Alternative Lending: A Regulatory Focus on the SME MarketGRANT THORNTON FINANCIAL SERVICES GROUP

The Financial Conduct Authority recently issued Consultation Paper 13/13 detailing its regulatory approach to crowdfunding and similar activities. Before it takes over the regulation of the consumer credit market from the Office of Fair Trading on 1 April 2014, the watchdog needs to consult on appropriate measures to protect borrowers and investors. Given the difficulties that small and medium-sized enterprises are currently encountering when seeking access to finance, the FCA is conscious of the need to adopt a balanced solution to protect both consumers and an industry that is gaining momentum.

February 2014FCA to publish statement and feedback to CP13/10 and CP13/13

March 2014FCA to publish final version of plain language guidance designed to help consumer credit firms and other stakeholders understand and navigate the new consumer credit regime

April 2014Responsibility for consumer credit regulation to transfer from the OFT to the FCA

April 2014FCA to publish paper on key risks in the market in order to establish intervention priorities

2 ALTERNATIVE LENDING – A REGULATORY FOCUS ON THE SME MARKET

Vince Cable,Secretary of State for Business,

Innovation and Skills

“We need to see more small, innovative,

alternative banks and non-banks. There are many new

financing models which have been created, such as peer-to-peer lending,

which have taken off like wildfire. I am now beginning to encounter

companies around the country which would have gone under

were it not for peer-to-peer lending.”

October 2014FCA will start considering applications for full authorisation from firms with interim permission

April 2016Full FCA consumer credit regime will come into effect replacing the interim permission regime

2019Department for Business, Innovation and Skills and HM Treasury to carry out post-implementation review reforms

2019FCA to complete a review of retained CCA conduct requirements and develop rule-based alternatives

ALTERNATIVE LENDING – A REGULATORY FOCUS ON THE SME MARKET 3

However, the prudential regulation that followed the financial crisis forced banks to boost capital ratios and, subsequently, had a cataclysmic effect on funds available for lending. The Breedon Report, which examined the financing of UK small and medium-sized enterprises (SMEs), concluded that there will be a finance gap of between £84 billion and £191 billion over the next five years1. Although the Breedon Taskforce could not identify a single solution to this problem, it established that raising awareness of alternative finance methods would be key.

The term alternative finance is capacious, thus is often applied subjectively. Commonly, alternative finance includes any form of finance provided by non-banking entities. It is thought that these

innovative funding methods will have a crucial role in the creation and survival of SMEs as traditional lenders continue to tighten their lending criteria.

Access to finance is particularly important for SMEs as it is often the principle facilitator that enables SMEs to execute their strategies and support operational business plans and processes. Therefore, improving credit flow to allow these businesses to invest and expand is vital, not only to avoid hindering their growth, but ultimately to circumvent impacting the national economy. It is estimated that these entities represent 50% of the UK’s GDP and employ 60% of the workforce.2.

1Breedon Report: “Boosting Finance Options for Businesses” page 32The Business Zone: “Viewpoint on the British Business Bank”

Traditionally, UK businesses have heavily relied upon banks to meet their funding needs.

AlternativeFinance

Online Invoice Trading

Supply Chain

Finance

Trade Finance

Crowdfunding

Rewards

Charity

Peer-to-peer

Equity

Retail Bond

Market

Self-Issued Retail Bonds

Asset-Based

Lending

4 ALTERNATIVE LENDING – A REGULATORY FOCUS ON THE SME MARKET

The government acknowledges the gravity of the funding gap and has adopted various measures in order to promote lending such as the Funding for Lending Scheme or the Enterprise Finance Guarantee. Particularly, the Growth Accelerator programme, supported by Grant Thornton, helps companies to overcome their barriers to growth by offering private expertise in one of four areas: access to finance, business development, growth through innovation and leadership and management training.

Additionally, efforts to raise awareness about alternative funding methods and regulate the industry are underway. The recent and significant growth of the crowdfunding sector has drawn attention to this emerging industry. With more than £492 million lent in 2012, crowdfunding is providing SMEs with invaluable access to finance, yet remains unregulated.

