Shadow Bank Lenders Are High on Regulator Watchlists
Damian Ghigliotty July 8, 2015, 11:47 a.m.
Commercial real estate lenders of all kinds can still feel the after effects of the housing collapse and financial crisis of 2007-2008. Ask their publicists and you might get a different response, but attend one of this year’s industry conferences and the concerns are as candid as they’ve ever been.
Increasingly, the focus has shifted from the regulation of banks to the regulation of large insurance companies and asset managers and what that means for other nonbank lenders down the line—private equity firms, commercial mortgage-backed securities issuers, real estate investment trusts, and even some of the more successful crowdfunding platforms that dabble in securitization.
“It is now eight years since major cracks in the financial system that led to the global financial crisis first appeared in nonbank entities and activities,” Federal Reserve Vice Chairman Stanley Fischer said in late March at a conference in Stone Mountain, Ga.
Those institutions, often referred to as shadow banks, “can pose the same key vulnerabilities as banks, including high leverage, excessive maturity transformation, and complexity, all of which can lead to financial instability,” Mr. Fischer said. “The failure of Lehman provides a good example. It was a nonbank, and its failure both imposed direct losses on its many types of counterparties and disrupted many markets with negative effects on banks.”
The Fed vice chairman had offered similar remarks at an industry event in Frankfurt, Germany, three days prior. The focus of those two speeches was not residential versus commercial lending, but instead significant potential threats to the global financial system.
It’s far from news that banks have become increasingly regulated in their residential and commercial lending post-crisis. The rules of the Dodd-Frank Act and Basel III combined have required banking firms with more than $10 billion in assets—Citigroup, Wells Fargo and J.P. Morgan Chase, among the many—to keep more capital on their books and undergo routine stress testing, in addition to other regulations.
What started as a censorship of the largest of firms has gradually trickled down to regional and local banks, including Signature Bank, which former Representative Barney Frank joined the board of this June, and New York Community Bank in the Empire State.
Those requirements have given nonbank lenders an extended opportunity to shine. A sentiment of “We help fill the void,” was what dozens of alternative finance executives told Commercial Observer between 2011 and 2014. But as the regulatory landscape continues to grow, the next set of rules is starting to creep up on many of those nonbank lenders, according to industry sources.
It was a hot topic at the CRE Finance Council’s 2015 conference in New York this June. Christina Zausner, the trade association’s vice president of policy and industry analysis, spoke in detail about the potential changes to nonbank regulation in the near future.
“The regulatory framework for insurance companies, nonbank CMBS lenders and large asset managers, in particular, is evolving,” Ms. Zausner later said in a series of interviews. “The question on everyone’s mind right now is whether the regulators are going to come away tomorrow thinking differently about CMBS or debt funds and mezzanine lending. They want to know what the regulators are going to tell them to change about their business strategies.”
One of the most visible signs of more regulation to come falls on the companies that have been and may be designated “systemically important financial institutions” (SIFI) by the country’s Financial Stability Oversight Council (FSOC). Those designations bring stricter government oversight as well as higher capital and liquidity requirements in the upcoming years. The FSOC, a group of 15 government regulators established under Dodd-Frank in 2010, works closely with the Financial Stability Board (FSB), an international body set up to monitor the world’s financial system with support from the G-20.
“The big moving part in terms of what’s going to change and look more like prudential regulation in the future starts with any lender that has been designated a nonbank SIFI,” said Ms. Zausner, herself a former senior examiner at the Federal Reserve Bank of New York. “Dodd-Frank basically said we’re going to treat the banks one way and then look across the entire financial system and identify institutions that we believe pose systemic risk.”
Among the known regulations U.S. commercial real estate lenders will face next year are stricter CMBS rules mandating issuers hold 5 percent of each deal. Ms. Zausner and others noted that some of the biggest regulatory changes to come are likely five or more years away as national and international authorities continue to roll out new laws over time.
The FSB, which publishes policy recommendations to bring more oversight and regulation to the global shadow banking system, is most concerned with leverage and maturity, or liquidity, transformation, one international regulator told Commercial Observer on the condition of anonymity.
