Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Primary Credit Analyst: Dhruv Roy, London (44) 20-7176-6709; dhruv.roy@standardandpoors.com Secondary Contact: Cameron Payne, London 02071767560; cameron.payne@standardandpoors.com

Table Of Contents
Relative Size And Importance Of European Shadow Banking Lags That In The U.S. Shadow Banking Encompasses A Wide Range Of Activities European Bank Deleveraging Is Set To Continue Traditional Banking Will Continue To Leave Shadow Banking In The Shade Shadow Banking Still Faces Barriers To Growth Wide Spread Of Ratings Reflect The Sector's Diversity And Fragmentation Appendix: Shadow Banking Has Two Main Forms Related Criteria And Research

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging
Although Western European banks have made substantial progress in deleveraging their balance sheets, they still have some way to go to comply with regulatory and investor demands. Moreover, there is increasing evidence of a gradual economic recovery in the U.K. and Continental Europe. Against this backdrop, alternative financing, also known as shadow banking, continues to grow, both in terms of volume and availability. However, in Standard & Poor's Ratings Services' opinion, a number of factors could constrain the growth of shadow banking in Western Europe--primarily the U.K. and eurozone--despite evidence of a growing need for alternatives to bank financing. Market and regulatory focus on credit intermediation outside the banking sector since the 2008 financial crisis has largely centered on systemic risk and threats to financial stability from the loose amalgamation of activities that is generally called "shadow banking." To many, the term shadow banking implies a set of opaque activities behind the scenes of mainstream banking. We recognize the rationale and the need for better regulation of the shadow banking sector. However, in our view, the significant role of shadow banking in financing the real economy, especially in the context of continued banking sector deleveraging, is often overlooked in debates on regulation. Overview Shadow banking entities comprise approximately 30% of eurozone financial assets compared to more than 40% in the U.S., indicating the relative underdevelopment of the sector. Western European banks will continue to deleverage even as the stock of lending to nonfinancial enterprises by eurozone banks has reduced by approximately 0.5 trillion over the past four years. The ongoing growth in Western European shadow banking is unlikely to completely fill the void left by bank deleveraging. Sluggish demand for credit, uncertainty over the effect of evolving regulation, and underdeveloped market infrastructure are among key barriers to growth in Western European shadow banking.

Relative Size And Importance Of European Shadow Banking Lags That In The U.S.
Shadow banking has developed to such an extent that it has become a substantial part of global finance. In the 20 jurisdictions it monitors, the Financial Stability Board (FSB; Global Shadow Banking Monitoring Report, November 2013) reported that the assets of "other financial institutions" (OFIs; a broad definition that excludes banking sector, insurance, and pension fund assets) equaled about 24% of total financial assets and 117% of combined GDP as of year-end 2012. However, there are wide differences in the relative size and importance of shadow banking between countries. OFI assets are 166% of GDP in the U.S., relative to 95% of GDP for assets of deposit-taking institutions. In the eurozone (European Economic and Monetary Union), however, the picture is reversed, with assets of

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

deposit-taking institutions representing 302% of GDP, versus 184% for OFIs. In terms of share, recent data from the Federal Reserve and European Central Bank (ECB) suggest that OFI assets comprise approximately 30% of total financial assets of intermediaries in the eurozone, versus more than 40% in the U.S. We define intermediaries as deposit-taking institutions, insurance and pension funds, and other financial intermediaries. Although the relative importance of shadow banking assets is smaller in Western Europe because of the historical dominance of bank financing, the direction of growth is clear. However, in our view this trend represents an early-stage development relative to the sector in the U.S. Furthermore, given the scale and pace of bank deleveraging and uneven recovery in credit demand across Europe, we consider it unlikely that the growth of shadow banking in itself will substantially make up for a contraction in banking activity over the medium term. Key barriers to more rapid growth of the shadow banking sector in our view include weak demand for credit, uncertainty over the effect of evolving regulation, and underdeveloped market infrastructure to address information asymmetry (for example, the need to help investors understand unfamiliar assets). A lack of standardization, for example, in terms of common documentation and legal standards, and insufficient market depth and liquidity in certain asset classes are also material constraints.

