Increased digitization, innovations in credit decisions and funding models, and the emergence of new lending platforms are all re-defining the commercial lending marketplace. Traditional lenders operate in an increasingly competitive market environment as nontraditional players make inroads, challenging historical norms. Innovative responses from traditional lenders will be critical to their ability to compete and grow.
There are several variables contributing to this new world of lending; from the macro level due to new competitors changing the broad environment of commercial lending to specific pain points affecting individual lending institutions to varying degrees, including increasing cost pressures on back-office operations and keeping up with increasing regulatory obligations
A look at the macro-economic environment reveals a mixed bag of indicators that will impact lending for several years. The World Bank estimates economic growth will slow to 2.9% in 2019, continuing the deceleration in growth rate to 2.7% in 2020-2021. Financing conditions are tightening because, among other things, interest rates are coming off of the historical lows from a couple years back. Downside risks have started to emerge. We are shifting from globalism to protectionism; trade tensions are elevated, and the rules of global trading are being strained, if not broken. A troubling phenomenon is occurring in large, emerging economies: the gates are closing. Governments, skittish about global economic trends, are introducing new policies to limit imports and exports. All of these factors could possibly disrupt markets.
On the other hand, a report from the World Bank and data from the Federal Reserve, March 2019 showed a 196,999 increase in jobs in the US. Unemployment is at 3.8% (Bureau of Labor Statistics) – a record low. Labor participation is at 60.3%. According to the US Bureau of Economic Analysis, we have had 10 years without a classic definition of recession.
While the US is not in recession; we are in the late stage of a long-standing expansionary cycle. This continues to be good news. However, while I can’t predict a definitive date, I do believe that the credit cycle will eventually turn negative over the next 2-3 years.
The Economic Cycle Vis-A-Vis The Credit Cycle
Where are we in the economic cycle today? While GDP has remained stable, the growth cycle has slowed. A look at US GDP growth by quarter from 1995 through 2018 illustrates that, even though we have seen incremental gains, we are nearing the end of the growth cycle.
Is the credit cycle going to give us a hint of what’s to come, or do we have to look at other things? Pension funds, economic growth and the stock market are other indicators to be factored in. But is the US economy really one economy anymore? Digital and analog systems behave differently. What should we be looking at? In the US, the economy is bifurcating.
By standard economic theory, flushing out excess capacity in the system is essential and it should have happened in the second or third quarter last year. In the past, harbingers of recession have been contraction of the credit cycle, flattening / inversion of yield curve, and the stock market taking a beating. All three happened last year. We had no recession. Why?
New Influences of the Economic Cycle
One primary reason no recession occurred in 2018 is that central bankers across the globe learned their lessons from 2008 and are now coordinating with each other to a much greater extent than in the past. No governments want to see a recession. The critical question is whether central bankers can and will continue to prop up their economies more deliberately than we have seen in the past 30-40 years.
Another reason is the change in governments’ fiscal and monetary approach. Essentially, governments are kicking the can down the road—a new behavior—that has increased the period of growth in the economic cycle. What else has changed?
Throughout the last almost 70 years, as tracked by the Board of Governors of the Federal Reserve System, commercial and industrial loans by all commercial banks have increased, and steadily.
However, it is also clear that economic downturns and recessions have interrupted this secular growth trajectory. In fact, in the last economic downturn in 2008 loan growth turned negative before the recession, and then continued to grow as the economic expansion restarted. We had a contraction earlier in this decade, and yet there was no recession after. As the chart (left) illustrates, we have also seen a very long stint of low charge-off rates since the financial crisis of 2008. This is important because charge offs and write off assets depress earnings and make lenders wary. A close look at individual segments supports this view.
For instance, in the Equipment Financing and Leasing sector, an end-user survey by the BEA, HIS Markit, Foundation published by Keybridge, LLC, the recent past and the immediate forecast look very promising. The $1 Trillion sector is well positioned for the future with many signs pointing to strong business confidence and increased investment as key sectors rebound. Additionally, the Purchasing Managers Index PMI Market Report recently gave a score of 55. (Anything over 50 is considered expansionary.)
Alternative Lending Disruptions
However, the traditional commercial loan space is experiencing considerable disruption. Take the Alternative Lending Segment, where total transaction value amounts to US $243,079.6M in 2019. Total transaction value is expected to show an annual growth rate (CAGR 2019-2023) of 10.7% resulting in the total amount of US $365,214.8M by 2023.
The alternative market’s largest segment is Crowdlending (Business) with a total transaction value in the US of $180BN in 2019. The highest cumulated transaction value is reached in China (US $222BN in 2019). Over the last six years, traditional finance companies have lost 11 percentage points of share; banks have lost 12 percentage points; credit unions have lost 10 points. Fintech and other lenders have picked up the 33 percentage points, growing from 5% share of the personal loan market in 2013 to 38% in 2018.
