We have all heard the story of the little Dutch boy who saved a town from flooding by putting his finger in a dike. What happens when the next hole opens? Well, he can always stick another finger in, can’t he?
The new “Tool Kit” for institutional investors
The Goldschmidt Committee recently published their interim report on the extension of “coordinated loans”, a term covering consortium and syndicated lending by institutional investors in Israel.
The executive summary of the report explains that institutional investors have become major players in the credit market in Israel, and have significantly expanded their market share of lending due to changes in the Israeli capital markets over the past few years (the Bachar reform and the pension fund reforms) while failing to address adequately the related risks. The Committee aims to improve the standard of lending by institution investors, and to provide the institutional investors with a “tool kit” to be used in their lending activity.
Sounds familiar? In February 2010 the Hodak Committee issued its report covering the extension of credit by institutional investors purchasing corporate bonds. The Committee analyzed the increase in market share of the institutional investors in the lending market (yes, caused by the various reforms of course), and the failure to address adequately the risks involved in such lending. The Committee went on to provide a “tool kit” for the improvement of the quality of the product and the associated risk management.
Reading through the Goldschmidt Report, one finds alongside corporate governance and risk management requirements imposed on the institutional investors themselves, also requirements that will be imposed on the other members of the lending consortium, and in particular on the arranger. It seems that these requirements may not reflect current practice, not only in Israel, but also in the other lending markets such as the UK and the US. Requirements imposed on the arranger, such as disclosure of other business with the borrower and its affiliates, duties of monitoring for certain events, disclosure of information obtained from other sources, and various other requirements, may well exclude institutional investors from this market altogether. Since the requirements are imposed also on the secondary market, this may mean that banks will be reluctant in practice not only to invite institutional investors to participate in lending syndicates but also to sell down their credits.
In the new Basel III world, this may have market-wide implications for the availability of credit generally (as banks may not be able to extend credit without identifiable means of selling down part of the risk, and, according to the recommendations of the Goldschmidt Committee, the arranger must in any event hold at least 15% of the credit on its books). Institutional investors may be driven away from “safer” bank loans (on the assumption that banks are better lenders, as mentioned in both the Hodak and the Goldschmidt Reports) into riskier areas of investment, driven by the same forces which created the problem of “inadequate” lending by institutional investors to begin with – excess liquidity combined with immense pressure to improve yields (caused by a combination of fierce competition and low interest rates).
Time for change?
Committee after committee, requirements are being imposed in the financial market to make institutional lending safer – Imposing “bank loan” standards for corporate bonds, and now in the Goldschmidt Report requiring that institutional investors “hitchhike” on bank expertise, giving them the benefit of inside knowledge of the bank’s relationship with the borrower and its affiliates and by imposing more and more requirements upon the arrangers of the lending consortiums. Are there free rides? I doubt it.
What is the real answer? Have we finally reached a point where we should admit the need for a change in the regulation of the institutional market, for example by bringing in one single regulator that can ensure adequate regulation across the board (thus also eliminating regulatory arbitrage and ambiguity)? Time will tell. Or perhaps, we will just stick another finger into the next hole that opens up in the wall.