Shadow Banking Encompasses A Wide Range Of Activities

As the shadow banking sector has evolved over the past few years, the way in which the industry has been defined has broadened. The term used to apply specifically to highly-leveraged, off-balance-sheet entities. Now, it generally applies to all bank-like activities (maturity, credit, and liquidity transformation) that operate without the back-stop of central bank liquidity or public sector credit guarantees, and, to a large extent, beyond prudential regulations, such as capital requirements. The FSB outlines two broad approaches to sizing the shadow banking sector: activity-based and entity-based. An activity-based approach encompasses classes of activities such as repurchase agreements (repos) and securitization. An entity-based approach attempts to identify businesses and institutions outside the banking system that engage in some form of credit intermediation as their primary line of business. We focus on an entity-based approach to minimize overlap with activities that are carried out by both banks and non-banks, such as repos. Therefore, in accordance with this approach, the shadow banking sector includes investment funds (including private equity funds), broker-dealers, structured finance vehicles, specialist finance companies, money market funds, and hedge funds. This broad definition of shadow banking is also reflected in the wide divergence of our ratings on Western European entities that engage in shadow banking-type activities, ranging from speculative-grade to the 'A' category. This dispersion of ratings reflects environmental factors, such as regulatory frameworks in a particular jurisdiction, as well as differences in business models, risk exposures, confidence sensitivity, and other idiosyncratic factors.

European Bank Deleveraging Is Set To Continue

We consider that the transition to stricter capital standards, combined with the asset quality review by the ECB and

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

subsequent European Banking Authority (EBA) stress test, is unlikely to slow the pace of banks' deleveraging in 2014. To date, improvements in the leverage ratios of Western European banks have occurred mostly through capital accumulation, as opposed to asset disposals, partly because these banks cannot afford to dispose of their illiquid, noncore assets at prices materially below their current carrying values. (See "Underwriting The Recovery: Ongoing Bank Deleveraging Constrains Credit Availability Across Much Of Western Europe," published June 28, 2013, on RatingsDirect.) Deleveraging has generally been in response to three trends: Regulatory changes toward more stringent capital, funding, and liquidity requirements; The weak macroeconomic backdrop, which constrains capital generation; and A general retreat among some major banks from wholesale and international banking activities, accentuated by political and competitive pressure on banks to extend lending to their home markets. Combined, these factors have restricted the overall lending capacity of the banking sector and led to financial fragmentation. One symptom of such fragmentation is a divergence in the interest rates on bank loans across Europe, with small-to-midsize enterprises (SMEs) in the periphery bearing the brunt of this restrictive credit supply. For example, according to the ECB's November 2013 survey on SME access to finance in the eurozone, the net percentage of SMEs reporting an increase in bank lending rates was highest in Spain and Italy. On the flip side, SMEs in Germany, Belgium, and France reported a decline in bank lending rates. In the eurozone, the cumulative shrinkage in bank balance sheets between the peak and October 2013 stood at 3.5 trillion, or 10% of the aggregated balance sheet of eurozone banks. In the U.K., the adjustment has been sharper: the decrease has reached nearly 20% or 2.1 trillion. A measure of the extent to which bank lending has contracted is the stock of lending to nonfinancial enterprises by eurozone monetary financial institutions (MFIs; representing the banking sector). According to ECB data, bank lending reduced 10% from a peak of 4.9 trillion at the end of January 2009, to 4.4 trillion at the end of November 2013 (see chart 1). This approximately 500 billion reduction in the stock of lending refers to direct commercial lending by eurozone MFIs. It does not include reductions in household lending and the indirect second-order impact of reduced exposure to securitized and other assets. Similarly, recent press reports have suggested that U.K. banks have reduced corporate loans by 400 billion since May 2012.

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Chart 1

Traditional Banking Will Continue To Leave Shadow Banking In The Shade

Less bank lending has resulted in more capital market financing. High-yield issuance by European nonfinancial corporates has grown steadily since the financial crisis (see chart 2). However, access to capital market debt funding has so far largely been limited to larger nonfinancial corporates, while mid-market companies and SMEs still rely on bank funding. The ECB reports that the most widely used external sources of financing for SMEs in 2013 were bank overdrafts, leasing, hire purchasing, factoring, trade credit, and bank loans.

