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Friday 25 November 2011

Alternatives To Traditional Business Funding

Huge thanks to MarketInvoice for the kind invitation to their event at the Cass Business School yesterday. The event really highlighted the gravity of the SME funding situation and the giant leap in understanding that is required of politicians and policy-makers in this area.

Chuka Umunna MP, Shadow Secretary for BIS, gave the keynote, and the panel included Andrew Cave, the Head of Policy at the Federation of Small Businesses, Emmanouil Schizas of ACCA Global, as well as Anil Stocker of MarketInvoice and Andy Ralph, director of a company that has raised significant amounts of invoice finance in the past quarter. 

Chuka gave some useful context:
  • All the recent banking industry figures point to a significant contraction in lending to SMEs in the past quarter. Worse, SME Finance Monitor says over half of SMEs applying for overdrafts this year for the first time have been refused, and more than 400,000 SMEs who wanted to apply for an overdraft in the third quarter  didn’t do so – a third because they were discouraged by their bank.
  • A recent BACS report also suggests that "half of all the UK’s small and medium sized enterprises are awaiting late payments. On average, each firm is owed £39,000 in late payments, with the total amount owed to SMEs having reached a staggering record figure of £33.6bn."
Less helpful, however, were Labour's proposed solutions to this mess. In summary, notwithstanding his glowing endorsement of MarketInvoice's as a useful private sector alternative to bank finance and the acknowledged need for more non-bank competition, Chuka said that Labour wants:
  • Banks to improve local relationship management;
  • The government to be more active and directly involved in improving payment and supply chain management;
  • To create a new agency along the lines of the US Small Business Administration and Small Business Investment Company programme, whereby SBICs use their own capital plus funds borrowed with an SBA guarantee to make investments in qualifying small businesses - a phenomenal soure of moral hazhard and downright fraud that's been well documented by David Einhorn in his US Senate Committee testimony and the book "Fooling Some of the People All of the Time"; and
  • To use government procurement to help SMEs (notwithstanding Labour's notorious reputation for waste in that area).

Perhaps it's beyond his shadow brief, but it was notable that Chuka made no mention of the discussion of alternative regulatory solutions here and in the US, nor the Cabinet Office focus on red tape that inhibits disruptive business models that specifically identifies alternative finance platforms. There was no reaction to the suggestion that alternative payment providers should enjoy the same tax subsidies that banks and other regulated institutions enjoy through ISA/pension allowances and individuals' ability to off-set losses against income. And no thought appeared to have been given to the idea of a clearly defined 'safe harbour' for the likes of MarketInvoice and peer-to-peer platforms from the rules on collective investment schemes and/or arranging deals in investments, to enable them to start up more confidently, quickly and efficiently.

In fact, Chuka's pitch rather underscored his party's role in helping to create our desperate need for alternatives to traditional business funding. Let's hope we see some decent ideas from the opposition in future.

In the meantime, it's down to the participants on MarketInvoice, Funding Circle and CrowdCube and the many angel networks to carry the alternative funding hopes of SMEs.

Wednesday 16 November 2011

A New Regulatory Model For Retail Finance - Update 1

"It's time for reflection..." FT.com
The fact that the US has taken the first step towards a 'Crowdfunding Act' requires an update of my earlier post on a new regulatory model for retail finance...

Non-bank retail finance models have been gaining momentum worldwide over the past six years, in spite of our creaking financial regulatory framework. Finally, it seems that framework is about to become more directly supportive. 

Since 2005 we have seen the launch of various innovative person-to-person, or peer-to-peer (P2P) finance platforms in the UK, US, Germany and elsewhere, which have been tracked here. These were launched by teams that spent considerable time and expense trying to accommodate existing regulation that favoured incumbents, with little or no regulatory assistance. Their goal was to enable those with surplus cash to connect directly with people who needed finance in a way that minimises costs and delay, and leaves most of the 'margin' with lenders and borrowers, rather than the middleman.

Meanwhile, we have all discovered that the existing financial regulatory framework, ironically designed to protect consumers, actually guaranteed the worst excesses amongst 'traditional' banks and failed to contain the risks posed by the "shadow banking" system. And although taxpayers have had to step in and effectively democratise the financial markets, we are still unable to extract badly needed funding from retail banks.

Against that background, it is perverse that the regulatory framework does not already directly facilitate simple, low cost, alternative financial services. And let's not forget that banks and other retail investment institutions continue to enjoy indirect tax subsidies through individuals' ability to off-set losses, as well as ISA and pension allowances for which unregulated alternative investments do not qualify.

While substantial innovation in consumer and small business lending has been possible, UK rules against marketing investments like bonds, shares and unregulated collective investment schemes, have made it much harder to offer direct, alternative funding for SME start-ups, trade finance and even social projects. Given a more proportionate investment regime, the likes of Crowdcube, MarketInvoice, Buzzbnk, Social Impact Bonds and the Green Investment Bank, for example, might operate rather differently. No doubt existing and new P2P platforms would take the opportunity to distribute multiple financial instruments, creating a far more substantial alternative to banks and other fee-hungry investment institutions.

Oddly, given its reputation for fast-paced innovation, the US has been (until recently) even less supportive of alternative retail financial models. Zopa, for example, which led the growth of P2P platforms with its launch of person-to-person lending in the UK, was unable to launch that model in the US despite lengthy consultations with securities regulators. And life has been unnecessarily complicated for the likes of Prosper and Lending Club ever since.

