Having been one of the first countries to implement the Alternative Investment Fund Managers Directive (“AIFMD”) and, as far as we can gather, having been the first country to approve an Alternative Investment Fund Manager (“AIFM”), the Central Bank of Ireland (“Central Bank”) has now turned its attention to the question of whether it should remove its prohibition on the origination of loans by alternative investment funds (“AIFs”). In this regard, last week it published a discussion paper (“Discussion Paper”) seeking the views of interested parties and posing questions on the topic. It should be noted there is already a significant number of Loan AIFs established in Ireland where the investment focus is on loan participation rather than loan origination.
The Discussion Paper defines Loan Origination AIFs as “those which undertake to source loan assets for their investment portfolio by directly originating loans rather than confining themselves to investing via loan assignments or loan participations”. The Central Bank regards loan syndication or secondary lending as being a “fundamentally different” discipline to loan origination involving different skill sets and for fund managers, administrators and custodians, a fundamentally different operational framework.
To date, the Central Bank has both prohibited AIFs from originating loans and from acting as a guarantor on behalf of third parties. The prohibitions reflect the Central Bank’s concerns that this activity might be regarded as banking business and otherwise fall to be regulated under new initiatives for the regulation of the shadow banking system.
However, the consultation is timely as the ability of AIFs to originate loans and thus lend directly to the economy would be a significant development that could help stimulate new lending via the capital markets.
The AIFMD provides an interesting regulatory context. Unlike UCITS, AIFMD does not seek to regulate the investment strategies and activities of AIFs as the regulatory focus is on the AIFM. Accordingly, it is arguable that the imposition of product based restrictions by the Central Bank amounts to “gold plating” and it is in this context that the Central Bank has indicated a willingness to consider higher profile risk options, such as loan origination, for AIFs.
The Case for Loan Origination
The Central Bank has certainly done their homework and the Discussion Paper follows an already extensive informal consultation process with industry. The Discussion Paper refers to the “Funding Gap” and sets out the arguments for non-bank funding options. It quotes European Central Bank President Mario Draghi as saying:
“in the United States 80% of credit intermediation goes via the capital markets. In the European situation it is the other way round. 80% of financial intermediation goes through the banking system."
Further support is given by Michel Barnier, the EU Commissioner for Internal Market who is quoted as saying:
“I do not think that financial intermediation should be left entirely and solely in the hands of the banks. And I am aware of the role that alternative sources of financing have to play in these difficult times for the European economy, where the banks have to adhere to more stringent prudential ratios. Alternative financing is therefore necessary, but it is important that it is carried out in a solid and transparent framework.”
There is also policy orientation support from the recent EU proposals with regard to Long-Term Investment Funds, Venture Capital Funds and Social Entrepreneurship all aimed at bridging the Funding Gap.
There is an implicit acknowledgement that the Funding Gap is even more acute in Ireland - which leads the Central Bank to the view that:
“if there is scope to moderate the current prohibition on loan origination by investment funds without other adverse consequences (e.g. related to investor protection, financial stability or monetary stability concerns) then it is something worth pursuing in the public interest.”
The Spectre of Shadow Banking
While the case for and the need for Loan Origination AIFs is overwhelming and, as mentioned above, such AIFs are not prohibited under AIFMD, the spectre of the various global initiatives aimed at developing a cogent regulatory framework for the shadow banking system looms large and the Central Bank will seek to ensure that any policy proposals will be in line with any regulatory framework established.
The Discussion Paper takes into account the policy recommendations developed by the Financial Stability Board (“FSB”) for the prudential regulation of shadow banking and the Discussion Paper adopts the position that “there is little doubt that loan origination by investment funds would be captured by the FSB definition of shadow banking.”
For those looking for a definition of "shadow banking", the Discussion Paper offers one from Timothy Lane, Deputy Governor of the Bank of Canada, where he explains that:
“shadow banking comprises activities involving some element of maturity and liquidity transformation, credit extension, and risk transfer, conducted partly or wholly outside the “traditional” banking system. It covers a wide range of activities, including securitisation, repos, and money market funds (MMFs) as well as some activities of non-bank financial institutions such as finance companies and credit hedge funds.”
The FSB considered five economic functions which should be considered in determining whether non-bank lending may pose systemic risks or result in regulatory arbitrage.
Two of these economic functions were of particular concern to the Central Bank in the context of Loan Origination AIFs:
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the risk that pooling of investor funds into a single product could create a “run” risk; and
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the fact that non-bank lenders may focus their lending activities on specialist sectors which are cyclical (like construction) and may rely on short-term funding.
To deal with these concerns, the FSB recommended a series of risk mitigants for regulators to adopt. The Discussion Paper posed the question that, with these risk mitigants in place, might the balance of public interest “be served by allowing investment funds to originate loans in certain circumstances?”
What Are the Risks and How Can They Be Mitigated?
The areas of risk associated with Loan Origination AIFs that the Central Bank has identified as requiring attention include concentration risk, liquidity risk, risk of investor runs, leverage, creation of new money through leverage, market/sector dominance, investor suitability and mispricing of credit.
The Discussion Paper sets out a number of measures that the Central Bank has identified to mitigate these risks and which are likely to form the basis for any guidance on the establishment of Loan Origination AIFs.
They are:
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diversification requirements that would set limits on the extent to which a Loan Origination AIF could lend to a single borrower without imposing a sector diversification requirement;
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focusing on senior secured debt with the possibility that Loan Origination AIFs may also be permitted to offer (but not exclusively) second charged or unsecured loans;
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requirements for liquidity management and maturity mismatches. This might require Loan Origination AIFs to be established as close-ended schemes, or alternatively, adopt robust investor redemption management policies;
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limits on leverage which seems to suggest that one of the policy orientations may be not to permit leverage, except as a temporary measure to facilitate treasury management;
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co-investment by managers to provide alignment with investors;
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demonstrable loan expertise on the part of the manager and a reference to imposing further constraints on the hot topic of remuneration;
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the imposition of criteria over and above the minimum MiFID professional client criteria;
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credit assessment requirements that would require Loan Origination AIFs to adopt detailed policies on credit risk. For example, policies on credit assessment, valuation of collateral, loan impairment provisioning, debt forbearance and management, ongoing monitoring and management of the loan book, etc; and
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monitoring of the loan book comprised of some form of post-authorisation Central Bank supervision of lending practices together with other options such as reporting by the Loan Origination AIF or its auditors on credit risk exposures.
What Might Loan Origination AIFs Look Like?
The Discussion Paper clarifies that Loan Origination Funds, if permitted, will be incorporated into a product regime with key product features. The Discussion Paper suggests that this will likely include some “hard wired” limits with regard to lending.
In the Discussion Paper, the Central Bank has flagged quite clearly what its thinking is. This is the first part of the process and it is likely, based on responses received, that this will lead to the development of a more formal consultation paper with more detailed policy proposal as a precursor to the implementation of a Loan Origination AIF regime.
The Discussion Paper is indicative of the willingness of the Central Bank to consider the role AIFs can play in direct lending to the economy and the development of an alternative source of lending to the current dysfunctional bank-credit model.
The Discussion Paper lists a number of key policy questions on the regulation of Loan Origination AIFs and is accepting responses to the questions raised until 13 September 2013. A copy of the Discussion Paper can be found on the Central Bank’s website.
If you are interested in participating in the Central Bank’s consultation and perhaps influencing the shape of future regulation of Loan Origination AIFs, you may reply to the Central Bank’s consultation. Alternatively, please contact one of Dechert’s financial services partners who would be happy to convey your views to the Central Bank.
