Alternative lenders have stepped up and played a vital role in helping SMEs and consumers during the past 10 months. However, there is no doubt there are challenges ahead. Chris Laverty looks at what alternative lenders can do now to prepare.
The full economic impact of the past year has yet to hit. This is primarily due to extensive support measures, such as government-backed loan schemes, furlough, VAT and rent deferrals and restrictions on statutory demands and winding-up petitions.
As support starts to unwind in 2021, small- and medium-sized enterprises (SMEs) will need to start repayments on any government-supported loans, as well as delayed tax payments, deferred rent arrears (subject to negotiations with landlords) and a build-up in trade debts. It's inevitable there will be a rise in SME defaults and therefore lenders will be faced with some difficult decisions.
Alternative lenders that focus on retail lending will have to consider how to manage continued coronavirus-related forbearance measures, provisioning metrics and the underperformance of customers.
Alternative lenders should prepare now for a bumpy ride
While the economy is partially shielded by the volume of state support offered to businesses, now is the time for lenders to start looking at their processes to see what they can do to become more resilient. Lenders should invest in their processes for identifying and dealing with borrowers in distress before things reach a point of no return.
This represents the first time that many newer alternative lenders have had to operate in an economic recession. Mindsets and internal processes need to make a significant shift from growth to recovery, which can all take time, resources and investment as process are developed and streamlined, and staff trained.
When speaking to lenders, we always ask the following questions:
What kind of credit processes do you have in place?
Do you have the right level of granularity in your data to identify stress in your portfolios in a timely way?
Do you have access to people who have experienced a downturn and understand how to protect the lender and borrower?
Many lenders are already increasing their collections teams and distressed business support in anticipation.
Secure adequate funding channels
It's important that lenders have adequate funding channels that can be tapped if needed. If lenders strategically want to support borrowers in their portfolio, but do not have access to the right funding, then the borrower may fail, which can ultimately put the lender at risk.
Some lenders in the peer-to-peer (P2P) sector have relatively recently switched to an institutional-only funding model, moving away from retail investment.
ThinCats and Landbay are two such platforms, while Funding Circle has currently paused its retail investment to concentrate resources on providing Coronavirus Business Interruption Loan Scheme (CBILS) loans.
An increasing number of institutional lenders are allocating funding lines to alternative finance providers and lenders should take time to nurture these relationships.
Lenders have a duty of care to their investors to ensure that they will be able to recover borrowed funds. Investor dissatisfaction in a P2P platform could result in investor institutions leaving, which could create a liquidity squeeze that can have long-term consequences.
HMRC preferential creditor status affects alternative lenders
HMRC has now regained its status as a preferential creditor in insolvencies. When a company goes into liquidation, any monies owed to HMRC in relation to PAYE, VAT, employee national insurance contributions, and Construction Industry Scheme (CIS) deductions now take priority over other creditors, in particular, unsecured and floating charge creditors. As alternative lenders are often one of the largest creditors of SMEs, this has a significant impact.
Lenders need to update their due-diligence procedures to consider the tax position of potential borrowers to assess what impact it may have on unsecured debt and floating charge security. Consideration should be given to whether the security position could be supplemented, or whether fixed-charge security is more appropriate.
Lenders should also require their borrowers to provide regular and relevant information on their tax affairs to understand when HMRC arrears may be building. This is particularly relevant, given many SMEs will have significant deferred tax debts as part of the government’s support measures. Lenders may want to review the pricing of facilities to compensate for any increased risk.
Secured lenders should also be aware of the effect of HMRC’s preferential creditor status. If a borrower in a lender’s portfolio is suffering financial distress, these new rules may change the options available to secured creditors. In some cases, enforcing insolvency may reduce the return compared to a consensual restructuring. HMRC’s preferential status is one more factor to consider when exploring the way forward and could make some previously viable options less attractive to secured creditors.
Mitigate risk posed by claims management companies
All lenders will be keen to avoid the sort of reputational damage that larger banks faced after the 2008/9 financial crisis. Since 2008, the number of claims management companies (CMCs) that specifically target SMEs has soared, and a survey by the Business Banking Resolution Service in May 2020 found that almost a third of customers said they had experienced behaviour from their lender in 2020 that would give them cause to lodge a complaint.
Developing robust internal policies is a way of ensuring and evidencing compliance with all regulatory standards, thereby mitigating the risk of such complaints. Maintaining detailed records of due diligence and creditworthiness tests will also help in the long term when responding to any restructuring or enforcement issues or complaints. It is likely that the FCA will scrutinise closely how lenders deal with coronavirus-related issues.
The FCA is also expected to use its new powers under the Senior Managers and Certification Regime (SMCR), which is designed to make individuals within financial institutions more accountable for their actions.
On January 7, 2021, the FCA published data from their financial resilience surveys that aimed to understand what effect the coronavirus situation was having on the finances of the firms they regulate. Within retail lending, 67% of respondents were expecting a negative impact on net income, and 58% expected a negative impact from coronavirus on their business models.
Based on the survey data, the FCA states that they expect failures due to the current economic downturn and highlights the importance of firms having comprehensive wind-down plans in place to prevent harm to consumers and achieve a more-orderly outcome.
Given how quickly the economy has changed, alternative lenders should act now to revisit and adjust their wind-down plan to reflect the current climate. In doing so, firms will ensure that they have the right preparation and safeguards in place.
Alternative lenders have more than demonstrated their importance in 2020, with many valuing the speed and flexibility they are able to offer compared with more mainstream lenders. 2021 will be a bumpy ride, but for those who can ride out the storm, there will be many opportunities ahead.