To help remedy the regulatory imbalance, as mentioned in August, three of the leading UK commercial P2P lending facilitators launched the Peer-to-Peer Finance Association (P2PFA) for platforms on which the majority of lenders and borrowers are consumers or small businesses (rather than, say, ‘investment clubs’ or networks of sophisticated investors). The P2PFA has adopted a set of self-regulatory measures that are based on similar FSA requirements for payment services platforms (which have a similar, low risk profile). In particular, the P2PFA Operating Principles require:
  1. Senior management systems and controls;
  2. Minimum amounts of capital;
  3. Segregation of participants’ funds;
  4. Clear rules governing use of the platform, consistent with the Operating Principles;
  5. Marketing and customer communications that are clear, fair and not misleading;
  6. Secure and reliable IT systems;
  7. Fair complaints handling; and 
  8. The orderly administration of contracts in the event a platform ceases to operate
  9. Appropriate credit assessment and anti-fraud measures
Earlier this month, the US House of Representative has passed a Bill HR 2930 (still subject to Senate and Presidential approval) which would enable the issuer of securities to raise small amounts of money from many people (crowdfunding) on the basis summarised below. Please note that I've used the helpful summary from VentureBeat, but replaced "company" with "issuer", as I see no reason on my reading of the bill and the definition of "issuer" in the Securities Act 1933 why this would not enable person-to-person lending, rather than merely raising capital for corporations (please seek your own independent legal advice):
  • "The [issuer] may only raise a maximum of $1 million, or $2 million if the [issuer] provides potential investors with audited financial statements.
  • Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income.
  • The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.”
Will this work in practice?

Absolutely. The challenge (and benefit) associated with such 'safe harbours' is that there is very little room for fee income. This in turn favours 'thin intermediaries', like the new electronic finance platforms, as a means of broad, open distribution. Proportionately regulating platforms to address horizontal issues like those covered by the P2PFA Operating Principles leverages economies of scale, leaving product providers to focus only on vertical product-specific requirements. Specifically, the platforms can control operational risk (including anti-money laundering); deliver transparency through adequate product disclosure and ‘my account’ functionality; and centralise customer service and complaints handling, with ultimate referral to financial ombudsmen or other complaints handling bodies. In addition, because the platforms provide a reliable audit trail, tax rules should permit losses to be off-set against gains and income derived via platform-related activity. Similarly, there is no reason why instruments distributed via these platforms should not also qualify for consumers’ tax-free ISA and pension allowances.

Further, the 'horizontal' form of credit intermediation adopted by P2P platforms solves the problems identified by the NY Federal Reserve in the 'vertical' model adopted by the 'shadow banking' system. Since each borrower's loan amount is drawn from many lenders at the outset, there’s no need to engage split a single loan into many pieces by securitising later. Lenders also achieve diversification across many borrowers at the start, so there is no need for a series of bonds, CDOs and so on to ‘transform’ interest rates, maturity or borrower type. The facilitator is not a party to the loan agreements made on its platform and segregates lenders’ funds, so it has no credit risk (or ‘balance sheet risk’), and therefore no need or temptation to engage in regulatory/tax arbitrage that banks and shadow banks attempt. The one-to-one legal relationship between borrower and loan owner is maintained for the life of each loan via the same technology platform (with a back-up available), so all the loan data is readily available to participants and it's easy to assess the performance of the loan against its grade. Risk remains visible, rather than being rendered opaque through fragmentation, re-packaging and re-grading of the underlying loans, guarding against moral hazard. 

Finally, by enabling the efficient use of technology to facilitate consumers’ desire for greater control over their personal circumstances, governments will be helping to build a decent, sustainable financial services industry.

Consumers and small businesses should expect further developments in this space throughout 2012.

Tuesday 15 November 2011

US Crowdfunding Bill

"It's time for reflection..." FT.com
Further to my recent post on a new regulatory model for retail finance, the US House of Representative has passed a Bill HR 2930 (still subject to Senate and Presidential approval) which would enable the issuer of securities to raise small amounts of money from many people (crowdfunding) on the basis summarised below. Please note that I've used the helpful summary from VentureBeat, but replaced "company" with "issuer", as I see no reason on my reading of the bill and the definition of "issuer" in the Securities Act 1933 why this would not enable person-to-person lending, rather than merely raising capital for corporations. However, I'm not a US securities lawyer, and you should seek your own independent legal advice ;-)
  • "The [issuer] may only raise a maximum of $1 million, or $2 million if the [issuer] provides potential investors with audited financial statements.
  • Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income.
  • The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.”
As mentioned previously, it would be great to see this sort of support for alternative finance from the UK authorities.

Tuesday 1 November 2011

FSA, OFT Seek To Avert Another PPI Scandal

Having covered the Great PPI Robbery - and the Redux - via Pragmatist for some years now, it's encouraging to see the FSA and the OFT remaining vigilant against another heist. Listen for any mention of a "debt freeze" or "debt suspension"; or a "debt waiver" or "debt cancellation" during your next discussion about a loan or mortgage - and assume a fee or higher interest rate or the need to make some kind of payment. You should also assume that activating the freeze or waiver will be harder than it looks.

If you think you need the insurance, you probably shouldn't be borrowing at all.

The FSA/OFT consultation on the guidance is open until 13 January 2012.