“If you are providing 30-year mortgages, but your primary source of funding is only for one month, which is much cheaper, then you are transforming maturity,” the regulator said. “This looks O.K. on the balance sheet when liquidity is abundant. But when market sentiment changes, it exposes the lender to serious problems, including bankruptcy.”
The SIFI designation reserved for large financial firms serves as a warning that a company’s failure, if it were to occur for any reason, could likewise trigger another global crisis.
In 2013 and 2014, the FSOC—with guidance from the FSB—designated life insurance lending giants Prudential Financial and MetLife, along with AIG and General Electric’s financial arm, GE Capital, as nonbank SIFIs.
Those designations were followed by a high-profile lawsuit from MetLife in January 2015 and the unexpected announcement in April that GE will break up and sell its $500 billion financial division, in part due to GE Capital’s SIFI tag.
Prudential, which holds more than $1 trillion in assets, did not take legal action over its designation, but has publicly said that it does not meet the standards of a nonbank SIFI.
AIG, for its part, could go as far as retooling its corporate structure to become less of a regulatory target, The New York Times’ DealBook reported in May.
All three firms are now subject to enhanced oversight from the Federal Reserve, as well as future capital requirements that are currently being decided on. The extent to which Prudential, MetLife and AIG will need to alter their commercial lending practices in the face of increased nonbank regulation remains up in the air.
“We manage our insurance companies to levels of capital that we believe are consistent with AA standards,” Scott Hoffman, Prudential’s vice president of global communications, said in a statement provided to Commercial Observer. “Our domestic insurance company, Prudential Insurance, meets or exceeds the statutory requirements of all states where we are licensed, including our home state of New Jersey, and New York.”
MetLife, which is still fighting its SIFI designation in federal court, has argued that the federal government should preserve “a level playing field” in the life insurance industry.
Overall, the growing number of regulations across the finance sector has brought more institutions into the advocacy and lobbying arenas, according to several of the people interviewed for this story. The main concern for alternative lenders outside of the life insurance realm is whether federal and international regulators will soon turn the Klieg light on them.
“If BlackRock or Fidelity were to be designated SIFIs, as some have said will happen, that would have major implications for our current regulatory environment,” said one industry executive, who asked not to be identified.
Ms. Zausner declined to name specific institutions, but said the SIFI debate has moved from insurance companies to diversified asset managers, as regulators continue to broaden their scope over nonbanking financial companies.
“Size is an important factor in this, but national and international regulators also look at interconnectedness, current regulatory regime and complexity,” she said. “Still, there is great concern in the industry that the regulators are relying too heavily on size and perhaps other less important factors.”
Smaller nonbank lenders that may not qualify as SIFIs, but that also pose systemic risk to the global financial system, are equal targets, said the international regulator. Hedge funds, securities firms and mortgage REITS are among the kinds of commercial real estate lenders that regulators are starting to monitor more closely for overleverage and maturity transformation, he noted.
“One area that regulators are becoming increasingly focused on is bank-to-nonbank relationships,” the regulator said. “The goal is to make sure that any risks in the nonbanking system don’t spill over to the banks and vice versa.”
To that end, the FSB and national regulators will continue to look at all types of alternative lenders that may or may not pose actual systemic problems, he added. “They have to keep thinking about the future as the shadow banking system evolves and make sure they haven’t missed out on anyone,” the regulator said.
As of July 2015, however, not everyone is experiencing such regulatory scrutiny. “I’m not seeing anything tangible,” said Bruce Batkin, co-founder and CEO of Terra Capital Partners, a New York-based fund manager that originates bridge loans, mezzanine debt and preferred equity investments. “I have read that regulators are trying to determine whether alternative lenders could pose systemic risk, but am not aware of any specifics.” He emphasized that his firm adheres to current regulations from the U.S. Securities and Exchange Commission and Financial Industry Regulatory Authority.
Mr. Batkin said increased scrutiny over nonbank lenders could have a “chilling effect” on the market’s ability to provide adequate refinancing proceeds for maturing loans as well as new capital for transitional properties and ground-up developments.
“Right now in real estate, there’s a reconsideration of how space is being used as our population ages and more millennials enter the workforce,” he said. “There needs to be adequate debt capital available to accommodate that. Borrowers need access to entrepreneurial, flexible financing that is not dependent on the FDIC to guarantee deposits nor heavily regulated by Dodd-Frank and Basel III.”
