While banks groan under the weight of regulation aimed at making the financial system safer, non-bank lenders that have emerged since the global financial crisis operate in a comparatively soft regulatory environment.
Unlike banks, private real estate debt funds are not bound by Basel Committee capital adequacy requirements or ‘slotting’ rules. While banks are funded through customer deposits or wholesale funding, private debt providers typically raise their capital from the institutional market – meaning they are not deemed a systemic risk.
“Debt funds don’t give investors money back until the end of the fund’s life,” says Dale Lattanzio, managing partner of debt fund manager DRC Capital. “This is typically eight to 10 years – far in excess of loan-making. It is unlike a bank where, theoretically, depositors could ask for their money back at any time.”
All real estate funds, including debt funds, are subject to the EU directive on Alternative Investment Fund Managers Directive (AIFMD), which lays down rules for the authorisation, ongoing operation and transparency for managers of alternative investment funds.
They must also report to clients in line with the EU’s newly implemented Markets in Financial Instruments Directive II (MIFID II), which is designed to inject more transparency into virtually all aspects of trading and applies to all types of investors within the EU. There is no major impact for private debt funds as they already provide the necessary data, some say.
In the UK, the Financial Conduct Authority governs to whom debt funds can market their products and how they can market them. In practice, most debt funds target professional institutional investors, including pension funds and insurance companies, which are, in turn, governed by their own set of regulations.
Debt funds are, therefore, among the least regulated of all alternative lenders as they use private capital and not money from the savings accounts of unsophisticated investors, like some peer-to-peer (P2P) lenders.
The part of the market into which retail money is invested is coming under increasing scrutiny from regulators, however, with some platforms in the wider P2P space having already failed.
Spanish platform Comunitae, which financed SMEs, ceased operations indefinitely last year due to fraud, according to a report in newspaper El Español, while UK lender RateSetter was forced to take over borrowers advertising group Adpod and Vehicle Trading Group, to protect investors from losses on loans, according to the Financial Times.
Former regulator Lord Adair Turner, the chairman of the UK’s Financial Services Authority until its abolition in March 2013, criticised the P2P industry in 2016, specifically the quality of credit checks on borrowers, stating that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses”.
However, the sector, which matches borrowers with lenders through online platforms, continues to grow. In 2016, the P2P property lending model generated £1.147 billion (€13.5 million) which represented an 88 percent annual increase, according to the fourth annual UK alternative finance industry report by the Cambridge Centre for Alternative Finance. All the while, regulation of P2P business is still being moulded.
In the UK, all P2P lenders are regulated under the same umbrella despite a wide spectrum of platforms – from consumer lending to SME. P2P lending is a varied practice, taking in secured and unsecured lending, with property P2P platforms normally securing a first charge. Others take credit risk on the borrower, while the likes of Octopus Property co-invest, taking the first-loss piece.
In the UK, P2P platforms must possess a FCA licence, which the majority now have. The FCA created a new P2P category after taking over the management of consumer credit from the Office of Fair Trading in 2014, and has been working to understand various P2P business models over the past few years as part of a process to grant full authorisation.
Regulation relates mainly to consumer credit, individual borrowers and small retail investors, from where P2P lending began in 2005. Regulation is less specific when it comes to real estate lending.
“There are various things we have to adhere to including capital adequacy ratios, albeit substantially lower than the level banks have to hold; it depends on the size of your active loan book,” says Brian Bartaby, founder and chief executive of Proplend. The real estate finance platform writes SME and secured property loans between corporate borrowers and lenders, which are a mix of individuals and institutional investors. P2P platforms in the UK are subject to financial resources requirements, implemented by the Financial Conduct Authority.
“What the FCA is concerned about, because we aren’t party to loan contracts, is that our corporate money is kept separate from our client [investors’] money and we have a standby servicer available if Proplend was to fall over, in order to manage out the loan book and ensure that lenders get their money back,” Bartaby says.
The FCA is due to publish an update on initial regulation on crowdfunding, to address the difficulty for investors to assess the risks and returns of investing on a platform as well as compare between different platforms, among other things.
“Some P2P platforms can be quite opaque in terms of how they work and how much risk investors are taking. In many cases, the end investor chooses individual loans to invest in; with our platform, investors’ capital is spread over a number of loans in order to give greater risk diversification. If you’re dealing with an unsophisticated investor, it seems inappropriate for them to make a lending decision and pick one loan over another,” says Ludo Mackenzie, head of commercial property at Octopus Property, which runs institutional debt funds as well as a P2P platform.
One private debt fund manager questions whether investors in P2P understand the illiquidity of the assets they are buying into: “The risk in buy-to-let lending is different from that of residential development lending, for example. Do investors know it can be difficult to get their money back when they want it? When the system is not working well you can’t easily sell – that needs to be disclosed properly.”
Some in the industry would welcome greater regulation of the P2P sector. “The P2P world is clearly a wide spectrum,” says Mackenzie, “some lenders operate with a huge amount of experience, stable platforms and a long-term outlook. At the other end, there are opportunistic lenders that have a short-term outlook and operate with weaker credit standards. There’s a risk that smaller platforms don’t generate enough revenue and profit to survive, which creates a legacy problem. Tighter regulation would increase the barriers to entry, making it harder for inadequate platforms to exist at all.”
While the fledgling P2P sector is heading for greater regulation, there is nothing obvious for regulators to clamp down on within the private debt fund market. “It’s not appropriate to regulate LTVs – there’s a place for mezzanine funds – and who they raise money from is already heavily regulated,” points out Mackenzie.
And with banks’ regulatory obligations growing ever greater, the advantage held by alternative lenders looks set to improve further. As part of an update on Basel IV regulation last month, it was announced that banks will be limited in the use of their own internal models to calculate risk-weighted assets and a relatively high capital floor of 72.5 percent will be phased in. If banks’ capital costs increase, the disparity in the cost of lending between alternative and bank lenders will widen, while certain areas of business could no longer prove attractive to banks, creating scope for challengers to branch out.
WHAT IS MIFID II?
The European Commission’s Markets in Financial Instruments Directive II
Applicable as of 3 January 2018
Applies to all types of investors within the EU
Designed to inject more transparency into virtually all aspects of trading
Private debt funds must undertake reporting to clients in line with MIFID II