How non-bank lending is reshaping the economy

How non-bank lending is reshaping the economy

What is non-bank lending?

Here's a common understanding of business credit: when small- and medium-sized businesses need capital to run or grow their business, they get a loan from a bank. This loan is standard, easily obtainable, and easy to understand.

While this may have been how business credit functioned in the past, it is very far from how the world works today. In 2022, small- and medium-sized businesses typically turn to non-bank lenders for their capital needs, in deals that lack standardization and bank intermediaries. In aggregate, the bank share of business debt is now less than 20 percent.

Non-bank lending is when investors extend loans directly to small- and medium-sized businesses, with no involvement on the part of banks. As we covered in a previous post on private credit, this type of credit enables businesses to access alternative funding sources, and has stepped in to fill the credit gap as banks have gradually exited the middle-market lending space. (Note: Non-bank lending is also sometimes referred to as "direct lending" or "private lending.")

How big are these small- to medium-sized businesses?

What types of companies borrow from non-bank lenders?

The definition of "small to middle market companies", per S&P Global, is companies with between $3 million to $100 million in EBITDA. This is a surprisingly large segment of the U.S. economy: Oaktree estimates that there are over 200,000 middle-market companies in the United States, and that these companies account for one third of U.S. private sector GDP and employment.

So the story of non-bank and private lending in the United States isn't just the story of the financial sector; it's the story of how one third of the U.S. private sector accesses capital in order to grow!

Small- and medium-sized companies account for one third of U.S. private sector GDP
Small- and medium-sized companies account for one third of U.S. private sector GDP

Is non-bank lending new?

How did we end up here? Well, one important thing to know is that the common narrative around how small- and medium-sized businesses access credit—the one in which banks do all the corporate lending, and which we shared at the beginning of this article—hasn't been true for a few decades.

The growth of non-bank lending and private credit isn't new; banks have retrenched from providing credit to middle-market companies since the 1980s. However, it is true that the Great Financial Crisis of 2007-2009 accelerated this exodus, with non-bank / direct lending assets under management (AUM) growing by over 800% in the decade following the crisis. After the crisis, increased regulatory scrutiny led banks to adopt more stringent lending criteria, and credit committees began rejecting loan applications from small- and medium-sized businesses that might previously have been approved.

The reason this trend has happened in middle-market lending (and not with larger companies) is that big companies (think Apple or Target) can raise money in the bond markets—a path that is unavailable to medium-sized companies.

What about consumers? How does non-bank lending impact consumer finances?

The rise of non-bank lending over the last decade has coincided with another (confusingly named) trend in finance: the growth of fintech companies (examples include student loan startup SoFi, BNPL company Affirm, and neobank Chime) that are themselves non-bank players in the finance space. The Department of Treasury calls these financial technology ("fintech") companies "non-bank firms" and notes that they "[contribute] to the diversification of firms and business models competing in core consumer finance markets."

Many of these fintech companies lend to consumers, and thus require asset-backed debt, which is a subset of private credit / non-bank lending. Nevertheless, these fintechs are not generally considered part of non-bank lending, as the industry definition of "non-bank lending" is, as noted above, institutional loans to small- and medium-sized businesses.

When referring to all consumer and business lenders that are not banks, we like to use "non-bank financial companies" (NBFCs) as a term of art, as this term includes players ranging from PE firms to P2P lenders.

What are key features of non-bank loans? What are best practices for non-bank loan management?

From a borrower perspective, some of the benefits of non-bank loans are greater flexibility in structure and capital access, while some of the drawbacks are higher interest rates and the possible requirement of equity as a part of the funding arrangement.

From a structural perspective, non-bank loans are characterized by greater lender control over downside risk and protection from rising interest rates. According to Oaktree, five typical characteristics of direct loans are: floating-rate coupons (tied to SOFR), short terms to maturity, strong covenants, less liquidity, and low correlation with public markets.

Most interesting, to us, are the operational and technological implications of the rise of non-bank lending, since business credit is moving in the opposite direction from many other parts of the economy.

Most parts of the economy are getting easier to navigate, more connected, and more transparent. In consumer finance, fintech startups are increasing the speed and transparency of common financial activities (e.g., borrowing and investing). Across verticals from transportation to healthcare, purpose-built software makes it easier than ever to streamline operations in, say, fleet management or patient data collection.

Yet in business credit, there has been a secular trend towards increased opacity, greater fragmentation, and a higher operational burden—especially for middle-market borrowers.

Business credit management is becoming more operationally intensive even as other parts of the economy are becoming more streamlined
Business credit management is becoming more operationally intensive even as other parts of the economy are becoming more streamlined

It's time for non-bank lending to catch up to every other part of the economy. For borrowers and lenders alike, that means selecting the right tools for reporting, workflow automation, and financial data management.

Over the past ten years, non-bank lending and private credit have increased financial flexibility for borrowers, but they've also put an operational strain on finance leaders. Smart capital management software can give middle-market borrowers and finance teams the best of both worlds: flexibility in financing and efficiency in financial operations.

Want to learn more?

Finley is private credit management software that helps companies with asset-backed loans save time and money by automating routine debt capital management tasks like borrowing base reporting, verification, and alerting. Today, Finley manages over $2 billion in debt capital for customers like Ramp, Parafin, and Arc. If you're interested in learning more about software that can help you streamline your debt capital raise and management, just schedule a demo or take a self-guided product tour. We'd love to chat!