Author: Johan Groothaert - CEO of Fiduciam

The world of finance and corporate culture are not always the best partners, as I have been able to witness extensively during my city career.  There is the culture of greed, but greed is a biological imperative and not really culture.  During my days at Merrill Lynch the board wanted to define a clear culture and launched the “five principles”, I still remember them by heart:  client focus, respect for the individual, teamwork, responsible citizenship and integrity.  But as the synthetic CDO debacle demonstrated during the financial crisis, these principles did not mean a lot to a number of Merrill Lynch employees and managers.  Had they done, Merrill Lynch would still be around as a successful independent firm.

For a corporate culture to be successful, it cannot just be a declaration, it needs to be embraced by all employees and be part of the DNA of a company.  It pulls employees together behind a mission, brings meaning to their work, gives them a sense of belonging, allows them to take pride in their jobs and motivates them.  This in turn leads to better performance and more satisfied clients, as research has shown over and over. 

In the financial services industry, the importance of corporate culture goes well beyond this, as it keeps a check on the biological imperative we are all born with: greed.  Financial services and greed are like fuel and fire.  Therefore, corporate culture has a very important role to play here, to channel this biological imperative into something constructive and sustainable. 

In this respect too much focus tends to be on rules and policies.  These can easily be circumvented and rarely deal with all situations in our complex world.  I am of the strong belief that for risk management to be successful, corporate culture is much more important than rules.  Yet it beggars belief that most of the focus of regulators and bank managers still tends to be on the latter, whilst largely neglecting the former.  The financial crisis did not happen because of a lack of regulation, it happened because too much reliance was placed on regulation and nobody cared about the corporate culture of financial institutions. 

It is the role of management to install a corporate culture, it does not grow simply by itself.  Therefore it is crucial for each manager to live the corporate culture day in, day out.  Just proclaiming a few principles does not make a lot of difference, as the Merrill Lynch example shows. 

The corporate culture I try to embody every day at Fiduciam is one of diligence, integrity, hard work and fairness, in an environment that is diverse, young, pleasant and ambitious.  No policy can ever replicate the benefits such culture brings and, most importantly, such strong culture is the necessary foundation for our rapid growth as a successful marketplace lender.

Whilst the P2P model gained traction rapidly following the financial crisis, it exhibits a number of shortcomings.

Firstly, retail clients and investors are often simply driven by yield, not evaluating the risks sufficiently.

In some cases ‘mom and pop’ type investors are not sophisticated enough to analyse the risks, looking only at the headline rate of interest they believe they will receive.

Several P2P platforms also do not provide sufficient information to their investors for them to make a proper assessment of each individual loan, even should the investor be qualified enough to do so.

This information asymmetry between P2P platform and investor is easy to understand from a GDPR perspective, but it does make the investor very dependent on the assessment that has been made by the platform.

A key concern is that many P2P platforms position themselves as an intermediary, but then, unlike any other type of lender, they do not invest themselves into their own loans.

This can cause a lack of alignment with the retail investors and means that the platform risks comparatively little in relation to the investor.

Arguably it also means that some P2P platforms have less incentive to ensure that each loan is underwritten as diligently as it might otherwise be if the platform or lender had its own money involved.

The loan may also be managed less prudently as a result, this is clearly not the case with every P2P platform, but the failure of Lendy does highlight the shortcomings of this model.

With many P2P platforms competing for the same retail investors, the platforms often pursue the highest yield deals, which tend to be the riskier loans.

Lendy is a good example of this, but naive investors may well be oblivious to the fact that this is why they are promised the higher returns.

Finally, a number of P2P platforms also provide access to institutional investors at preferred terms. The question is, what downside such “preferred nation status” deals could cause for the retail investors.

There are obviously a number of high-quality P2P platforms out there, and the demise of Lendy has somewhat unfairly tarnished the image of this entire sector.

However, it is questionable whether a number of the P2P platforms can get to the necessary scale to operate profitably and to play a meaningful role in the lending landscape.

One could expect many sub-scale P2P platforms to have challenges and we expect further P2P lenders to disappear both this and next year.

Many bridging lenders are financed by a funding line provided by a bank or specialist debt fund.

Typically, these funding line providers will finance between 70–90% of the loan, with the remainder being financed by the equity of the bridging lender or through a junior funder.

