In our previous article "Bank Equity As A Crisis Predictor", we have discussed the notion that bank's health is essential to the real economy as bank lending play a central role in keeping the economy well-functioned.
In this article, we discuss another half of the lending channels - the nonbank credit.
It is important to note that non‐bank credit is broader than shadow banking. Shadow banking, the source of financial crisis 2008, only includes non‐bank entities with short-term funding and potential financial stability risks related to leverage, liquidity and maturity mismatches.
In comparison, the sources of nonbank credit are wide-ranging, it can take the form of bond financing, or loans by a diverse group of lenders that include investment funds, non‐bank mortgage providers, foreign lenders or the government. In fact, in modern financial systems, the size of non‐bank credit is often as large, or maybe even larger, than bank credit.
In their recent working paper “Nonbank Lending“, economists Sergey Chernenko, Isil Erel, and Robert Prilmeier provided an insightful overview of the characteristics of nonbank lending during the post-crisis period.
They built a hand-collected dataset of credit agreements signed by a random sample of publicly-traded middle-market firms between 2010 and 2015. Publicly-traded middle-market firms are defined as firms with revenues between $10 million and $1 billion, and they account for about one-third of all U.S. jobs and of private sector GDP.
First of all, who are the nonbank lenders?
In their sample, the lenders include finance companies (FCOs), bank finance companies (bank FCOs), investment banks, insurance companies, business development companies, private equity (NYSE:PE) and/or venture capital (NYSE:VC) funds, hedge funds, investment managers, and others.
Among them, FCOs (23%), PE/VC firms (19%), and hedge funds (16%) account for the largest share of nonbank lending.
Source: “Nonbank Lending“
The next question is, who are the nonbank borrowers?
Firms that borrow from nonbanks are younger, as nonbank borrowers are on average 28 years old, compared to the borrowers from the banks who on average have a firm age of 37 years.
Nonbank borrowers also tend to spend a larger fraction of their assets on R&D, around 9% on average, compared to 5% of bank borrowers. Nonbank borrowers get smaller loans ($74 vs. $188 million) also.
An important difference between the two is that nonbank borrowers are significantly smaller than bank borrowers in terms of their book assets and EBITDA. The average nonbank borrower has book assets of $364 million and EBITDA of $30 million, while an average bank borrower has book assets of $604 million and EBITDA of $75 million.
More importantly, nonbank loans are priced 457 basis points higher than the interest rate on bank loans. According to Chernenko et al., part of this difference is due to nonbank borrowers being riskier.
After controlling for firm characteristics and other loan terms, they suggest that there are still around 200 basis points average difference in interest rates between the bank and nonbank market.
One explanation Chernenko et al. suggested is that nonbank lenders, such as hedge funds and other asset managers, may have a comparative advantage in identifying good investment opportunities. The unprofitable, R&D intensive firms that these lenders provide funding to may require more ex-ante screening than older than established firms that are already profitable.
Given that nonbank lenders engage in more ex-ante screening than bank lenders, the interest premium can be a compensation for the screening expenses.
While Chernenko et al. have provided a detailed investigation of an important segment of the nonbank credit market, it might not be fully representative of the whole nonbank lending channel.
This is where another recent research paper “The Non‐Bank Credit Cycle“, by Esti Kemp, René van Stralen, Alexandros Vardoulakis, and Peter Wierts comes in and, at least partially, complete the picture.
Kemp et. al took a macro perspective of the nonbank lending market, and investigate the cyclical properties of non‐bank credit and its relevance for financial stability.
Instead of building a database of nonbank lending one case at a time, Kemp et. al estimate non‐bank credit to private non‐financial sector (NYSE:PNF), simply by subtracting (domestic) bank credit to PNF and non‐resident bank loans to PNF from all sector credit to PNF, with data from Bank of International Settlement (NASDAQ:BIS).
The graph below shows the relative size of nonbank credit as a percentage of GDP, compared to the size of bank credit as a percentage of GDP:
Source: “The Non‐Bank Credit Cycle“
Many observations are above but relatively close to the 45‐degree line, indicating that bank and non‐bank credit generally are quite similar in size within countries. That means nonbank credit account for almost half of all lending.
Source: “The Non‐Bank Credit Cycle“
Kemp et. al then investigate the characteristics of the nonbank credit cycle. The graph below illustrates the percentage of countries in an upward cycle in bank credit (Blue) and nonbank credit (green).
Source: “The Non‐Bank Credit Cycle“
First, we can see that the upward phases in several countries at the same time are more common for bank credit than for non‐bank credit.
This is because banks are more homogeneous as a group of lenders, and the large banks often operate across borders; meanwhile, non‐bank credit is provided by a more diverse group of lenders, where the underlying financial intermediaries may not be as internationally connected as their banking counterparts.
Second, the authors find that the run‐up to the Asian crisis and the EU's run‐up in forming the monetary union, which encouraged economic convergence, are the period for which the highest number of countries. Twenty-seven out of thirty-four countries, or 79%, in the research sample, experienced an upward cycle in non‐bank credit.
Most importantly, the four researchers also showed that non‐bank credit growth can act as a leading indicator for currency crises and, perhaps also for a sovereign debt crisis. Bank credit cycle, on the other hand, while able to predict systemic banking crisis, it doesn't have the ability to foresee currency crisis.
One explanation is that non‐bank credit provision – and in particular bond financing – is at times more closely related to movements in international capital flows compared to bank credit supported by deposits in domestic currency. Non‐financial corporations tend to borrow in foreign currency‐‐included in our non‐bank credit measure‐ when interest rates abroad are relatively lower.
A reversal in capital inflows worsens the ability of firms to rollover their debt, while, at the same time, domestic authorities may need to maintain higher interest rates to support the peg. As such, the ability to maintain the peg may be curtailed when nonbank credit from abroad is elevated, as it amplified the consequences of adverse shocks that can lead to currency crises.
In sum, due to the lack of data availability, nonbank credit has often been neglected by academics and most investors. As the two research papers mentioned above, however, it might constitute around half of all credits in the financial market.
Investors and regulators should definitely pay heed to the health of nonbank credit market, to avoid something similar to the shadow banking crisis of 2008 happen again.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.