Why include personal loans here? The consumer disruption will affect commercial banks in the consumer sector as well as commercial lending and other traditional lenders; it is only a matter of time.
Additional Pain Points for Traditional Lenders
Added to these global, macro variables, there are unrelenting pressures for traditional lenders to bring down the cost of back-office operations. This is not because profits or spreads are down, nor is it due to shareholder pressure. These cost savings are essential so that CEOs and their companies can invest more in new product development, marketing and promotion. These savings are foreseeable due to technologies that did not even exist in workable form as recently as five years ago.
Artificial intelligence and machine learning are disrupting the lending operations environment and changing the game. Machine learning takes a lot of information, analyzes it and incorporates it over time to help mitigate risk, reduce errors and gain greater efficiency. According to the International Data Corporation, AI investment will grow to $35.8 B this year in retail and banking and to $79.2 B by 2022. Analysts estimate that artificial intelligence will save the banking industry $1 trillion; contingent, of course, upon the level of comfort that consumers have with AI.
Clearly, as the game is changing, it is incumbent upon lenders to adapt as well in order to compete. And it is not just in the realm of technology that these changes are occurring. The Code of Federal Regulations (CFR) codifies the general and permanent rules promulgated by the departments and agencies of the federal government. The total number of pages published in the CFR annually provides a sense of the volume of existing regulations with which American businesses; workers, consumers, and other regulated entities must comply.
Has the credit cycle given us a hint of what’s to come. Is there still a lock step relationship between interest rates and the economic cycle? There used to be. But that is much less certain in today’s environment.
What are the implications for the US economy? First, as stated before, the US is still in a record long recovery. Most indicators reviewed above are positive. However, the economic benefits have not reached all citizens or all small business. While corporate profits are robust and the stock market reflects this, we are now in very serious trade disputes with some of the next largest economies in the world.
The economy goes through four stages, based on output or GDP—expansion, peak, contraction and recovery. As stated above, I believe we are in a late cycle expansion.
How long that expansion continues is contingent in part upon the wild cards in the market, major disruptions we must grapple with every day. These wild cards include the many more methods of financing. And as we track these changes and advances, we must carefully weigh the risks versus the opportunities of what we can apply in our own businesses.
Among the many potential exposures and challenges banks and financial services institutions face just in the traditional mortgage market are the use of crypto currencies, data security, evolving customer expectations, increasing pressure from competition, disruption by nontraditional players, investor expectations and the ever-changing regulatory compliance obligations.
Dealing With the New Environment Going Forward
From a lender’s point of view, as a result of the above, securitization is even more critical than ever before. Not only has the external environment changed rapidly beyond just Uniform Commercial Code (UCC) File and Search, the broader economic environment has become more challenging and tougher to navigate. Asset securitization is speeding up. It’s harder to correct an initial error; there are fewer resources, less time and money to do the job. In short, managing a portfolio and risk for the long term requires capabilities that provide better visibility and control.
There are four realities I recommend keeping a close eye on as we make decisions about technology, cost-cutting and new approaches to help with not only keeping up with, but outpacing the market:
- We are in an unusually long expansion cycle.
- The credit cycle is showing signs of softening.
- Cost pressures and quest for efficiency will continue.
- Compliance is unlikely to become less complex for the lenders.
We live in a world defined by disruption and change that requires us to anticipate and manage what is already here as well as what is coming. To flourish in today’s complex environment, we need to be willing to change decades-old business practices and innovate to compete.
This is an essential set of skills for lenders now, and it is recognized as an emerging core competency for institutions. Successful, sustainable change management is more critical than ever before.
Author: Raja Sengupta is executive vice president and general manager of Wolters Kluwer’s Lien Solutions (WKLS). As the chief executive of the business, he leads a growing organization focused on providing search and filing services through its nationwide network. WKLS caters to top U.S. banks and global financial services companies and is the market leader for UCC and other types of liens.
Before joining Lien Solutions, Sengupta was executive vice president and general manager of CT Small Business, a Wolters Kluwer business that provides compliance solutions to small and mid-sized businesses for business formations, business license, digital brand protection and other Governance, Risk & Compliance issues.
Sengupta has deep roots in the financial services world and has broad experience in leveraging technology and organizational and process redesign to reveal commercial opportunities and increase value in organizations. Prior to Wolters Kluwer, he served as general manager and business leader of American Express, where he led the development and launch of the Merchant Financing business, regarded as a marketplace innovation in alternative commercial lending.
Sengupta started his career as a management consultant in Mitchell Madison Group¹s New York office. Subsequently, as global head of Banking and Financial Services Practices at Inductis LLC (now part of EXL Service), he played a critical role in the firm¹s growth, positioning it as a reputable player in big data analytics.
He received a bachelor of science degree in technology from the Indian Institute of Technology (IIT) and a master of business administration from the Indian Institute of Management (IIM). He can be reached at email@example.com.