While most bridging lenders use such funding lines, some are financed on a different basis. An alternative funding route is the P2P model, very popular a few years ago, but maybe less so today. The greatest risk with this is regarding investors’ money, rather than for the lender, which has increased FCA scrutinisation and the recent confirmation of new rules for P2P platforms.

Another alternative funding model is direct institutional funding, such as pension funds and institutional investors taking a direct stake in the loan book, but as there is no fixed template for this model, it takes longer to set up. Finally, there is the route of securitisation, but for such structures to be efficient, a large loan book is required. 

For that reason, many bridging and alternative lenders go for the traditional funding line model. There are many providers, it is a well-known template and it allows new bridging lenders to get out of the starting blocks easily. The problem is the funding lines are all quite similar in what they can offer, which restricts the options available to the borrower. 

In fact, many banks and credit funds have been attracted by the healthy returns of such funding lines and have been eager to find more interested bridging lenders.

The providers of the funding lines typically impose restrictions on the type of loans — for instance, the type of real estate, the loan term, loan size etc — that can be funded with the funding line and impose further risk parameters on the overall loan book. This is normal, after all, they are exposed to the risk of the loan book. Where the losses on the loan book exceed the equity buffer provided by the bridging lender, the provider of the funding line can start losing money.

Some restrictions stipulate that the lender has to buy back the loan after a period of time, say 90 days. In this case, the risk is greater for lender than for the supplier of the funding line. These restrictions mean the lender would need sufficient capital to be able to buy back the loan while continuing to support its business, as well as a robust internal process on the underwriting and servicing side.

Such risk management techniques become somewhat self-defeating, though, if all funding line providers impose similar risk parameters, creating a particular segment. This results in more money chasing bridging loans than the natural market demands in this segment, leading to an erosion of LTVs and interest rates. 

We believe that this is what we are currently witnessing in the UK market. Risk-return characteristics for bridging loans substantially improve when one moves outside of the segment that is backed by funding lines.

Metro Bank’s share price dropped to a record low earlier this month, down 75 per cent compared to January, a consequence of an error in risk weighting its commercial buy-to-let loans which came to light earlier this year.

As an alternative lender we were in a good position to observe some interesting developments in the commercial buy-to-let market over the past three years.

For example, in 2015 the majority of the bridge loans Fiduciam provided were related to buy-to-let. But progressively during 2016 and 2017 we lost this business as the challenger banks, including Metro Bank, became more aggressive in this segment, offering substantially lower interest rates.

This was incomprehensible to us as the international banking regulation framework, Basel III, requires a substantially higher risk weighting for commercial buy-to-let loans than for residential mortgages.

Basel III increased these risk weightings following the financial crisis to ensure that banks have sufficiently strong capital buffers when they have to write down loans during recessions and continue to have the confidence of savers at all times.

Eight per cent interest needed

According to reports, Metro Bank had erroneously put a risk weighting of 35 per cent on its commercial buy-to-let mortgages, which it had to increase to 100 per cent, as required by Basel III.

Considering the Basel III risk weighting and capital requirements framework, and assuming a 70 per cent cost-income ratio, which is an average for the UK bank sector, we have calculated that a bank would have to charge interest rates of approximately 8 per cent per year on commercial buy-to-let mortgages.

This would achieve a return on equity of 20% which would be a fair expectation set by bank shareholders.

Basel III did open a window for alternative lenders such as Fiduciam, which are financed by institutional risk capital rather than bank deposits or bank funding lines, to enter the commercial buy-to-let market, thereby reducing the demand on banks to provide such commercial buy-to-let mortgages, and consequently to lessen the risk on banks’ balance sheets.

More risk re-weightings to come?

We now understand better what has happened, at least at Metro Bank, however questions remain.  Some challenger banks continue to offer very low interest rates on commercial loans, which appear to be inconsistent with Basel III.

As an international lender we also observe that Basel III is implemented differently across the E.U., which is hard to understand considering there is an EU regulatory framework.

For instance, in the Netherlands a low risk weighting for commercial buy-to-let loans is standard, fuelling a frothy real estate market.

Finally, we notice an increasing number of challenger banks are lending to alternative (non-bank) lenders at low interest rates, which raises the question how those funding lines are risk weighted.

Metro Bank has tackled its Basel III risk weighting issues and has since raised more than £375m in equity, assisting in a recovery of its share price, but based on the above observations the question arises whether we will see similar risk re-weightings in the wider challenger bank sector and even internationally.