Since the financial crisis, there has been substantial growth in non-bank lending platforms, including fintech companies along with an increase in banking regulations. With the growth of non-banking lenders, Jan B. Brzeski, managing director and chief investment officer of Crosswind Capital and Arixa Capital, questions if the government should increase regulations of non-bank lending to “level the playing field.” We sat down with Brzeski for an exclusive interview to talk about the regulation environment of bank and non-bank lending.

GlobeSt.com: Why should we regulate non-bank lenders?

Brzeski: The world of real estate finance has evolved and changed substantially since the financial crisis. Non-bank real estate lenders have seen rapid growth and real estate fintech lenders have grown from virtually nothing into a whole new category of lenders that is likely here to stay. Meanwhile, banks continue to face heavy regulation, leading some to ask, does the government need to “level the playing field” between bank and non-bank lenders, including fintech companies, in the interest of fairness?

GlobeSt.com: How are non-bank lenders currently regulated?

Brzeski: Non-bank lending has been an important part of our economy for decades. Non-bank lending is getting more attention today—especially lending by private equity-style funds and by fintech lending platforms. However, insurance companies have long been active lenders on real estate. When companies borrow by issuing bonds, the investors in those bonds are effectively lenders and most of them are not banks. Mortgage companies that originate loans to homeowners and then package and sell those loans to government agencies such as Fannie Mae and Freddie Mac are also non-bank lenders.

Few if any of these non-bank lenders enjoy a government guaranty the way banks do on their FDIC-insured deposits. What then is the argument for regulating their lending activity? Certainly if they are lending to unsophisticated consumers, there still needs to be a watchdog preventing them from taking advantage of consumers by baiting them into loans they don't understand or want.

Beyond protecting consumers, it is interesting to note whether these lenders hold their loans on their balance sheets until maturity, or repackage and sell off the loans. We will revisit this question later in this article. As a general principle, less regulation of lending activity tends to allow for more innovation and a wider range of services offered, both of which are positive, all other things being equal.

GlobeSt.com: What if markets fail?

Brzeski: There is one nuance that may bear watching by regulators. What if a non-bank lender makes excessively risky loans, leading to a kind of lemming effect whereby all of that lender's competitors start to also make risky loans to avoid losing business. Could we see waves of bankruptcies by groups of such lenders? We know from the recent financial crisis that markets can fail, leading to great damage. It is hard to forget interviews after the collapse of Lehman Brothers with former Federal Reserve Chairman Alan Greenspan, who was widely viewed as a guru who could do no wrong. He played down the risks leading into the crisis and knew afterwards that he let down the country by not tightening regulation earlier. “Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief,” said Alan Greenspan, Federal Reserve Chairman on Oct. 22, 2008 during his testimony to House Committee on Oversight and Government Reform.

Still, the author believes that non-bank lenders do not need to be regulated more at this time. One reason is that undisciplined non-bank lenders can be allowed to fail without endangering the overall economy too much. There are vast pools of capital ready to take advantage of any distress in the credit markets, which will act to shore up failures by non-bank lenders fairly quickly. An interesting topic for further analysis is the growing set of relationships and in some cases dependencies between banks and non-bank lenders, which this article will touch upon later.

GlobeSt.com: How is the capital raising and balance sheets at banks currently regulated?

Brzeski: As discussed previously, banks are already regulated highly both in terms of how they can raise capital (from whom and with what disclosures) and in the composition of their balance sheet. The latter issue includes regulation about how many turns of leverage they can use, but also other important technical issues such as matching the maturities of the loans they make (their assets) and the money they borrow (their liabilities). There is good reason to regulate these issues to protect taxpayers who would have to bail out a failing banking system. With Republicans currently in control of both Congress and the White House, one might expect decreased regulation on banks in the coming months. A separate article addresses what is

Likely to change for non-bank lenders if banks are freed from many of their post-crisis regulatory burdens. To summarize, we do not expect a dramatic unshackling of bank regulations,[i] but rather a gradual loosening. Lawmakers understand that voters were deeply angered by the financial crisis. There is a perception that fat cat bankers benefitted while millions of working people paid the price. For this reason, many Republicans who may otherwise favor freer markets and less regulation are unlikely to side with bank executives to roll back bank regulation very much in the near future.

