Easing The Squeeze: The Rise in Popularity of Alternative Financing
Banks across Europe are increasingly seeking to minimise their exposure to corporate credit risk by reducing their portfolio of “relationship lending” clients. According to a European Central Bank report from April 20041, commercial banks are doing more than just maintaining their interest rates; they are also lending smaller amounts for shorter periods, demanding more collateral, and imposing stricter covenants. The report showed that the tightening of credit standards has settled but is still steadily increasing.
European businesses have, however, to obtain their liquidity from somewhere. There has been much talk of a consequent enthusiasm for alternative financing tools ranging across securitisation, leasing, private equity, mezzanine arrangements, etc.
In order to understand the financial priorities for UK and European companies over the next 18 months, Siemens Financial Services recently commissioned research amongst senior financial managers at the top 1000 European companies. Specifically, the research sought to:- understand the key financial priorities of European businesses to the end of 2005; and to gauge the proportion of current relationship bank lending that would switch to alternative financing techniques by 2005.
Relationship lending is defined by Prof Otmar Lessing in a speech to the European Central Bank2 as “where banks and their customers build up agreements on terms of credit, implying… secured access to credit lines at pre-set prices.” Relationship lending therefore effectively cushions a bank’s customers against liquidity or interest rate shocks. In the case of a drop in cash flow, a firm can draw on a credit line that has previously been negotiated. Of course, the firm pays what amounts to an additional premium in order to benefit from this insulation.
So what is suppressing the availability of such relationship lending? The obvious first factor is the economic slowdown that has affected European nations to a greater or lesser extent. Even in the UK, held up as the most robust European economy at present, company insolvencies may have fallen (-8.3 per cent) since their early 2003 peak, but according to business analysts Marketscan3 the proportion of UK growth companies at April 2004 had virtually halved compared to the previous year. In Germany, business insolvencies in 2003 were sharply up (+5.5 per cent), and the trend was still upward for the first quarter of 2004. France fared even worse, with 2003 increase in business insolvencies of +6.5 per cent.4
Basel II is also having an effect even prior to its required implementation at the end of 2008. First, banks are testing their internal rating systems in order to build up a body of reliable data that will help prove the efficacy of these internal credit rating models, allowing them to persuade the regulator to reduce their capital adequacy requirements. Secondly, the advantage (in terms of lower capital adequacy requirements) which well organised European banks can gain from improving their corporate credit risk assessment is considerably less than that repaid by similar efforts on the retail banking side, a fact likely to lead to the continuation of less sophisticated, blanket credit policies, especially regarding SMEs where smaller earnings are often not deemed to justify manual credit assessment.
A glance at a range of top banks in the UK, France and Germany, Europe’s three largest economies, confirms that the majority are reducing their relationship lending portfolios5. Leaving aside banks that have recently grown through acquisition or merger, examples of standard loan volume changes 2002-2003 range from -1 per cent (UK), through -15 per cent (France), to as high as -28 per cent (Germany).
Many banks are, however, aiming to retain an income stream by arranging alternative credit arrangements themselves. In their Commercial Lending Market Overview, research organisation Celent remarked that, “Banks are less likely to hold onto assets and therefore beginning to look to secondary markets to unload distressed debt and lower their exposure… There is a push for greater liquidity in the secondary market to lower portfolio risk during today’s turbulent times.” It is also worth quoting from Hypovereins Bank’s 2003 annual report, which states that, “Corporates & Markets cut €25.5bn from its total risk-weighted assets as part of the 2003 transformation program, while simultaneously minimizing the associated loss of earnings…. We have successfully completed the switch from lender to integrated capital market bank…. We offer capital markets products for our Mittelstand customers.” It is also interesting that Commerzbank makes much in its 2003 annual report of its initiative to make €850m of other banks’ money available for smaller business finance, employing the benefit of the bank’s credit rating on behalf of smaller customers in order to retain their business but not fully underwrite the lending risk.
It would be a mistake, however, to think that all banks are managing to change their role from direct, relationship lender to alternative finance arranger. Our research revealed that a predicted 11 per cent of traditional relationship lending will swing to alternative financing techniques by the time we reach 2006. A sizable proportion of this swing is likely not to be financed by banks.
Raising asset-backed finance from the capital markets has become increasingly popular amongst larger corporates, principally by securitising their invoice ledger. Properly structured, and with automated daily input and payment performance reporting (a legal, as well as regulatory, requirement), this can introduce lines of liquidity that can be cheaper and are separate from the traditional relationship lender. However, more interesting is the recent emergence of invoice securitisation for SMEs, thanks to improvements in automation of the process. Pools are being formed through the aggregation of many SMEs’ debtor books, into a portfolio size that is economic to offer to the capital markets. The natural players in this space are factoring companies, who simply use this pooled securitisation technique to refinance.
A second phenomenon is the entry of private securitisation finance provided by major multinational companies as an investment instrument for their own cash pools. These non-banking sources of finance for SMEs are able to draw on their own sales channel and supply chain financing experience, with all their associated credit performance models and data, in order to understand and manage SME invoice finance risk. This is critical to SME liquidity trends, as these small to medium-sized companies would – at the moment – find it difficult to access such finance on reasonable terms. A further benefit will also accrue to both lender and borrower after a period of several years. Non-bank invoice finance may be regarded as preparing its borrowers for the capital markets some years down the line – building a provable history of credit quality and payment performance which can later be presented (on an aggregate basis) to the rating agencies in order to obtain top investment grade status for capital markets refinancing. The borrower obtains highly rated priced finance, while the lender receives an arrangement charge.
