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The potential for creating some 10000 new jobs in European non bank finance securities administration Back
PAT WALL, who heads up an Irish Government task force to develop non-bank finance, looks at the opportunity the funding gap presents for Ireland. 'Europe needs an alternative source of business financing to augment that provided by banks. 'Europe's governments, regulators and industry players must respond in order to finance the recovery'. 'The development of a European non-bank finance market is a project at least as great and arguably more urgent', he says.
Europe has been very slow to recover from the financial crisis with unemployment rising in most countries. In contrast the US is showing clear signs of recovery. One of the factors behind this contrast in fortunes is the availability of credit to fuel business investment and working capital. Both in the US and Europe banks are being squeezed by regulators, politicians and investors. But the impact in Europe is much greater where business has long been much more reliant on bank funding.
Pat Wall

In July the Central Bank of Ireland issued a discussion paper on entitled “Loan Origination by Investment Funds”. The paper, which invites responses by 13th Sept, was in response to pressure from the asset management industry to allow investment funds to make loans to corporates and SMEs. The CBI paper is a welcome response and it is to be hoped that it will result in a policy change allowing the Irish based industry to respond.

Luxembourg already permits such lending. It is interesting to reflect on the circumstances in which the CBI has issued its discussion paper.

Non-bank finance - Europe compared to the US
In the US, banks accounted for about 25 per cent of corporate lending compared to about 90 per cent in Europe according to statistics for 2011. The US has a much better developed non-bank finance market allowing investors to participate directly in direct lending. In Europe most lending is intermediated through banks. The squeeze on European Banks has resulted in a credit squeeze for European businesses.

Non-bank finance - emerging European consensus
Ireland made the issue a theme of its Presidency of the EU. Speaking at the Eurofi conference held in Dublin in April this year Jacques de Larosiere said;
“The consequence of deleveraging of banks is that demand for loans among good quality businesses and projects is not being met”. Michael Noonan, Irish Minister for Finance said; “The EU must improve the effectiveness of the financial system in channelling savings towards the financing of both infrastructure projects and also enterprises, especially SMEs.”

And, John Moran, Secretary General of the Department of Finance had this to say: “There are lessons to be learnt from good practice in the US, Canada, and Australia where pension funds, insurers and mutual funds are active investors in the economy. New instruments and products will have to be developed to attract further capital market funding for Europe.”

It is sobering to reflect that the US has an 80 year head start on Europe. The more diverse funding landscape is attributed to the 1933 Glass-Steagall bank reforms following the Wall Street Crash of 1929. The US financial environment enables investors and asset managers to directly participate in the creation and syndication of corporate lending. The greater flexibility and maturity of the US market has created a virtuous cycle resulting in a well regulated deep market for loans making them a suitable asset class for mutual funds and pension funds. The secondary market for debt in the US amounts to about $400 billion annually. By comparison the European market is small. But that will change, rapidly.

European debt funding gap
Depending on who you believe, the European funding gap, the difference between what business will need and what the banks can provide over the next 5 years is somewhere between 2 and 4 trillion Euro. Non-bank finance has to play a major role in bridging this gap. To quote from a Department of Finance report issued in April 2013: “Attracting increased flows of capital from institutional investors and effectively channelling it towards long term investment in infrastructure projects and the SME sector is now a core policy priority for Europe.

The challenge to the European Financial system is enormous. Despite the EU single market and the existence of the euro, the market is still a patchwork of different banking, lending and bankruptcy laws.

The s-word: ‘shadow banking’!
The need to respond appropriately to the squeeze on bank credit has not been helped by muddled thinking on so called “shadow banking”. Happily the light is beginning to dawn that not all non-bank financing activity is shadow banking and not all shadow banking is bad. To quote from an IMF Staff Discussion Paper of Dec 2012: “Shadow banking...provides important financial intermediation functions distinct from those performed by banks...These functions can be economically useful and need to be understood and properly regulated.

However, the term “shadow banking” has by now acquired negative connotations and to equate non-bank financing to “shadow banking” is dangerously simplistic.

Alternative sources of financing cannot be developed if all lending activity is straight-jacketed into traditional banking rules. It was those very rules and the dominance of bank lending in Europe that has given rise to the current problems. Non-Bank finance needs to be understood as a separate activity and regulated accordingly.

In essence it is the process of directly matching investor capital with lending opportunities. If properly conducted,non-bank finance has the potential to eliminate the central problem of traditional banking; the conversion of short term liabilities (deposits and wholesale funding) into long term assets.

Non-bank finance can eliminate this problem by matching investors and borrowers with similar risk and maturity appetites.

Long Term Funding - EU Commission
The EU Commission issued a Green Paper on 25th March 2013 “Long-Term Financing of the European Economy” in which it acknowledges the diminished capacity of banks and the need to facilitate alternative sources of financing. The Green Paper sets out a series of questions and invites responses within 3 months. Commenting on the Green Paper, Eurofi states in its paper published for the High Level Seminar in Dublin in April 2013: “Considering the lengthy EU regulatory process....it is essential to agree by the end of June a strong and ambitious EU action plan that could remove existing barriers...”.

