The recent collapse of alternative lender Greensill has thrust the spotlight firmly on non-traditional, less regulated financial services firms. But is shadow banking a dangerous dark art or a valuable cog in the financial services system?
although the Greensill crisis may eventually be filed in history as a political story, there are plenty of financial and regulatory questions to be addressed before the involvement of a former prime minister and the lobbying of government are fully investigated.
In early 2021, it became clear that Greensill Capital, a sizeable shadow bank that enabled businesses to borrow money to pay their suppliers, was struggling and on the verge of bankruptcy.
The crisis deepened in March when BaFin, the German financial watchdog, banned Greensill Bank, the German subsidiary of Greensill Capital, from doing business – and reportedly filed a criminal complaint against its management.
This followed a forensic audit in which BaFin raised concerns around bookkeeping, in particular for transactions linked to GFG Alliance Group, the famous steel empire headed by Sanjeev Gupta.
In a statement, BaFin said: “Greensill Bank was unable to provide evidence of the existence of receivables in its balance sheet that it had purchased from the GFG Alliance Group. For this reason, BaFin has already taken extensive measures to secure the bank’s liquidity and to limit risks for Greensill Bank.”
This was a critical blow to Greensill Capital, which counted former Prime Minister David Cameron as an adviser, and it filed for insolvency on 8 March 2021.
It was a crisis that has thrust the issue of shadow banking – or alternative lending – back into the spotlight, not least because the fallout has damaged traditional financial institutions, including Credit Suisse, which were doing business with the collapsed lender.
According to the Financial Times, the Swiss bank, which had several ties with Greensill Capital, including $10bn worth of funds, reported a 78% fall in profits for the second quarter of 2021.
As the shocks from the implosion continue to spread, many are questioning whether regulators will seek to get more control of a mode of lending that sits outside the main regulatory regime.
Furthermore, the plight of Greensill Capital has raised concerns about the evolution of the global financial system in which alternative lending is a growing presence, and the ability of the regulatory authorities to keep up.
A pressing need for alternatives
There is no doubt that alternative lending has a crucial role to play in the financial services ecosystem. To give one example, it’s a necessary financial mechanism for SMEs that are struggling to cope in a tough economic climate.
Alternative lenders played an increasingly vital role in delivering state-backed loans to UK SMEs, including the Bounce Back Loan Scheme (BBLS) and the Coronavirus Business Interruption Loan Scheme (CBILS).
As the banks were hit by unprecedented demand, which put a huge strain on legacy technology that was already creaking, AltFi.com research highlighted that of the 115 accredited CBILS lenders, 60% could be classed as an alternative lender.
“Traditionally, it’s never been made particularly easy for SMEs to gain access to finance,” says Jo Gibson, Head of SME Non Bank Channel at fintech platform Incomeing.
“The answer to some of the problems faced during the pandemic were the government-provided CBILS and BBLS programmes, which mobilised the alternative lenders alongside mainstream banks.”
As Gibson points out, even before the pandemic, SMEs faced well-documented problems when it came to accessing credit.
In recent years, banks and other mainstream financial institutions have cut back on business lending because of the comparatively high costs involved in acquisition, delivery and servicing, as well as the limitations of legacy technology and processes.
These pressures have been increased by more stringent regulations, such as Basel III and Capital Requirements Directive, which have resulted in banks further reducing loans to small businesses and sole traders as they seek to strengthen their capital requirements and decrease leverage.
These conditions have prompted huge growth in the shadow banking system, as alternative lenders, brokers and other credit intermediaries that fall outside the realm of traditional regulated banking step in to address the shortfall.
A recent report by Cambridge University’s Judge Business School revealed that global alternative finance volumes grew by 24% in 2020 – a remarkable figure when you consider the economic disruption that characterised last year.
It’s also fair to point out that much of the alternative finance sector enjoys a good relationship with regulators, especially in the UK, with the Financial Conduct Authority (FCA) seen as a progressive entity keen to work with the new generation of lenders.
The Peer-to-Peer Finance Association (P2PFA) was set up by alternative finance companies, including Zopa and Funding Circle, in 2011 to actively lobby the FCA to regulate the burgeoning sector.
Flamboyant outlier or warning?
So should Greensill Capital be considered a bad apple or representative of a wider problem in the sector?
The Financial Times, among other publications, believes Greensill bore many of the classic signs of a financial accident waiting to happen.
Its charismatic founder, Alexander David ‘Lex’ Greensill, is considered by many to be a stereotypically flamboyant entrepreneur.
The company’s website talks up his trajectory “from humble beginnings to revolutionary thinking”, drawing on anecdotes from his childhood at his parents’ sugar cane and melon farm in Australia.
There were also concerns about the speed of Greensill Capital’s growth, which can often be a red flag for excessive risk-taking and a poor-quality loan book.
The shadow bank was created in 2011, when Lex Greensill left his banking career – which included stints doing global supply chain financing at Morgan Stanley and Citibank – to follow his entrepreneurial desires.
By 2019, Greensill Capital had extended $143bn of financing to more than 10 million customers and suppliers in 175 countries.
Its heavily concentrated portfolio was another warning sign. The Scope rating agency estimated that in 2019, two-thirds of Greensill Bank’s loans originated from a single group of linked private companies – almost certainly part of Sanjeev Gupta’s business empire.
BaFin called out this concentrated exposure when it ordered the German operation to be closed.
Regulatory lens set to intensify
As with any sector, there are good and bad players in the alternative lending space. While there is a clear need for shadow banking in our post-pandemic economy, its capacity to spring dangerous systemic shocks shouldn’t be underestimated.
There is currently a lack of transparency in certain areas of the financial markets, and the risks that some alternative lenders take on aren’t just borne by themselves – they are shared by the banks and the other market participants they partner.
In the Greensill case, insurers and outside investors have also been caught up in the ongoing losses.
There are likely to be more losses associated with new non-bank entrants moving into the traditional markets to cater for increased demand.
Alternative lenders typically seek to operate in a more high-risk manner than the banks have done, but without being required to disclose much of their activities.
Because these entities rely on outside investment from other institutional investors, any failures can easily create a ripple effect across the markets.
This is why many commentators expect further legal fallout from the Greensill losses. Lawsuits have already been raised against Credit Suisse on behalf of the investors in its Greensill-related funds.
The banks themselves will be looking at exactly how these losses occurred and whether anyone else can be held accountable for them. And the regulators will be taking a closer interest in the actions of all those involved.
The challenge for the regulators, as always, will be how to appropriately regulate a burgeoning sector without stifling the innovation behind it. In the shape of the FCA, the UK at least has a regulator that is used to working with ambitious new entrants.