After the global financial crisis, strict regulations were put in place to prevent corruption and fraud and this meant that the banks were forced to pull back from the previous laxity in giving out loans.
As a result, SMEs which were now being refused loans had to find alternative finance.
Direct lending filled this gap in the market and offered mid-market companies a new source of liquidity.
Non-bank institutions are now taking advantage of regulatory changes and direct lending is booming.
Direct lending has become the norm in the US – with the UK and France playing catch up as the most prolific direct lenders in Europe. In fact, Deloitte reported that 2017 was the strongest in five years for direct lending in Europe with $24.5bn raised.
Borrowers are attracted by the lower rates and quick loan decisions that the direct lenders can offer and lenders are attracted by the investment opportunity with higher returns and low volatility.
However, one of the reasons that direct lending has had some bad press is that it can be riskier and despite improvements in direct lending regulations, diligent human judgment is vital.
The Growth of Regulation
Regulation in the direct lending industry is certainly progressing; before 2014 there were no requirements for direct lending platforms to be FCA regulated.
From 2014-2016 Interim permissions were granted by FCA to existing direct lending platforms with a requirement for them all to become fully authorised.
From 2017 direct lending platforms are regulated – or they fall outside the regulatory definition and this is key:
Regulation should not be wholly depended on as it doesn’t guarantee quality:
- Regulatory hurdles aren’t big for a basic lending model
- Not all direct lending platforms are created equal – a mix of quality remains
- There are few barriers for a new platform to pass
Types of Borrowers
With no end in sight for the demand for loans – types of lenders have expanded. For example, ten years ago, banks dominated the financing of small and medium-sized corporations.
Today this has been distributed among a far greater number of players:
Alternative lenders have become ever-present in the UK financial system and banks are not so much relied upon when they tighten their belts and stop the flow of money. This enables thesmaller business to access finance and grow; all good for the economy.
The last year has been a relatively healthy one for direct lending with low default rates, only a modest tightening of policies at the end of 2017 and a pretty much benign financial landscape.
A potential reduction in interest rates for lenders
Direct lending platforms are increasingly competing for borrowers on price rather than speed which may lead to a reduction in interest rates for lenders in 2018:
Banks are now re-entering the loan market and will potentially share in the direct lending market.
Open banking initiatives may encourage may also lead to banks adding direct lending services to their packages for their customers.
Companies outside financial services will also potentially be offering direct lending services.
Alternative financiers will be supported for generations to come
The forecast is that direct lenders will compliment not disrupt with the collaboration between direct lenders and traditional lenders.
Direct lending will remain an alternative source of funding for traditional lending institutions.
The flight to quality
A ‘flight of quality’ is predicted in the next few years which could slow down the direct lending market but improve the reputation of the industry. Many weaker platforms have already failed as they are overtaken by stronger, more trustworthy platforms.
There will also be a move towards direct lending platforms being progressively staffed by financial experts who will make the decisions – leading to a higher quality market.
In fact, most direct lending platforms are now managed by a head of credit with fifteen or more years of experience:
Add to this, more platforms are meeting the borrower or applying human analysis before offering the loan:
The success of the direct lending platforms is now driven by their ability to lend to high-quality borrowers.
Direct lending is a maturing and fast-growing asset class and will evolve to accommodate stricter regulation and other stakeholders and creditors.
With a demand for loans that shows no signs of stopping and lucrative benefits for the lenders, there is still a strong strategic case for investing in direct lending.
The regulatory climate is also supportive – the European Commission did not constrict the industry due to the fact that it does not pose significant financial instability or risk to investors.
However, with quality and safety paramount, shrewd human judgment is key to continue to promote a good reputation.