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Chart 2

The FSB's shadow banking sizing illustrates that the banking sector continues to play an outsized role relative to OFIs in key Western European countries (see chart 3). In fact, the data in chart 3 overstate the relative size of OFI assets to a degree since the FSB definition includes, for example, plain vanilla equity and bond funds, which are typically not what we think of as shadow banking. Furthermore, even in countries with a relatively large shadow banking sector such as the U.K. and The Netherlands, the picture is skewed by the presence of a number of foreign institutions. Deposit-taking institutions in Western Europe therefore remain more important than in the U.S. despite the multi-year bank deleveraging trend. We do not expect this picture to change materially over the next two-to-three years.

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Chart 3

Data from S&P Capital IQ illustrates relatively slow growth in the number of new shadow banking entities in Western Europe since the 2008 financial crisis. There was a rapid increase in the number of shadow banking entities in Western Europe up to the peak of the pre-2007 credit cycle, and a subsequent drop-off in growth rates (see chart 4). While this doesn't measure the volume of assets managed or intermediated by these entities, combined with FSB data on the relative importance of the banking sector, it does point to the stability of the relative importance of banks versus nonbanks.

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Chart 4

Shadow Banking Still Faces Barriers To Growth

We note several positive developments in the shadow banking system in Western Europe. For example, press reports and market commentary often suggest strong growth in nonbank funding for European mid-market companies and SMEs. For example, commercial finance brokers in the U.K. have reported substantial rises in credit arranged for SMEs, including a rapidly developing market in peer-to-peer lending. There is even evidence of banks entering into partnerships with shadow banking entities. One recent example is Barclays Bank PLC's collaboration with BlueBay Asset Management Ltd. (BlueBay) to provide so called "unitranche loans," whereby BlueBay funds the riskier part of a loan. BlueBay has previously shown interest in this area, with the launch of a 800 million direct lending fund in 2013. Similarly, UniCredit SpA is entering into a deal with U.S.-based hedge fund Marnier Investment Group to transfer some of the default risk on a 910 million loan portfolio relating to energy and transport projects. Furthermore, there appears to be increasing activity in the European CLO market. Nevertheless, in our view several factors continue to constrain the sector. A significant near-term threat to the development of shadow banking will likely be anaemic growth in credit demand despite the macroeconomic recovery.

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Even as banks continue to deleverage, not all of the lost lending capacity will need to be replaced straight away as businesses and households continue to repair their finances. Central bank surveys appear to confirm this view. The ECB's SME survey asked: "Has your need for bank loans increased, decreased, or remained unchanged over the last six months?" Most respondents reported that their need for external financing as bank loans had remained unchanged or declined (see chart 5). Unsurprisingly, sluggish growth in credit demand is most likely to be the case in weaker peripheral eurozone economies--for example, Banca d'Italia's most recent survey of business and industrial firms suggests that credit demand is set to decline.
Chart 5

Regulatory initiatives to better control and monitor the financial stability risks posed by shadow banking remain at an early stage, which in our view could also hamper the sector's growth. Examples include the Alternative Investment Fund Managers Directive (AIFMD), which comes into effect this year, and proposed changes to the regulation of European money market funds. AIFMD covers the authorization, operation, and transparency of alternative funds in the EU. It may force some asset managers to exit the management of alternative funds rather than bear the cost and complexity of additional regulation. Similarly, proposals to regulate money market funds include some significant changes that may limit the industry's growth and flexibility. Under these proposals, short-term money market funds in Europe will either have to convert to

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

a variable net asset value structure or build up a capital buffer of up to 3% of the fund's assets. The proposals also call for restricting certain eligible asset types, such as asset-backed securities, establishing an internal credit assessment process, and setting minimum daily and weekly requirements for liquid assets. Another example of regulatory headwinds is the EBA's Technical Standards on securitization retention rules, whereby CLO managers will have to comply with minimum risk retention or "skin in the game" rules. Other obstacles include a lack of market liquidity for certain shadow banking assets, limited, albeit growing, institutional investors' appetite for alternative asset classes, and a paucity of independent benchmarks and information that would help investors better understand hitherto unfamiliar asset classes. (Standard & Poor's mid-market evaluation scale assesses mid-market companies' creditworthiness in an attempt to address this market need.) Cultural factors, such as borrowers' reluctance to veer away from long-term banking relationships, are also important aspects. We believe that many of these constraints, such as increased regulation, are here to stay. We consider that other constraints relating to market development will ease, but that the pace of progress will likely vary substantially by country. It remains to be seen whether the interplay of these factors will eventually lead shadow banking in Western Europe to approach the relative size and role of the sector in the U.S.

