate under stressed conditions.
  • Conversely, using looser credit structures for borrowers who appear to be well capitalized, when their underlying portfolios are highly risky and subject to large losses.
  • Failing to properly assess the operational controls of borrowers and their ability to manage complex portfolios and business models. How good is the borrower’s own credit reporting and how well does it monitor its clients? Does it track and share early warning indicators?
  • Failing to properly assess the quality and quantity of investors when providing capital call facilities backed by committed capital.
  • Not understanding the borrower’s own credit policies, underwriting standards, and exception trends.
  • In secured facilities, overestimating collateral values and not adjusting advance rates to market conditions.
  • Not recognizing and/or not structuring around significant concentration risk in the borrower’s business, which could be any combination of single obligor, sector, geographic, or asset type.

In addition, reputational risk is always a factor to consider when lending to non-depository financial institutions. If the borrower is financing risky clients, this could create reputation risk for the bank involved, particularly in a workout situation. Therefore, it’s important to understand the sectors and specific clients being financed. A good rule of thumb is if a bank would not lend directly to the end borrowers, then it should think twice about lending to the entity directly.

There are undoubtedly other credit risks not indicated above. However, this list serves to outline some of the principle risks and to demonstrate that successful lending to this broad sector requires industry knowledge, effective underwriting standards, significant due diligence, and ongoing monitoring. Consistent with broader trends during recent years, banks have enjoyed strong credit quality in these sectors, but that could change, and understanding these key credit risks is important to any institution with exposure to these industries. 

Please look for the next Industry Insight on Tuesday, August 15, Managing Risk in Indirect Auto Portfolios.

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