Are banks really retreating?

Joe Millward

Epsilon Direct Lending

Much has been written on the growth of the private credit asset class in Australia and for all the nuances between credit strategies there is one consistent message: that the market opportunity exists in large part because the banks are retreating from this traditional line of business, driven in turn by increasing regulatory pressures from the regulator. But how much of this claim is true? If the latest reporting season suggested that banks are growing their corporate lending books, where is the disconnect?

The answer lies partly in one key fact. Corporate lending is not a single homogenous product. The Australian corporate loan market exceeds $1 trillion. It’s huge! Businesses borrow for a wide variety of reasons, and lenders structure their loans to meet a wide range of needs. The focus in this commentary is on loans directly made by lenders to corporate borrowers, and so excludes consumer lending and securitisation of loans of any format.

Looking at the banks, leading the charge is CBA which grew its business banking lending volumes by 12.5% year-on-year or $13.2bn. This equates to 1.7 times system growth. NAB also posted 6.6% growth in business lending to $116.6bn in the year to September 2021. That’s hardly a retreat.

At the same time, EY have just released their Australian private debt market update, and note that the market has reached $133bn, representing growth of 21% year on year. 

 So if fund managers have also gathered an extra $34bn over the period, and the banks are growing at above system, what are we missing?

The banks are conveniently leaving their institutional banking loan balances out of their presentations when promoting their business lending growth statistics. Secondly, bank presentations usually normalise for business units they have sold or wound down. For example, CBA’s institutional loan portfolio shrank by $3bn over the year to December 2021, against a backdrop of huge debt issuance to support ASX listed refinancings and historic highs in M&A activity. Westpac also recently exited their auto loan book, reducing exposures by $1bn.

Therein lies part of the answer. Banks really are exiting some segments of the market, creating an opportunity for private credit funds. Certain private credit asset classes typically referred to as “specialist lending” such as receivables financing are supporting the growth of many funds due to banking exits. However, a reduction in bank exposure to certain other segments such as private equity buyouts for large companies, does not mean it’s all happy hunting for funds. Huge offshore private credit funds, international banks and our local super funds are quickly filling the void, and this is putting pressure on returns for private credit funds operating in the syndicated lending segments (large transactions placed with multiple local and global lenders.) Similar competitive pressures are also faced within real estate lending, where banks are actually increasing exposure at the lower risk end.

What about other strategies? Pointing to “banks are exiting” as a rationale for building a sustainable private credit business might be reasonable for some managers, but is not a valid reason for pursuing strategies that banks have never (or at least very rarely) operated. 

Banks do not provide loans for distressed or special situations lending, nor do they provide mezzanine loans to property developers. 

 What about a loan to a holding company of a financier, where the cash from the loan is ultimately used to provide equity funding for their next loan fund? These examples are of lending markets are very small, highly specialised and which have always been outside the risk appetite for the majors, certainly during recent memory.

So what exactly are the banks doing and why? There are several components which lead to opportunities for private credit funds. One of the reasons cited earlier suggested that the bank retreat is due to the regulatory pressure created by APRA. This is partly true. The formula used to calculate regulatory capital requirements is highly complex. However, simplistically, APRA provides exponential relief (i.e. lower capital charge) on lending the further you move up the credit rating curve. The same process occurs with real asset security and senior secured security positions (think senior secured loans against real estate) and reasonably short tenors (anything over 3-4 years gets expensive from a capital charge perspective).

Banks are also constantly trying to improve their cost-income ratios against a backdrop of increasing compliance and IT transformation costs. This drives a desire to lower the cost to service customers. All of these pressures point to two initiatives: Simplifying loan products and automating the credit decision process. A standardised loan is far easier to originate for banks, who employ thousands of staff. In order to get regulators to sign off on automated credit decisioning engines, a high volume of lower values loans are needed. The legal agreements and associated terms and conditions for a bank loan are typically linked to “boiler plate” loan documentation, whereas loans provided by specialist credit funds can be customised to much more bespoke legal agreements. This has true value to borrowers who will often be willing to pay a premium (i.e. higher interest rate) for tailored arrangements. 

Esoteric risks, such as those prevalent in acquisition financing, are not well suited to commoditised bank lending and private credit funds focused on loans which require a high degree of customisation, such as acquisition financing, are in high demand.

There are many reasons why the growth of a healthy private credit market in Australia is a positive development for our economy. Providing higher risk loans to businesses that haven’t been able to attract bank loans historically is a good thing, providing investors understand and are rewarded for the risk they are taking. Having private credit funds compete head on with banks is also a positive development as businesses have more choice. Nature abhors a vacuum and capital does a good job of filling it. The next time you’re told that a private credit fund offering will originate a ton of great quality loans because of the exit of banks, ask yourself, or indeed the manager, these questions: Have the banks ever actually provided these types of loans? And is there a valid reason for them to exit if they have?

Joe Millward
Founding Partner
Epsilon Direct Lending

Epsilon Direct Lending is an Australian based non-bank corporate lender and private markets investment manager

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