Amid banking disruption, everyone wants a piece of lending
August 11, 2023 | RSM US LLP
Liquidity within the financial institutions industry is drying up so quickly that the landscape will soon look like an Arizona desert. The speed and magnitude of interest rate hikes, the Federal Reserve’s persistent reduction in its balance sheet, and multiple bank runs have left businesses and consumers sitting in a tight spot of uncertainty. Further contributing to the liquidity crunch are products with more attractive yields, such as money markets, that have triggered an acceleration in the flight of deposits.
The traditional banking sector is looking more and more like a punching bag every day as it takes continuous hits to its liquidity metrics. The most recent data, through March 31, shows a 20% year-over-year decrease in liquidity ratios for all insured institutions, per the Federal Deposit Insurance Corp. As of July 31, call report data showed the trend of liquidity deterioration continues, with those liquidity ratios dipping by another 4% in the second quarter.
Despite the telling metric already hitting a double-digit decrease, the ratio will further deteriorate as the Treasury issues approximately $555 million worth of bonds throughout the summer to help replenish its coffers.
Financial institutions have weathered the storm for some time, but in Q1 2023 their dominance in the lending market showed the first sign of lessening since the 2007-09 financial crisis. Lending decreased for the first time since the start of the pandemic, with banks shedding $15 billion of total gross loans off their balance sheets, signaling to nonbank lenders that there is ample opportunity to make an entrance and take market share.
Furthermore, the Fed’s second quarter senior loan officer opinion survey results showed tighter loan standards and weaker demand for major loan segments, such as commercial real estate, residential real estate, commercial and industrial, consumer, and others. Banks reported that conditions will continue to tighten for the rest of 2023 due to the uncertain economic outlook, expected deterioration in collateral values, and of course, deterioration in liquidity positions.
Private credit’s golden time
One segment that could play a significant role at this moment is private credit, which is increasingly used as an umbrella term that includes traditional direct lending, buyout financing, real estate and infrastructure debt. Because private credit can be seen as being everything to everyone, it’s natural that everyone wants in. Over the past few months, traditional asset managers, hedge funds, sovereign wealth funds and venture capital funds are piling into what is now a must-have product. Private equity funds also doubled down and grew their private credit allocations or launched specialty credit vehicles. According to Bloomberg, 67% of institutional investors plan to increase their allocation to the asset class by 2025.
The uptick in private credit is merely a function of broader macroeconomic conditions. When interest rates increase, valuations lose their froth, exit opportunities stall, and banks tighten their lending requirements, private credit is often seen as the answer. The private credit market has tripled since 2015, to $1.5 trillion, according to Bloomberg, and could grow to replace as much as $40 trillion of the debt markets. Institutional flows to private debt funds exceeded $200 billion for the third time, as PitchBook fundraising activity shows below.
While the floating rate basis and short-duration credit are attractive to managers looking to deploy capital in the current economic conditions, private credit is not without risk. For example, direct lending market defaults have already reached $1.7 billion this year. Moreover, according to a survey from Proskauer Rose LLP, 76% of executives of global private credit firms expect portfolio defaults over the next 12 months, a percentage way up from 31% just last year.
TAX TREND: Private credit
If you are considered a foreign person by the IRS’ definition, and you are employing capital to a private credit fund, you may be subject to taxation under the U.S. tax regime. A fund that lends money on a regular and continuous basis in the U.S. will generally be treated as conducting a U.S. trade or business. Income generated in connection with a U.S. trade or business is considered effectively connected income (ECI), generally taxed at the graduated rates.
Alternatively, a fund that buys loans in secondary and tertiary markets is commonly not treated as conducting a U.S. trade or business, so the income generated would not be considered ECI. However, it may fall under the fixed, determinable, annual or periodical (FDAP) category. FDAP income is generally subject to a 30% rate of withholding unless the foreign person qualifies for a reduced rate under a tax treaty.
Specialty lenders want in, too
Specialty lenders may be in a position to capitalize on the tightening of credit by traditional financial institutions. In the Federal Reserve’s 2022 Small Business Credit Survey, respondents said they turn to nonbank specialty lenders for two main reasons: speed of decision and chance of being funded. In this survey, 24% of respondents indicated they used a nonbank financial services provider. This is up from 21% in the 2021 survey. Specialty lenders, particularly fintechs and companies that have partnered with fintechs, have established data-driven underwriting and credit evaluation models that enable near-instantaneous decisions. Shortening the decision-making process and providing borrowers with quicker access to capital is a competitive advantage.
Many specialty lenders have developed a niche lending to a particular population, such as customers who might not qualify for traditional loans. Commercial lenders may serve certain industry segments (hospitality, construction, etc.), while consumer lenders may serve specific demographic groups. This niche expertise can help assure borrowers that the lender understands their specific needs and has a track record of providing capital on terms that are manageable for their business or personal situation, thereby providing a more personal and tailored borrowing experience.
Another critical reason specialty lenders may be able to gain market share in the current environment is their ability to manage risk, specifically credit and default risk. In addition to making data-driven underwriting decisions, successful specialty lenders need robust debt servicing and collections functions. These capabilities position them to mitigate the risk inherent in accepting borrowers who no longer meet the credit profile of a traditional lender.
Risk management is key
In this opportunistic environment, nonbank lenders need to watch out for the credit deterioration that normally side-saddles looser underwriting requirements. History has shown larger defaults related to private credit loans when compared to loans underwritten by traditional banks.
CONSULTING INSIGHT: Credit risk management
Financial institutions often struggle with credit risk management because they lack the necessary workforce to manually review and document critical processes. An effective credit review function remains one of the most effective elements of the credit management framework. Learn how RSM can address your credit risk issues and streamline your processes to increase efficiency and confidence.
Stiffer regulatory requirements are a pivotal difference between traditional institutions and private credit. In the wake of the 2007-09 financial crisis, the entire ecosystem went through a gritty process of tightening underwriting standards and ensuring that the loans originated were truly fortified. Adapting to those stringent rules allowed traditional banks to enter the current difficult environment from a position of strength. Years of hard work and diligent underwriting requirements have led to bank portfolios with low loan-to-value (LTV) and solid debt-service coverage ratio (DSCR) metrics. Other lending companies were not subject to the same regulations and consequently are more at risk as they take over lending market share.
To mitigate potential downsides, nonbank lenders should consider sound risk management procedures, such as the implementation of a formal credit review process that includes:
- Assessing customer concentrations and identifying the true risk present in each unique portfolio
- Analyzing integral metrics such as LTV, DSCR and debt-to-income, as well as collateral determination and guarantor details, to better evaluate the borrower’s ability to repay the loan
- Identifying and addressing potential problem loans early on, to facilitate a beneficial conclusion while leaving charge-offs and losses at the door
Nonbank lenders have plenty of opportunity to move further into the private credit space, but diligence and caution are critical to their success.
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This article was written by Brandon Hollis, Angela Kramer, Nelly Montoya and originally appeared on Aug 11, 2023.
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