GlobeSt.com: How do you believe non-bank lenders, including fintech, companies should be regulated to “level the playing field”?

Brzeski: In the economic theory of efficient markets, two lending funds delivering 8% net returns to their investors should have very similar risk profiles. In practice, this is not at all the case. As an example, one fintech company with no presence in Southern California has recently made a number of loans that none of the local experienced lenders would make. They are lending 75% of cost on land that will later be developed, typically into townhomes. The most experienced local lenders will lend at most 50-60% of cost on land, because they know this is the most volatile asset class. They also limit land to a small percentage of their overall portfolios. By contrast, the fintech company's last four loans in this region were all land loans. They are simply eager to put money to work, and they don't have the relationships to do so without carving out their own separate—and much riskier—niche.

In the JOBS Act of 2012 there was a provision—called Regulation A+—allowing companies to raise money not only from sophisticated investors but from anyone. Reg A+ also allowed companies to advertise their offerings freely which in the past was always strictly prohibited. The intent was to allow more innovation and job creation by reducing the barriers to raising capital. Now some fintech firms are using this provision to raise money, which they invest into real estate and mortgages. Fintech firms are measured on their revenue growth, but lenders are ultimately judged by the quality of loans in their portfolios. As Warren Buffett has said “You don't know who is swimming naked until the tide goes out.”

One possible area for regulators to consider is that most investors are not equipped to tell the difference between cautious lenders with strong borrower relationships, and venture-backed start-ups trying to make a splash by demonstrating huge growth rates. A perfect example is LendingClub, which allowed their loan quality to deteriorate as they pursued rapid growth, among other problems. Most likely these issues will work themselves out as less disciplined lenders experience losses. However, there could be quite a bit of damage done in the meantime, as investors learn that all 8% returns are not created equal. Some are manufactured in a way that increases the risk of principal loss dramatically—either by lending too much, by lending on assets that are too volatile, or by using too much gearing internally, all of which increase risk.

GlobeSt.com: In general, why should we regulate lenders?

Brzeski: The best argument for regulating lenders is that they often interact with ordinary people. The difference in sophistication between finance businesses and ordinary consumers and investors creates a justification for the government to set and enforce minimum standards on the conduct of lending businesses. Without some basic laws and regulations, the door is left open both to con men and to those savvy enough to create “heads I win, tails you lose” scenarios, where the losers are often vulnerable members of our society.

On one hand, lenders should not market their services deceptively to unsophisticated borrowers, particularly if those borrowers are consumers lacking the background to fully understand nuanced loan costs, terms and conditions. A recent example is the marketing of loans with low “teaser rates” to sub-prime borrowers before the financial crisis. Our elected representatives want to make sure that loans are not sold cynically to borrowers who are highly likely to default en masse when low teaser rates reset to more normal rates. This is not to excuse the many borrowers who took out such loans without thinking through the consequences—sometimes to speculate on real estate, and sometimes simply to consume far more than they could actually afford.

On the other side of the equation, when banks and non-bank lenders raise equity, issue bonds or otherwise take on debt, elected officials likewise have an interest in regulating how the investments are marketed and who may purchase these securities. For example, suppose a convicted criminal was able to start a bank and raise money from unsophisticated retirees by promising “guaranteed 15% returns”. Suppose further that the securities being sold were very risky and could be wiped out under a wide range of circumstances, but that none of the risks were disclosed in the documents provided to the investors. While investors should be cautious and ideally should know better than to be convinced by scams, we know that in practice many investors don't have the tools or connections to distinguish between solid investments and risky investments sold by scammers and slick salespeople.

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Should We Step Up Non-Bank Lending Regulation?

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