Despite being an ancient concept that was originally used to fund the base of the Statue of Liberty, crowdfunding is currently in vogue. It consists of financing businesses and loans with contributions from a large number of sources, often using an online platform. The internet and

online platforms have increased the ease with which those in need of finance are connected to those disappointed with the low returns currently offered by traditional banks. There are numerous varieties of crowdfunding: some are charitable donations that provide intangible benefits, others do offer financial returns and the third category grants a combination of both.

Consumer credit arranged via loan-based crowdfunding platforms was originally regulated by the Office of Fair Trading (OFT). These lenders were obliged to comply with the guidance this body issued; however, from April 2014 they will be regulated by the Financial Conduct Authority (FCA). The latter shares the government’s desire of making these alternative forms of finance more secure and accessible. The FCA has accepted a challenging undertaking: it must offer sufficient protection to borrowers and investors alike; nevertheless, it needs to adopt a proportionate, risk-based approach as stringent regulation would severely hinder the industry before it has fully developed.

Vince Cable,Secretary of State for Business,

Innovation and Skills

“As businesses are continuing to

struggle to get credit from their banks, developing

alternative lending channels is essential so firms are less reliant on banks.”

The importance of alternative lending channels

PrivatePlacements

BusinessAngels

VentureCapital

CorporateVenturing

Business Growth Fund

Private Equity

PublicEquity

MarkersPension-Led

Funding Asset-Based Lending

ALTERNATIVE LENDING – A REGULATORY FOCUS ON THE SME MARKET 5

Christopher Woolard, the FCA’s Director of Policy, Risk and Research, described the purpose of the suggested rules as follows: “Consumers need to be clear on what they are getting into and what the risks of crowdfunding are. Our rules provide this clarity and extra protection for consumers, balanced by a desire to ensure firms and individuals continue to have access to this innovative source of funding”3.

In its paper, the FCA distinguishes between investment-based crowdfunding and loan-based crowdfunding. The former, which consists of investing in businesses by buying unlisted shares or unlisted debt securities, is already regulated by the FCA. Nonetheless, the regulator has seized this opportunity to underline the risk associated with investment-based funding and highlight that such forms of finance should only be promoted to people who understand their inherent dangers or to those that can financially cope with potential losses. Thus, investors will need to attest that they will not deposit more than 10% of their ‘net investible portfolio’ and, if they are not under investment advice, they will need to pass an ‘appropriateness test’.

In contrast, the regulator’s approach to loan-based crowdfunding platforms is much lighter as they are considered to be lower risk. Essentially, the FCA will treat these platforms as any other designated investment, with an exception: peer-to-peer lenders will not be covered by the Financial Services Compensation Scheme (FSCS) and the regulator expects firms to disclose the lack of coverage to potential investors. Platforms will

have to comply with two of the FCA’s rulebooks: The Conduct of Business Sourcebook (COBS) for investors and the Consumer Credit Sourcebook (CONC) for borrowers. Financial promotions rules will also be applicable.

3The Financial Conduct Authority outlines how it will regulate crowdfunding: http://www.fca.org.uk/news/the-financial-conduct-authority-outlines-how-it-will-regulate-crowdfunding4CASS 7.35COBS 2.2 and COBS14.3

The FCA’s proposals for loan-based platforms can be summarised as follows:

1. Firms will have to comply with minimum prudential requirements in order to ensure their on-going viability. The regulator recognises the potential negative impact that disproportionate prudential requirements could have in the market; preventively, it has proposed a three-year transition period before these measures come into force.

2. Platform operators will have to create programmes that ensure loans can be managed in case of platform failure.

3. Those lenders holding client money will need to apply the existing client money rules contained in the Client Assets sourcebook (CASS). Therefore, firms will need to put in place adequate organisational requirements to safeguard clients’ rights4.

4. To comply with the Distance Marketing Directive, consumers will be given cancellation rights. They will have the opportunity to cancel the loan or withdraw their funds from the platform within 14 calendar days.