At the same time, lease finance is likely to be a major beneficiary of the swing away from relationship lending. SFS research6 predicted a 2004 rise in IT leasing of 5.5 per cent in the UK. The attractions of leasing are not simply tapping into additional lines of credit, but also cash flow friendly finance, as well as the flexibility of being able to upgrade equipment during the term of the lease. Terms are fixed at the beginning of the lease, so provide for dependable financial planning, cushioned from market or economic volatility. Despite the downturn in business investment between 2000 and 20037, the proportion of UK business investment financed through leasing has risen by over one percent, and this reflects the long-term trend in leasing growth.
In the case of larger corporations, pioneers have been concentrating more on working capital management efficiency – in other words, improving credit status through better cash management through a central in-house banking function. The goal is to demonstrably manage risk better, deliver transparency, and therefore improve access to reasonably priced liquidity.
The central management and monitoring of credit lines and bank accounts can help reduce the size of credit lines and credit risk. Centralisation (with effective automation) allows better use of liquidity reserves, reduces processing costs, improves reporting accuracy, and reduces the overall susceptibility to financial risk. By offering in-house banking functionality as an outsourced business process, this option becomes accessible even to smaller corporations. The feedback from users indicates that the use of a corporate in-house bank operated by a service provider could be another trend for treasury operations in the future. Moreover, the role of treasury is extended to include planning and monitoring functions.
One further factor that driving interest in alternative finance from non-banks is the increasing, if unwritten, linkage between the banks’ low-margin vanilla lending and their high-profit consultancy or arrangement fees. According to a report from Greenwich Associates8, 60 per cent of all European companies take credit commitments into account when awarding bond mandates. And at the same time, banks are trying to link the availability of basic liquidity to awards of more lucrative business. Unfortunately, this situation favours the financially strong company, and penalises the weaker ones. Acquisitive, cash-rich companies with M&A business to place (ironically also those least pressured about their working capital finance rates) are in a position to call the tune. Highly leveraged companies that are neither acquiring nor expensively restructuring, are least able to negotiate their lines of credit down. A recent report in the Economist9 opined that the average US bank makes about 40 per cent of profits from fee business (rather than interest income). In a competitively deregulating Europe, we can assume that the European model will move closer to the USA where, according to research by Fitch, the rating agency, two thirds of Europe’s corporate debt is supplied by banks, as opposed to nearer one third in the USA. In the USA, the overall volume of business lending has stabilized, it has not kept pace with the growing demand for corporate credit. To quote the Federal Deposit Insurance Corporation, “If one looks only at non-mortgage bank lending, one sees a decline in bank market share, seemingly related to the growth of non-financial business sector debt. Meanwhile the share funded by finance companies has steadily increased, now accounting for 20 per cent of shorter-term non-financial business sector credit.”
So not only are financing volumes moving away from relationship bank lending – they are also moving away from banks altogether. Pressure from bank shareholders for return on their investment is naturally steering institutions away from lower margin business, and finance companies are using their experienced credit assessment expertise – especially regarding SMEs – to fill at least an element of the funding gap.
Bank relationship lending is in decline in Europe relative to the growing demand for corporate finance – working capital solutions in particular. Companies are therefore concerned by the squeeze in availability of reasonably priced credit and are increasingly looking to alternative finance provision in the form of asset-backed borrowing, leasing and private equity. Although motivations might differ, financial priorities and the take-up of alternative finance appear from our survey to be broadly consistent across different European countries. Companies taking advantage of alternative finance provision (in return for which they invariably have to provide more data or payment history than a bank would demand) are likely to reap a double benefit – their financing costs will usually be lower, and they will come from a different financier than their relationship bank, thereby boosting available lines of liquidity. In some cases, banks themselves will arrange alternative finance on a commission basis for their clients. However, a significant proportion of this swing to alternative finance will be picked up by non-bank financiers. In all events, the greater financial transparency demanded by non-bank finance provision is expected to have a meritocratic effect on business lending in Europe, allowing rate to closely match risk even in SME finance.
1 European Central Bank -Bank Lending Review – April 2004
2Relationship Lending in the Euro Area, Prof. O. Lessing, 24th October 2002, Second ECB Central Banking Conference
3 Marketscan, UK Growth Company Report, July 2004
4 CreditReform Economic Research Unit, Insolvencies in Europe 2003/4
5 A recent report from Mercer Oliver Wyman – Business as Usual? The Future of Business Banking in Europe, January 2004 – notes that banks have the opportunity to convert their relationship lending customers to alternative financing instruments if they are sufficiently nimble.
6 Siemens Financial Services, Releasing the Pressure, March 2004
7 UK – Office of National Statistics; Germany – Federal Bureau of Statistics; France – INSEE
8 Greenwich Associates, interviews with over 260 corporate finance executives at FTSE 500 companies, October 2003
9 The Economist, 2nd July 2004