2021 was an eventful year for private debt in Europe. The enduring low-yield environment saw continued demand for private debt offerings, in part due to the illiquidity premium on offer. For some banks, the prospect of enhanced capital requirements will increase the popularity of originate-to-distribute and balance sheet light lending business models.
European debt emerges stronger than expected
While 2020 brought dire predictions about the outlook for European credit in 2021, these ultimately proved to be overblown. Many rating agencies revised down their default forecasts as 2021 progressed. Several factors were at play. Real estate markets across Europe were buoyant, with euro area house prices posting their highest annual increase since 2006 in the second quarter of 2021. On the consumer front, unemployment rates across the EU remained low, while government measures such as furlough schemes or Kurzarbeit provided additional support, helping to keep default rates on consumer loans low.
That meant that the minority of investors who were willing to take on riskier loans in the first half of 2020 have ultimately been rewarded. It seems that European debt remains an attractive investment class, robust even during a crisis. Looking to 2022, the outlook remains positive though with significant uncertainty. Businesses are in a position of having adjusted to the impact of COVID-19, though it remains to be seen how badly supply chain shortages will impact the economy, with component shortages and increased prices hitting key industries, including manufacturing.
Venture finance becomes a teenager
2021 saw more and more venture funds move into providing debt financing and working capital, instead of just venture capital. Growth was strong – albeit from a very low base. For many parties, there was a penny drop moment as investors realised that it isn’t sufficient simply to provide a firm with equity – businesses need debt and working capital too, otherwise too much management time ends up being allocated to raising capital. Specialised debt financing and working capital solutions will create additional financing opportunities for institutional investors, including banks.
Investors increase allocations to less liquid strategies
Another notable trend in 2021 was investors rolling up their sleeves and making the decision to allocate to less liquid strategies. After successive years of pounding credit spread in traditional asset classes – such as corporate bonds – increasing numbers of investment committees have gained a firmer grasp on the relative value and risk return from investing in whole loan assets and those with more meaningful yields.
Low yield environment likely to endure
With the European Central Bank having declared that it doesn’t expect to raise rates in 2022, despite inflationary pressures, investors can expect low yields to endure for many European fixed income investments. Investors will continue to look at alternative assets, ensuring that that private debt remains an attractive asset class.
Nevertheless, other central banks are taking a different route: the Bank of England increased its rates by 25 basis points in December, while the US Federal Reserve has signaled three hikes in 2022. If yields rise significantly in the US, that could lessen demand for euro-denominated debt from US-based investors given greener pastures at home. Nevertheless there is an expectation in some market quarters that the ECB will indeed be forced to raise rates.
Europe continues to play catch up with the US
In many areas of the private debt market, Europe remains far behind the United States. This can be observed across multiple facets of the market, including issuance volume, speed of deployment, market participation, and the availability of market data. One consequence of the delayed evolution of alternative lending in Europe is that the asset class itself is missing out on a surprising number of investment strategies; CrossLend CEO Oliver Schimek wrote about this in a blog post which tackled this topic earlier in 2021.
Despite this, there were some bright spots, including the release of a package of proposals to drive forward the Capital Markets Union (CMU). At CrossLend, we strongly believe that data availability and standardisation driven by technology are the key elements needed to facilitate streamlined cross-border capital market transactions. This will be a groundbreaking way to finance the real economy. That’s why we have spent the last few years optimising on our platform, which serves to digitise and harmonise data, automating processes in the private debt space. We wholeheartedly support the development of the CMU and we are looking forward to seeing what 2022 brings in this regard.
German savings banks look for tools to manage RWAs
The management of risk-weighted assets (RWAs) is creeping into the minds of more and more savings banks in Germany. Successive quarters of strong loan book growth, coupled with the prospect of increasing regulatory capital requirements is pushing lenders with strong credit business but lower equity levels to consider seeking out tools for RWA management. That includes selling assets to private debt investors via platforms like CrossLend’s marketplace in order to achieve loan derecognition.
Historically, lenders were happy to keep loans on their books, but attitudes have since changed – a trend set to continue into 2022. Less-capitalised banks will either need to scale back lending in segments with higher risk weightings, or use RWA management tools in order to continue their traditional business without interruption. One solution is to share a certain volume of their originations with outside investors. Most banks considering this are willing to allow participation from a wide array of investors, though some are looking to limit distribution to their peers, namely other savings banks.
One consideration however is that many of these loans have relatively low yields – 4 to 5% is the approximate ceiling, but average yields are far lower – meaning that they will mainly be attractive to conservative institutional investors such as pension funds and insurers, or other savings banks. Bear in mind the sizeable pool of German savings banks with weaker loan business – for these institutions, investing in derecognised assets may be a good solution to deploy capital.
The completion of Basel III forms a new mountain for banks to climb
The release by the European Commission on 27 October of a new banking rules reform package, set to finalise the implementation of the Basel III agreement in the EU (commonly referred to in the banking industry as Basel IV), will be a major focus for banks going forward. It caps off a mammoth process that began way back in 2010 with the initial announcement, having been first implemented in mid-2013. Now, implementing the finalised version will take the best part of another decade.
This may actually be good news for banks: the timeline for the full implementation of the new capital rules, specifically the output floor, is more generous than the original proposals from the Basel Committee on Banking Supervision (BCBS).
The output floor is one of the central elements of the reforms, and it is set to create higher baseline capital requirements for banks using an internal ratings-based (IRB) approach to calculate risk weightings. Coming into force on January 1st, 2025, the output floor will introduce a 50% multiplier on risk weightings calculated according to the standardised approach for credit risk, rising to its final value of 72.5% by 2030.
The package of reforms also requires banks to systematically identify, disclose, and manage ESG risks as part of their risk management, with scrutiny from banking supervisors set to fall on banks’ exposures to ESG risks.
While for some banks, the outcome will be higher capital requirements, complying with the new rules will be a focus for all banks and will consume significant internal resources. Ultimately, while some industry participants may benefit from greater comparability of risk-based capital ratios between lenders, many banks will need to assess and re-evaluate their current business models. Greater use of originate-to-distribute and balance sheet light lending to help maintain or grow lending volumes may be one outcome. Find out more about CrossLend’s balance sheet management solutions for originators here.