Since the financial crisis authorities have stated that they want asset owners and managers to play a bigger role in the transmission of savings into the real economy. As longer-term and much lower-leveraged entities, they tend not to run the same risks as banks. The argument was made in a 2013 Green Paper from the European Commission on “Long-term Financing of the European Economy”:
The diminished role of banks in long-term lending opens up new needs and opportunities for other financial institutions […] The long duration of their liabilities allows institutional investors, at least in principle, to make buy-and-hold investments in long-dated productive assets, achieving higher yields to offset longer-term risks and lower liquidity inherent in many of these assets. Their longer time horizons enable institutional investors to behave in a patient, counter-cyclical manner, restraining “short-termism” and reducing the need for maturity transformation.
As the Green Paper suggested, some of these bank-disintermediation opportunities can generate the yields required to meet multi-decade insurance and pension liabilities for which government bonds are no longer adequate. As such, the life and pensions sector in particular has increased its allocations to private-placement corporate bonds, high-yield, securitized lending, and private debt and mezzanine. In addition to partnering with asset management institutions, some asset owners are moving their balance sheets directly into liquidity-provision and lending, across asset-backed, loan, real estate and corporate markets. The shadow banks of the pre-crisis world are giving way to the shadow banks of the post-crisis world: insurance companies, pension plans and direct lending funds.
These opportunities come with challenges. Some are associated with the bank-disintermediation opportunity itself: for example, the staffing and infrastructure requirements can make banks unwilling to cede ground and institutional asset managers unable to take it. Others arise as banks withdraw from certain activities: some fixed income markets are now harder to trade in because banks cannot afford to hold large inventories of bonds on their balance sheets, for example.
In this paper we identify some of the major opportunities and challenges that have arisen across a range of asset classes and strategies, and describe the new landscape that investors now inhabit. We divide our survey into three areas of opportunity: engaging in activities that banks are no longer able to; helping banks shrink their balance sheets; and seeking to exploit more attractive risk premiums in markets where banks have withdrawn from activity.
Investors and the Changing Banking Landscape: A Snapshot
|“Investors can…”||Key Regulations||Asset Class / Strategy||New Opportunities||New Challenges|
|“…engage in activities that banks are no longer able to.”||Volcker Rule||Hedge Fund & Private Equity Secondaries||Restrictions on banks owning interests in hedge funds and private equity funds are forcing sales into the secondary markets|
|Hedge Funds||Restrictions on proprietary trading are sending trading talent into the fund industry||Ex-bank traders may not have good buy-side relationships or a non-bank desk track record|
Interagency Guidance on Leveraged Lending (Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency)
|Specialist Direct Lending||Capital adequacy and proprietary trading restrictions have led to withdrawals by banks from niche lending opportunities such as lending against royalty streams|
|Private Debt Direct Lending||Private debt can replace bank debt in deals that exceed Interagency Guidance on leverage thresholds|
|Mezzanine & Preferred Stock Financing||Mezz and preferred stock can bring deal leverage below threshold, unlocking bank debt|
|Private Equity Co-investment||Equity can bring deal leverage below threshold, unlocking bank debt|
|Dodd-Frank X & XIV||U.S. Residential Mortgages||Many creditworthy individuals struggle to get mortgages because they are no longer eligible for agency MBS inclusion||Mortgages still need to be originated.
Mortgage administration is very staff and infrastructure intensive compared with trading in MBS
|“…help banks as they shrink their balance sheets.”||Basel III||Private Debt Direct Lending||Capital adequacy rules are causing banks to shrink their assets, leaving a “lending gap” that investors can fill through direct lending, either self-originated or via partnerships with originating banks||Loans still need to be originated. Loan administration is very staff and infrastructure intensive compared with trading in securities such as CLOs, CDOs or bonds|
|CLOs||As in previous balance sheet-shrinking cycles, securitizing bank loans and other assets can remove them from capital adequacy calculations||Risk-retention rules have made securitization balance sheet-intensive for CLO structuring entities, too|
|Hedge Funds||Regulatory-capital strategies can be designed to transfer some of the risk of banks’ assets to hedge funds, in return for a premium, without the risk-retention constraints of a traditional CLO. Hedge funds may replace banks as providers of various capital-markets or risk-transfer services: writing put options is just one example|
|High Yield Bonds & Loans||We think that the high-yield markets will continue to grow and change profile, especially in Europe, as corporates increasingly turn to capital markets rather than banks.
Bond and loan terms are converging as more corporates use both routes to raise capital, giving combined bond-and-loan investment platforms an edge
|Covenants are loosening in loans as they become more bond-like.
Bond investors attempting to address the loan market, and vice versa, may lack the scale and expertise to do so without a genuinely integrated platform
|“…take advantage of risk premia that may be more attractive now that banks have withdrawn from certain activities.”||Basel III
|Private Debt||Now that banks are less inclined to hold loans on balance sheets, even in volatile markets, higher premiums may be on offer for private liquidity providers|
|Hedge Funds||Tighter capital-adequacy rules and constraints on proprietary trading mean banks hold lower inventories of securities as liquidity buffers for markets, and can provide fewer risk-transfer services, resulting in pricing anomalies that can be exploited by arbitrage strategies||In credit markets, the same tightness in liquidity can result in higher trading costs that make such short-term opportunities expensive to execute|
|High Yield Bonds||As banks hold lower inventories of securities as liquidity buffers for markets, private debt funds or credit funds with longer investor lock-ups may be able to harvest higher illiquidity premiums, especially during market sell-offs||For traditional funds that offer investors liquidity at short notice, these more illiquid markets are a risk to be managed rather than an opportunity to be exploited|