The financial crisis of 2007-2008 was driven by financial institutions investing in subprime mortgages that had a higher default risk than bank managers and regulators deemed likely. But when homeowners started to default on their mortgages, many financial institutions who had packaged and sold those mortgages incurred in large losses, and some even failed. The crisis revealed that many banks were not maintaining adequate capital and liquidity buffers to cope with stressed macro-financial conditions, let alone the excessive financial risks that some advanced economy banks had taken on. Consequently, in the aftermath of the financial crisis, the Basel Committee on Bank Supervision (BCBS) implemented regulations requiring banks to maintain some minimum capital and liquidity requirements. These set of international banking regulations, commonly referred to as Basel III, created certain guidelines designed to address the weaknesses in the banking system exposed by the crisis in order to reduce the risk of widespread system failures and future financial crisis. But while many agree that Basel III is making the banking industry more resilient, critics also argue that it is taking a toll on the economy in the process. In particular, many critics have long been sceptical about the Basel III reforms’ benefits and believe they will actually harm – rather than benefit –  businesses by causing a significant reduction in lending to SMEs. Meanwhile, this has also represented an opportunity for specialist lenders, less tied up by the constrains introduced by Basel III requirements, to step in and support lending to SMEs.

The impact of Basel III has been strongly felt in the development finance industry because under the new guidelines, each bank must group its assets together by risk category so that the amount of required capital is matched with the underlying risk level of each asset type. Basel III uses assets’ credit ratings to determine their risk coefficients and accordingly issues guidelines for the risk-weighted assets (or RWA) that banks need to maintain as collateral. The purpose is to prevent banks from losing large amounts of capital when a specific asset class declines sharply. And while regulators consider several tools to evaluate the risk of a specific asset, the issue is that they see development finance as carrying a higher risk than other types of lending such as mortgage or bridge lending. This is , mainly due to the lack of income streams generated by the collateralised property while it is in the development phase and to other risk factors associated with the construction and market variables such as the lack of transparency around the future cost of construction materials. Under the new regulations, there is a tightening of capital requirements for property development finance projects which makes lending to them costlier and less attractive. For example, banks that wish to maintain exposure to land acquisition, development, and construction (ADC) need to set aside RWA’s of up to 150% for loans to companies/SPVs and of up to 100% for residential ADC loans. Furthermore, newly introduced net stable funding ratio (NSFR) and liquidity coverage ratio (LCR) force banks to (i) match longer-term lending (such as for development finance) with longer-term funding, and (ii) hold more cash-like assets for project funds. Finally, there might be reluctance from banks to commit to longer-term development funding due to increased uncertainty over further regulatory tightening. Since the 2008 crisis, there have been frequent changes to regulatory standards, ranging from Basel II.5 to Basel III and to recent additional reforms to Basel III.

What this meant in reality is that many banks started to divest from their real estate development finance portfolio in the aftermath of the 2007-2008 global financial crisis. However, it also created an opportunity for specialist non-bank lenders like Blend. With their nimble structure, flexible funding sources, and experienced lending team, specialist non-bank lenders have demonstrated that they are able to plug the funding gap left by traditional lenders.

David Alcock,

MRICS, Managing Director, Blend