Wide Spread Of Ratings Reflect The Sector's Diversity And Fragmentation

Our ratings on Western European entities focusing on on- and off-balance-sheet shadow banking activities cover a wide range (see chart 6). This reflects some of the structural strengths and weaknesses of the shadow banking entities' respective business models. Our ratings are concentrated on U.K.-based entities, partly reflecting the relative maturity of the shadow banking sector relative to that in Continental Europe. As examples, we rate alternative asset managers 3i Group PLC (3i) and Intermediate Capital Group PLC in the 'BBB' category. The ratings on these two entities are supported by their relatively long track records, broad range of investment strategies, and diversified portfolios. The ratings also reflect the trend toward diversification away from their traditional areas of focus, such as 3i expanding beyond private equity into debt management. Our ratings recognize idiosyncratic factors such as defensible franchises with high barriers to entry and low credit risk. One such example is U.K. auto leasing company Motability Operations Group PLC, whose mandate is to provide cars to those receiving the government's disability living benefit. In general, our ratings on shadow banks on the off-balance-sheet/asset management side of the spectrum (see Appendix) benefit from lower confidence sensitivity--funds often have lock-ins and defined investment periods--and an absence of material maturity mismatches. Offsetting factors, however, include our view of the high risk profile of their investments, uneven cash flow and profitability, and relatively high, albeit declining, leverage. Our ratings on most on-balance-sheet entities, such as specialist finance companies, are generally constrained by their narrow business focus, high credit risk, and reliance on confidence-sensitive wholesale funding. U.K.-based second-lien/bridge financing lender Jerrold Holdings Ltd. is an example of this. In addition to high credit and mispricing risk, our ratings on distressed consumer debt purchasers reflect their inherently high regulatory and operational risk and often aggressive leverage policies.

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

Chart 6

Appendix: Shadow Banking Has Two Main Forms

Credit intermediation outside the banking sector encompasses entities with varied business models, asset class focus, track records, and levels of regulatory oversight. Notwithstanding this diversity, these entities can be broadly classified into two categories (see chart 7). The first category of shadow banking entities are companies that manage off-balance-sheet vehicles such as alternative asset managers and structured investment vehicles including collateralized loan obligations (CLOs). These firms invest in and manage third-party funds and typically invest in a range of credit-related asset classes. Investing in credit-related asset classes can imply both direct lending, for example, by specialized loan funds for commercial property assets and loans to mid-market companies; or indirect credit intermediation, where funds purchase distressed bank assets. In the latter case, funds may be viewed as enablers of credit creation by taking distressed assets off bank balance sheets. The second category of shadow banking entities mainly comprises companies that take on-balance-sheet risks such as specialist finance companies (see chart 7). Here the model is similar to that of a bank, with a key difference being the

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Underwriting The Recovery: Growth In European Shadow Banking Is Unlikely To Offset Bank Deleveraging

use of primarily wholesale funding for a typically more concentrated asset profile relative to diversified bank balance sheets and a lack of central bank access. Even with on-balance-sheet shadow banking entities, we can draw a distinction between entities that engage in direct lending, versus enablers of credit creation, such as purchasers of distressed consumer debt portfolios from banks.

Related Criteria And Research

Related Research
Underwriting The Recovery: Insurers' Role As Investors Expected To Be Preserved, Jan. 14, 2014 Underwriting The Recovery: European Securitization Could Fund More Lending, If The Regulatory Stance Softens, Oct. 22, 2013 Underwriting The Recovery: Ongoing Bank Deleveraging Constrains Credit Availability Across Much Of Western Europe, June 28, 2013 Credit FAQ: Standard & Poor's Mid-Market Evaluations Explained, June 24, 2013 Mid-Market Funding: Q&A: How The Development Of Private Placement Financing Could Aid Mid-Market

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Companies In Europe, July 18, 2013 Underwriting The Recovery: Financing The Path Back To Growth In Europe, April 10, 2013 Underwriting The Recovery: Internal Financing And Financial Discipline Keep European Companies On An Even Keel, April 10, 2013 S&P's Rating Actions are determined by Ratings Committee. This commentary has not been determined by Ratings Committee. The opinions expressed in this article do not represent a change to or affirmation of Ratings Services' opinion of the creditworthiness of any entity/entities (named or inferred) or the likely direction of ratings.
Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com

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