Loan funds
In the US a well developed mature secondary loans funds market has resulted in an asset class suitable for investment by mutual (retail) funds. The relatively embryonic nature of the European loan funds market means that there is a relative scarcity of traded loans. At its current stage of development, the European market is more suitable as an alternative asset class suitable for professional investors.

The relative scarcity of loans in the secondary market is exacerbated by European Banks’ constraints in originating new loans. If the European market is to develop, as it must, financial players and regulators must devise structures that reflect the reality of the banks -a lack of capital- but its importance in relationship management, especially in SME lending. Players other than banks need to be allowed to originate and service loans subject to appropriate regulatory oversight.

There is already a steady demand for professional investor funds largely being met by Luxembourg special investment funds (SIFs).This will change over time as the European loans market matures and deepens. The European goal should be to create an asset class suitable for investment by retail/UCITS funds.

The Luxembourg regulator already allows professional investor funds to originate loans and the publication of a discussion paper by the Central Bank of Ireland is to be welcomed. It is encouraging that the CBI recognises the nature of the challenge as evidenced by these remarks by Pat Brady, Director of Policy and Risk at the Irish Funds Industry Association (IFIA) conference in June 2013: “There is a debate over how best to raise financing for firms in Europe without relying so heavily on the banking system. The lack of credit from the traditional banking system has led to calls that an alternative to traditional forms of lending must be considered as a way of meeting that demand. UCITS are unlikely, in my view, to have a role in this regard. However, I think the time has come to ask the question of whether AIFs could have a role. Would it ever be appropriate for a collective investment type structure to operate as a vehicle for funding of corporates and SMEs in Europe?”

Can the IFSC be an international hub for non-bank finance?
Many of the skills, resources and legal structures needed to support non-bank finance are already present in the IFSC. These include:
- Securitisation and Collateral Intermediation Structures - Section 110 Companies
- Leveraged Investment Structures including Hedge Funds - Qualifying Investor Funds(QIFs) and Professional Investor Funds (PIFs)
- Global Custodians and Administrators
- Money Market Funds
- Deep Legal and Accounting Expertise

REITs , Real Estate Financing and Infrastructure Funding
The Irish 2013 Finance Act introduced a Real Estate Investment Trust (REIT) regime. This may stimulate some local investor interest in Irish property but is unlikely to be attractive as a vehicle for international investors. However Ireland does have an attractive regime consisting of the Qualifying Investor Fund (QIF) and the special purpose vehicle known as the Section 110 Company.

Could it become a centre for international property financing akin to the successful international aircraft leasing sector? It would be difficult to replicate the aircraft leasing model given the nature of the underlying assets, but there are already a number of such real estate/infrastructure structures already domiciled in Ireland. There are additional issues to be overcome, mainly tax, but in this Ireland faces no greater challenges than other potential domiciles. Gains and income on real property are generally taxed where the real estate is located and there is limited scope for creating tax neutral investment vehicles in third countries. Luxembourg has had some success in offering itself as an international real estate funds domicile. This was based on its unique tax treaty arrangements which are being rolled back as treaties are renegotiated. There is an opportunity for development of a real estate/infrastructure finance hub in Ireland. The structures and skills needed to support this activity are there.

Employment potential
Ireland is a major global centre for the administration of investment funds. The industry employs some 12,000 people. Ireland is also an important global hub for non-bank finance in the form of leasing, in particular aviation finance. Ireland has deep expertise in structuring and administering international syndicated loans for real estate and infrastructure projects. In back office and middle office there is an existing strong base of expertise in the administration of loan books and arguably a surplus of capacity within the banks.

If Ireland can leverage these attributes, its membership of the Eurozone and access to the single market it is well placed to benefit from the development of a non-bank finance market in Europe. It is helped by the fact that it is English speaking with close affinities to the US and London where much of the non-bank finance front office expertise resides.

It is not “pie in the sky” to aspire to jobs growth in a well developed non-bank finance hub measured in thousands. In the funds industry practitioners estimate that it takes 1.5 people to administer a traditional investment fund and 3 people to administer a loan fund. Extrapolating from the funds industries 10,000 people administering about $2 trillion in assets the potential for loan funds is impressive assuming that the European market for non-bank finance increases by between 2 and 4 trillion euro over the coming 5 to 10 years as predicted.

Europe needs an alternative source of business financing to augment that provided by banks. Europe’s governments, regulators and industry players must respond in order to finance the recovery. Ireland with Luxembourg was among the few countries to seize the opportunity created by the Single Market for collective investment funds. The development of a European non-bank finance market is a project at least as great and arguably more urgent. Luxembourg has led the way, can Ireland follow?

I will leave the last word to Michel Barnier, Internal Markets and Services Commissioner who said in March 2013; “Ensuring our economy and our financial sector...are capable of funding long term investments is an important but complex task. We need to identify what barriers exist to long - term financing, and what more can be done to overcome them.”
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