EDHEC: Discussion of the Central Bank of Ireland discussion paper on loan origination by investment funds
Posted: 20 September 2013 | Source: EDHEC
The Central Bank of Ireland has issued a discussion paper on loan origination by investment funds, in which it suggests that developing alternative sources of ennancing to bank loans may be beneficial to the real economy but requires the careful consideration of the potential development of "shadow banking" risks.
In this response to the discussion paper, we argue that the development of alternative sources of financing is most relevant with regards to long-term private debt, in particular the financing of SMEs and infrastructure projects. The demand for such financing has been identified as instrumental to long-term growth in Europe, which justifies regulatory changes. We add that such instruments are also appealing for institutional investors as supplier of long-term credit, as they increase their allocation to "direct investments" in liquid assets yielding predictable cash flows.
Nevertheless, it is a mis-conception to oppose bank and non-bank lending when discussing alternative sources of finance. Loan origination by shadow bank entities requires numerous economic functions that are best and often only provided by banks. In effect, recent research shows that banks have directly created and managed most shadow banking activities to date.
Banks are thus likely to play numerous roles in the decision to originate long-term loans taken by ringfenced investment funds. The new funds would be more accurately described as off (bank) balance sheet origination vehicles in response to the demand for long-term funding of the real economy, under the constraints imposed by the implementation of Basel-3 to the regulated banking sector.
This conclusion is instrumental in our understanding of the potential contribution to systemic risk of investment funds allowed to originate private debt.
Systemic risk, the risk of observing cascading defaults across the financial system, is state-dependent and the regulation of specific types of investment vehicles should focus on their marginal contribution to systemic risk i.e. their propensity to create additional losses in bad states of the world. We argue that, closed-ended debt funds dedicated to building genuinely long-term private debt portfolios for institutional investors would create minimal liquidity, maturity and credit transformation risks. With limited links to other financial institutions and no maturity and liquidity funding mismatches, an exogenous shock (e.g. a recession) affecting the asset value of private debt funds across the board could lead to losses for investors but would seldom create additional losses that propagate throughout the financial system in bad states of the world i.e. contribute to systemic risk.
Endogenous shocks to systematic risk factors are highlighted in the literature as more likely to create feedback loops and increase systemic risk. We focus on the role of collateral/underlying valuation and leverage.
Historically, the gradual lowering of underwriting criteria, in a context where investment products were opaque made asset valuations (two market participants agreeing on a price) impossible in bad states of the world, further propagating losses and blockages in the financial system. The quality of the collateral/underlying of an investment fund originating debt instruments is determined by the credit risk of its borrowers. To avoid contributing to systemic risk, we argue that the credit risks of the underlying asset
and of the fund themselves should be adequately and transparently benchmarked using well-recognised cash flow reporting standards.
Second, the widespread use of leverage in shadow banking can magnify losses and thus contributes directly to increasing systemic risk. However, we argue that a distinction should be made between fundlevel borrowing that is either senior or junior to investors claims, as well as between short-term and long-term fund borrowing.
Indeed, while short-term borrowing may be useful for operational purposes, it may also be used to pay back investors and mask the deterioration of the fund's asset value. Conversely, long-term fund borrowing, matching the investment term agreed with investors for the fund may provide a useful first-loss junior tranche (provided by a bank-manager) or it may provide a senior tranche boosting the returns of the fund's investors, especially if the fund's assets are otherwise very safe, low-yielding instruments.
In the junior case, the net marginal contribution of such leverage to systemic risk would be positive but, in all likelihood, small i.e. a synchronised increase in underlying defaults would hit the providers of the junior tranche simultaneously, possibly in a bad state of the world, but this loss would be small relative to the size of the financial system.
In the case of senior fund leverage, its ability to contribute to systemic risk is a matter of asset risk. For example, debt funds with underlying assets that almost never default in any state of the world (e.g. infrastructure project finance debt backed by government revenue guarantees, as is the case in the UK or France) could be highly leveraged since their propensity to create new losses in bad states of the world would be almost zero.
Conversely, leveraging debt funds with underlying assets that are highly correlated with bad states of the world (e.g. loans to SME) would constitute a net positive contribution to systemic risk.
In conclusion, we highlight the basic features of what a long-term private debt fund (LTPDF) would look like. Using the example of an infrastructure project finance debt fund, we suggest credit risk such benchmarking may be done using standardised cash flow reporting of debt service cover ratios, to achieve what we call "shadow banking in broad daylight."
We also conclude that regulated banks will play a pivotal role in the development of such non-bank sources of financing for the real economy. In effect, properly regulated shadow banking debt funds are the opportunity to combine the benefits of a focus on collateral / underlying value, which requires benchmarking and transparency, with the significant value otherwise created by banks in the financial intermediation process, especially certification effects and the reduction of information asymmetries, leading to lower default rates, and the monitoring and re-contracting of borrowers' debt, leading to higher recovery rates.