Among the Basel III bank rules to go into effect this year is a new set of capital requirements for acquisition, development and construction loans classified as “high volatility commercial real estate.” The new rules impose a higher risk weight on HVCRE loans, up from 100 percent to 150 percent, requiring the banking institution to hold more capital on its books for such deals.
Additionally, borrowers in those cases must contribute 15 percent cash equity to the project before the lender advances funds in order for the loan to be reconsidered as a regular, non-HVCRE mortgage. Appreciation in land value does not count toward the equity in those cases.
“Regulators are concerned about the concentration of those loans and what it does during a downturn,” said Rick Lazio, a partner and head of the affordable housing and housing finance practice at the national law firm Jones Walker. He noted that the Federal Reserve and other authorities have a growing desire to set up a regulatory regime for nonbank lenders.
“When it comes to the buildup of leverage among shadow banks, one of the biggest concerns is that leverage and maturity occur in stages,” Mr. Lazio, a former U.S. representative from New York, added. “One of the common threads in commercial real estate is that by the time construction on a development is completed, market conditions may have changed, demand may have dropped, and the value of the collateral may be impaired.”
One of the other big topics at this year’s CREFC conference in New York was whether another downturn could impact the U.S. economy by 2020. That conversation quickly spread after a room full of institutional real estate lenders agreed almost unanimously by show of hands that the country is likely to experience another recession in the next three to five years. What will this mean for alternative lending?
“It’s unrealistic to think that alternative sources of financing, especially as they grow in importance for the industry, would remain untouched by regulation,” said Sam Chandan, founder and chief economist of Chandan Economics.
Mr. Chandan said that improving financial regulations now to make them less opaque to those who adhere to the rules could help mitigate pressures on borrowers and lenders whenever the next downturn occurs.
For the regulators, the key issue is identifying which institutions pose the most risk before the U.S. and global economies experience another collapse, Mr. Lazio said.
“One of the things with downturns is that you don’t see them coming,” he said. “It is likely that that is on the minds of the Fed, and more broadly the federal regulators, as they look to address the issue of leverage in the nonbank world.”
Daniel Tarullo, the tough-talking Fed governor appointed in 2009, has spoken publicly about the need for increased nonbank regulation on several occasions. Mr. Tarullo, who also serves as chairman of the FSB’s standing committee on supervisory and regulatory cooperation, brought his concerns to Congress in February 2014.
“Since the crisis, regulators have collectively made progress in addressing some of the close linkages between shadow banking and traditional banking organizations,” the influential regulator told the U.S. Senate Committee on Banking, Housing, and Urban Affairs. “Still, we have yet to address head-on the financial stability risks from securities financing transactions and other forms of short-term wholesale funding that lie at the heart of shadow banking.”
The Fed’s Mr. Fischer echoed those sentiments in Georgia this March. “The nonbank financial sector in the United States is larger, and plays a more important role, than it does in most other countries,” he said. “The nonbank sector has produced material benefits: increased market liquidity, greater diversity of funding sources, and—it is often claimed—a more efficient allocation of risk to investors. However, threats to the stability of the overall financial system have also increased.”
Messrs. Tarullo and Fischer declined to comment for this story through a Federal Reserve spokesman.
The concern among institutional lenders and investment firms is that more regulation, if overdone or not done in the right way, can tax resources to an unsustainable level, according to those with close ties to the industry.
“If you talk to any financial institution about the 300 different rules coming at them, you’ll find that capital and liquidity requirements are usually their biggest and most immediate concerns,” Ms. Zausner of CREFC said. “As time goes on though, I think regulations tied to compliance reporting and data analysis will also be seen as resource constraints.
“The question for a lot of these firms as they look ahead is whether they have the technology and personnel in place that will allow them to comply with the latest regulations,” she concluded.
In the near future, however, those financial pains may lead to muted cries as increased regulation becomes more prevalent across the board.
“Soon enough, you’ll hear everyone start to say that they’re ready to absorb whatever the regulators throw at them,” said one industry insider, who referred to the issue as fraught and asked to remain anonymous. “When the time comes, they’re not going to say anything different, as a matter of policy, and that’s because they won’t want any of their investors to pull out and cause a liquidity crisis.”