Shadow Banking – Lending is no Longer Just for Banks

While the name ‘shadow banking’ invokes something dark and mysterious, it simply means unregulated lending activities by regulated entities or non-bank lenders.

Q: What does this exactly mean, and how did shadow banking come about?

A: Since the credit crisis of 2007 and 2008, regulatory changes to the banking system have occurred and sweeping changes have brought opportunities in this zero interest rate environment. In Canada, some of the first to act were private lenders who would underwrite mortgages and were institutionalized to take on new partners and sources of capital in order to finance new construction seen in our urban centres. South of the border, peer-to-peer lending groups, many that are online, were created to fill the vacuum left by the banks exiting the consumer lending business.

In both cases, these areas are being driven by the investor’s growing demand to obtain a yield higher than current interest rates, the corporate desire to borrow, and the consumer’s need for funding.

The lenders in this sector operate across a diverse marketplace which includes: direct lending, mezzanine finance, distressed debt and various strategies which assist in supporting bank loan portfolios.

Q: How big is this market? A: We have seen recent estimates that this market exceeds $75 trillion globally, with private debt funds amounting to $450 billion. Taken in context, the market capitalization of Apple exceeds $700 billion alone!

Q: Who is providing the money to this sector? A: Many of the world’s pensions and sovereign wealth funds are bridging the funding gap by investing in this area, either directly, or in most cases through alternative credit funds. Non-bank lending is growing at a very strong rate with the funds enjoying the support of institutional investors who have a medium to long-term horizon.

Q: Is there a typical time horizon? A: Given the illiquidity of the underlying investments, there are typically two types of structures used. A closed-end fund is similar to private equity, which has a commitment and harvesting period with a time horizon ranging from 3 to 7 years in duration. In other cases, the fund may be open-ended, but requires a notification period of between 45-90 days and minimum investment terms of a year or greater. In either case, the potential for yield and total return is at this point higher than traditional public debt sources such as bonds.

Q: Do these funds employ leverage? A: These funds typically employ either no leverage or low amounts of leverage (unlike the banks that used to be the key lenders in many of these areas with ratios up to 40 x). There is significant oversight and regulation of this industry which provides not only investor protection but reduces systemic risk.

Q: How does one access these alternative lenders? What is the process for investment? A: At Northland Wealth, we currently employ many of these strategies within client portfolios. We initially look through our vast network for managers who not only exhibit institutional quality characteristics but who also possess an informational and operational edge in a sector or area in which we want to gain exposure. We then complete significant due diligence (reviewing the manager, performance, operations, compliance, legal conditions of the fund, etc.) before we commit capital. However, we understand that the work does not end there - continued review and oversight is imperative to ensure that the original investment thesis and rational was correct.

Q: Is the shadow banking system going to disappear? A: While the future is always uncertain, given the forecast for low interest rates, investment in non-bank lenders should be a strong consideration for families that require a combination of yield and return not dependent on public markets. This area is not likely to disappear any time soon.

Arthur Salzer, CFA