5. Approved lenders will be required to report their financial position, complaints received and their client money holdings to the regulator.

6. The information disclosed to consumers will need to follow the financial promotions rules. As a result, current practices such as comparing lending platforms’ interest rates with deposit account rates will be forbidden. Consequently, a more adequate description of the investments’ nature and risks5 is expected.

On 24 October 2013, the FCA issued a Consultation Paper on its regulatory approach to crowdfunding and similar activities (CP13/13).

6 ALTERNATIVE LENDING – A REGULATORY FOCUS ON THE SME MARKET

“The characterisation

of peer-to-peer simple loans versus debt-based crowdfunding models as

low-risk versus high-risk is, in our view,

a mistake”.

Chair of the UK Crowdfunding Association

As anticipated, the consultation paper provoked swift reactions. While regulation is expected to increase consumer confidence, and was largely welcomed by the industry, there was also much controversy. The chair of the UK Crowdfunding Association (UKCFA) stated that: “The characterisation of peer-to-peer simple loans versus debt-based crowdfunding models as low-risk versus high-risk is, in our view, a mistake”6. The Association has publicly announced that it will lobby for a more granular breakdown of the investment opportunities offered by the crowdfunding sector7. Indeed, some consider that the FCA’s projected regime is over-simplified; for instance, there is no proportionality according to the risk associated to the different types of loan.

The impact that these reforms will have in the industry is yet to be seen. The regulator acknowledges that higher consumer protection comes at a price. So far, it has published a cost-benefit analysis which indicates that the proposed rules will result in certain companies leaving the peer-to-peer industry and that compliance costs will be permanently higher for those that survive8. Inevitably, greater accountability will have a negative impact on the rates that have so drawn customers to alternative lenders.

According to the FCA’s calendar, those companies that hold an OFT licence, will need to apply for ‘interim permission’ before the 1 April 2014. Therefore, this is the perfect time for firms to assess whether they are ready to comply with the regulator’s demands or whether they need to undergo a strategic decision-making process to assess the implications of compliance upon their business model and, ultimately, their

survival in a redefined marketplace. Platforms with interim permission will be able to apply for full authorisation from the 1 October 2014. Before the 1 April 2016, all prospective regulated firms must ensure that those individuals in control functions are registered as ‘Approved Persons’ by the FCA9.

Although the regulator has conferred a reasonably long transition period, and many of its proposals are a close reflection of the Peer-to-Peer Association code of conduct, firms will still need to operate a profound review of their existing governance and control strategy and put into place new regulatory reporting mechanisms. Financial promotions will require specific attention in order to comply with some of the FCA’s key principles: treating customers fairly and providing information which is ‘clear, fair and not misleading’ to help them make informed decisions. Alternative lenders must not forget that, as the regulator itself stated, the FCA has much stronger enforcement powers than the OFT.

While the estimated £840 million that will be lent by alternative finance providers in 2014 only represents 2% of annual UK business lending, the fact that this amount has grown at a rate of 90%10 year-on-year cannot be disregarded. Peer-to-Peer lenders have been described as ‘game-changers’; not only due to the seductive rates they offer, but because both borrowers and investors are captivated by their speed and simplicity. Although they have been defined as ‘a passing fad’ by some bankers, the industry benefits from the government’s support. Whether the regulator will manage to strike a fair balance between customer protection and encouraging competition in the lending sector is yet to be seen.

6The FT 28/11/2013: “Crowdfunders and peer-to-peer lenders draw lines in the sand”7Crowdfunding & Regulation: A response to FCA consultation paper CP13/13 (Daniel Kieran)8CP 10/139CP 13/13 page 1210Nesta: “The Rise of Future Finance. The UK Alternative Finance Benchmarking Report.”

ALTERNATIVE LENDING – A REGULATORY FOCUS ON THE SME MARKET 7

Reactions to the FCA consultation paper

“The balance the Regulator

strikes between consumer protection and encouraging competition, will dictate whether this

industry survives or thrives.”

Grant Thornton UK LLP @GrantThornton

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