Brexit: Has it created a unique opportunity for alternative finance providers?
September 2016 | EXPERT BRIEFING | BANKING & FINANCE
The UK referendum result has caused uncertainty in the financial services industry, but could this be a time of opportunity for alternative capital providers?
Alternative capital providers are generally non-bank lenders or intermediaries to lending by non-banks. Some are regulated, while others are not. Alternative finance embraces lenders from the smallest participants in peer-to-peer platforms to multibillion dollar global direct lending funds and they cover diverse product areas such as leveraged finance, real estate finance, factoring, supply chain finance, leasing, consumer lending and trade finance, but not, for example, lending to investment grade corporates.
The referendum has a number of actual and potential consequences for the alternative finance industry.
The actual consequences are that the referendum result has caused political and economic uncertainty in the UK and the broader European Union. Sterling has declined against the US dollar and to a lesser extent against the euro. Some hard assets that depend on a stable business environment, such as UK commercial real estate, have declined in value. The UK has been downgraded by several credit rating agencies. Based on comments from the governor of the Bank of England, there appears to have been some disruption in the ability of UK banks to access funding in the international markets.
Beyond the actual consequences, there are many potential consequences that are harder to evaluate. These consequences are influenced by many other factors. It appears that growth will slow in the UK and, to a lesser extent, the EU. This may lead to a recession in the medium term, at least in the UK. The fall in sterling will make imported goods more expensive in the UK and sterling exports from the UK cheaper to international consumers. Firms operating from the UK in some sectors, including financial services, may have reduced access to European customers. Uncertainty as to how much this access will be reduced (for as long as this lasts) is likely to make the UK a less attractive place for international businesses to establish themselves if they wish to access the broader common market. When it leaves the European Union, which appears likely to occur in 2019, the UK will lose the ability to influence European regulation, but may be able to cut its own path in some areas of its own market such as, within the broader Basel framework, bank capital regulation and domestic financial services. The UK has tended to be a voice for liberalisation of the financial services industry within the EU and it remains to be seen how the European regulatory environment will develop once its influence is removed.
So what could this mean for alternative finance? Alternative finance depends on two key inputs – the availability of other attractive investment opportunities for the people and institutions which fund the alternative finance industry, and the level of competition from banks and other mainstream finance providers in the lending market.
It appears quite likely that Europe (and the UK in particular) will experience ongoing economic and political uncertainty for the next few years. This, along with many other factors, may mean that equity markets remain volatile and certain sectors, including the real estate sector, for example, will continue to be challenging. Central bank programmes appear likely to drive down yields on conventional fixed income investments, such as deposits, and yields on government bonds may well stay low. A lack of attractive investment opportunities has been a key factor in pushing investors into alternative finance and Brexit looks likely to have a negative effect on conventional investment for relatively risk-averse investors. A low interest rate environment means the meaningful spread between the net yields available on alternative finance platforms on the one hand and bank deposit rates and government bonds on the other are likely to prevail for longer.
Some key advantages of alternative finance investment opportunities are that they can be relatively short dated, such as investments in receivables finance where money may be on risk for as little as 40 days, and yields are not closely correlated to market asset values. This can be attractive in uncertain times. If 10-year gilts paid a coupon of 5 percent and were not subject to major fluctuations in market value, fewer private investors would be interested in making peer-to-peer loans, which are both more time consuming to implement and riskier.
Banks and regulated asset managers will bear the brunt of the regulatory uncertainty caused by Brexit. A regulated institution may lose its passport to operate in a particular jurisdiction, but an unregulated activity is unlikely to become regulated as a result of Brexit. The aftermath of the financial crisis saw some jurisdictions that have traditionally limited the access of unregulated institutions to their lending markets, such as France and Italy, increase access for foreign alternative capital providers in some areas through products such as mini-bonds. This is unlikely to change as a result of Brexit. A lightly regulated institution may also be able to establish itself more quickly in a new jurisdiction than a bank, if it is necessary to develop a physical presence. Interestingly, the UK is the first country to develop a bespoke regulatory framework for peer-to-peer and equity crowdfunding platforms. In other markets, these platforms have often been shoehorned into existing regulatory frameworks, unnecessarily stifling this form of alternative finance.
If it becomes harder to raise capital on a cross-border basis in Europe, this may be harder for all participants, conventional and alternative, but fundraising activities by alternative capital providers seem generally to be focused on small numbers of sophisticated investors in specific jurisdictions and may not be significantly affected. Banks that are subject to credit rating downgrades are likely to experience an increased cost of funds raised from private sources, such as the interbank market, and possibly a withdrawal of deposits. This will affect their ability to lend at competitive rates.
Alternative finance is particularly focused on smaller borrowers, such as start-ups, SMEs and consumers. If these segments receive less attention from banks, it can only be a good thing for alternative capital providers. There was a clear trend for banks to retreat in some of these areas prior to Brexit due to factors such as changing regulatory capital standards. This trend may be more likely to continue – particularly if there is a recession. Banks are likely to continue to prioritise their better and larger customers and cut costs in order to deliver higher returns on investment for their shareholders.
In summary, Brexit is unlikely to slow and could well accelerate the growth of alternative finance alongside the conventional banking sector as investors continue to seek attractive short term returns and sound borrowers do not have access to more cost-effective finance from conventional sources. Provided that this does not lead to significant losses by investors, and particularly retail investors, this diversification of finance may bring some benefits for the broader economy.
Nick Stainthorpe is a partner at Reed Smith. He can be contacted on +44 (0)20 3116 2939 or by email: firstname.lastname@example.org.
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