The post-crisis years saw the ascent of non-bank or "alternative finance", and practitioners remain upbeat. But if rates rise further, or economic conditions tighten, what do they say about the risks?

Almost a decade after the bankruptcy of Lehman Brothers helped precipitate the 2008 financial crash, conventional bank lending has recovered but not to the heady days before the crack-up. And with tighter capital rules and compliance splurges, upstarts are treading on banks’ hunting grounds.

The world of alternative credit, sometimes known as private credit, private debt or “shadow banking”, covers a multitude of areas in different parts of the world. To take one example, there has been the ascent of peer-to-peer lending platforms (P2P), where internet-driven networks have enabled potential lenders and borrowers to join hands although without the customary deposit-protection backups of regular banks. Such loans often involve property as collateral – the P2P sector hasn’t yet been tested by a recession. (To see a feature by this publication back in November 2015, see here.)

Other parts of the jigsaw puzzle are credit funds, including hedge funds and they provide lending in specific spaces. Volumes are large. According to Willis Towers Watson, alternative credit stood at $139 trillion at the end of 2016, with investment-grade corporate bonds – “mainstream credit” – at $59 trillion. Another report by the organisation ARES (Opportunities in Global Direct Lending: A historical and prospective view of the US and European Markets, April 2018), explained why bank consolidation and rise of non-bank lenders had come to pass. That report estimated that the size of outstanding middle-market direct loans in the US to be $910 billion, and around €120 billion ($141.3 billion) in Europe. It says there are more than 50 direct lending managers in Europe (150+ in the US).  

With P2P lending, the totals involved aren’t in the same bracket as the credit funds space, but not to be dismissed lightly. The cumulative total lending volume via this channel rose over £7 billion ($9.34 billion) by the end of 2016 (source: Peer2Peer Finance News, January 2017). 

The peer-to-peer space continues, although possibly some of the media hype around it has faded. Recent UK government measures have sought to underpin it, such as making P2P loans eligible in retail funds, a way of taking this “niche” mainstream. The Innovative Finance Individual Savings Account, a retail fund widely used, was rolled out in 2016 and peer-to-peer activities are eligible investments. 

What is the potential and the dangers?
“I think there are a lot of untapped opportunities for specialist, niche lenders to be successful and I am slightly surprised we haven't seen more innovation in the lending side of the industry, or at least outside of the consumer finance space,” Jake Wombwell-Povey, chief executive at Goji, a UK firm providing information for the sector, told WealthBriefing in a recent interview. Alternative finance platforms that it tracks include Funding Circle, Lendinvest, ArchOver, ThinCats and Rate%Setter.

Perhaps unsurprisingly, Wombwell-Povey is bullish on the sector.

“When you have a look at the platforms themselves, I see huge potential for platforms to partner with incumbents or partners to grow into new segments and products and thereby grow their scope and scale. But when you look at the investor side of the market, we at Goji see the most potential for growth in the financial advisor space - both advisors and their clients are looking for something to help them achieve steady income with low levels of volatility and correlation to their existing portfolios - in today's market with low interest rates, growth and high equity valuations it's difficult to find that sort of profile amongst traditional investments so alternative finance has really come into its own,” he continued. 

The financial crash is almost a decade ago, and memories can fade. So what could happen as and when interest rates rise to more normal levels? 

“If interest rates increase, the whole financial space would be impacted, both traditional banks and fintech lenders,” Ricardo Fernandez, chief marketing and sales officer at Prodigy Finance, a very niche player indeed: providing finance for post-graduate students. As the firm lends with a floating interest rate, its margins would not be hit if interest rates rise, Fernandez said. 

However, Fernandez said there low-rate environment is positive for fintech lenders because they can beat the yields of traditional lenders. “I’d expect increasing adoption of investing via such platforms as RateSetter and Funding Circle in the UK, especially when there is heightened volatility in equity markets.”

Wombwell-Povey is sanguine on the interest rate question. “The way I often think about interest rate scenarios is to remember that most lending and savings products are linked to the base rate or Libor. So if the base rate increases 100 basis points then the rate paid on deposits, and the rate paid on credit, is likely to increase by the same 100bps. So, making a return on lending should always have that 350 - 700 bps premium (depending on the risks involved) over putting your money in the bank,” he said.

“The real question I think is what happens when the bank rate exceeds the rate of inflation, and investors can park their cash in bank without worrying about their wealth being eroded in real terms. For example, if the bank rate was four per cent, inflation was two per cent, then most banks would probably pay three per cent on deposits meaning many investors may not look to put their money elsewhere regardless of how much money they could earn. Now the return you may get on relatively low risk lending could be eight per cent-ten per cent but a huge number of low risk investors wouldn't look beyond their bank,” he said. 

Risk, rewards
Of course, one reason for the superior yield on offer is that P2P don’t receive state-backed protection for depositors if things go wrong, so the additional yield is reward for the additional potential risk of loss to creditors. 

And that leads to the need to reiterate how such non-banking lending in some ways is a push away from the “moral hazard” of state-bailouts, as creditors must scrutinise borrowers rigorously, and spread risks, to protect their own pockets. 

The ascent of direct lending, peer-to-peer activity and other non-bank approaches is also part of a wider hunt for yield and diversification seen in the wealth management space. Family offices, to take one example, increasingly talk of the merits of direct investing and bypassing funds and intermediaries altogether – so long as they can afford the time and effort for due diligence.

Sometimes non-bank lending is dubbed “shadow banking” and in certain countries, such as China at present, the term is decidedly unflattering because it carries connotations of poor oversight and lack of transparency. (In 2016, a top executive at Chinese conglomerate Fosun, which has bought a number of European private banks, dubbed P2P in China as “basically a scam”. Click here to read about problems with this sector in China.) 

Clearly some of the fault-lines that might exist in more developed economies such as the UK will only show up when economic conditions darken. For the time being, it appears there remains appetite in this space.