Tue 19 May 2020

The FCA and another difficulty with Asset Finance

Am I alone in having deep misgivings about the regulatory creep evident in the FCA's recent "Dear CEO" letter of 15 April? While this was issued in relation to the COVID crisis, the problem content appears to have timeless application. It applies FCA regulation through the back door to unregulated agreements between funders and SMEs. 

The application of this new guidance to asset finance is fraught with difficulty and, in my view, if such application is intended, it demonstrates a misunderstanding of how asset finance works.

The FCA says this in the letter:

" Accordingly, we expect that for each bank that lends to SMEs there is a Senior Manager, or Senior Managers where appropriate, with clear responsibility for that activity. Furthermore, the FCA recently recognised as an industry code the Lending Standards Board’s Standards of Lending Practice for Business Customers . This code will be something we consider in how Senior Managers and other relevant employees under the SMCR discharge their duties."

In other words, to protect SMEs, the FCA will use its senior manager authorisation regime to control the behaviour of authorised lenders in that marketplace. The control in question is an expectation that the Lending Standard Board's (LSB) business customer standards will in effect constitute FCA guidance.

Now, admittedly, there are some open questions here as to what the FCA means by this. First, it starts by referring to "each bank". What does this mean in the context of what follows? Most asset financiers are not banks, though some are owned by banks. Are all of them the target of this guidance? It would be a brave senior manager in an FCA authorised business which interpreted this as not applying to them. Second, does it extend to asset finance at all? There is good reason to suppose it doesn't, first, because asset finance is not lending (and SME asset finance, unlike lending, is currently not subject in many cases to FOS jurisdiction) and, secondly, because the LSB code referenced is the one relating to "Lending Practice". On the other hand, if you go to the LSB website to view its Business Customer codes, the asset finance variation on the lending code sits side by side with that lending code. And, of course, those FCA authorised persons who are bound by the LSB's codes come within the LSB's asset finance code as well as the lending code anyway.  So, while it is unclear what the FCA means by this letter in relation to asset finance, the consequences of its possible application need to be considered.

And we need to remember a crucial distinction between the lending market and the asset finance market, namely, many asset financiers, provided they do not engage in regulated business, are not subject to authorisation by the FCA at all. Some of those unauthorised businesses may be members of the FLA or the BVLRA and thus subject to their separate styles of code. Some are not. So, we have a playing field potentially which is anything but level.

Now, being judged against the LSB guidance will, so far as its philosophy applies, be of little concern to most asset financiers. While the provisions of the guidance are extensive, they simply for the most part require customers to be treated fairly and transparently. These provisions are not where the problem lies; asset financiers have business reputations to protect like everyone else. Furthermore, to a large extent asset financiers, unlike lenders, obtain their business from specialist asset finance brokers who will take a dim view of their own customer being maltreated by a third party funder to whom  the broker has introduced the customer. The problem rather lies in how the LSB asset finance guidance suggests asset financiers should behave when worried about their asset - and, remember, asset financiers own the assets they have funded and need to be sure, as such owners, that the assets are being looked after. These are the relevant provisions in this connection which I think could be troublesome:

"If, after exploring all the options open to the customer, it is clear that recovery of the asset is required, the Firm should ensure that the customer is provided with clear information as to what this entails.

Firms should apply an appropriate level of forbearance where, if after having made contact with the customer, it is clear that this would be appropriate for their situation.

If a Firm is aware that a customer is, or suspects that they are, in financial difficulty but is able to maintain their borrowing commitments to the Firm, the customer should be given the opportunity to take action to turnaround the business.

Firms should work with and support a customer’s turnaround plan where the Firm believes that it has a good chance of succeeding

If a Firm is unable to support a turnaround plan, the customer should be notified of the reasons why and given a reasonable period of time to consider the options open to them."

It is these sentences which, in my view, demonstrate that neither the LSB nor the FCA fully appreciate how asset finance works, the benefits it can bring to those with a viable business but constrained in their ability to borrow, and then how that relates to the funder's ability to recover the funded equipment. There is no mention in the LSB code of the risks of the asset depreciating during a repayment indulgence period nor of situations where it is in jeopardy.

Asset finance is not lending; rather it is the making available of funding by way of what is, in international parlance, a "purchase money security interest". The amount of money made available is the price of the asset which the asset financier will own and make available to the hirer/lessee on terms whereby that hirer/lessee has to look after it and pay for it. It is funding specific to the acquisition of the asset. This means that the underwriting process is fundamentally different. A lender looks at a potential borrower's accounts, assesses its credit covenant and may require security over what will usually be a non-depreciating asset base to bolster the assessment of the borrower's ability to pay, but looked at over the whole of the business. The security element is secondary. The asset financier on the other hand looks first and foremost at the value of the asset financed, its depreciating value over the term of the finance and its ease of recovery and sale if problems arise with the finance. The credit covenant will be reviewed as well, but the emphasis is different; it's the secondary consideration. I sometimes explain that the differing approaches to underwriting are like looking at the same customer through different ends of the telescope.

Now, I fully accept that the foregoing analysis of the differing approaches to underwriting is simplistic and each asset financier has its own balance of methodologies. In particular, those asset financiers which are owned by banks may have underwriting criteria which are more closely aligned with those of their parent organisations, though over time, in my experience, the extent of that alignment will vary enormously. But the generality about the difference in approaches is true.

Which leads me to my point in all this. As we all know, many, many billions of pounds are currently outstanding and owed to asset financiers by SMEs. Those deals will have been underwritten taking full account of the depreciation profile of the asset and its recoverability and saleability, but not taking account of restraints on recovery introduced by the FCA or LSB. Depending on how you interpret what the FCA and LSB are saying, there is a real danger that they want the underwriting of asset finance deals to be much more closely akin to lending criteria. This has the consequence, firstly, of asset financiers currently and historically relying on underwriting criteria which are now to be disapproved of, and, secondly, restricting the amount of funding available by way of asset finance. In a post-COVID world where debt-serviceability even in previously flourishing businesses may be much constrained for a period of time, this seems to be the opposite of what should be being encouraged. In that post-COVID world, asset finance for business based on an expert appraisal of the asset and accepting there may be uncertainty about the overall business going forward will be a crucial tool in restoring the economy and should not be unthinkingly prejudiced. 

I am not of course arguing that there should be no discouragement of irresponsible behaviour by relevant regulators. Nor would asset financiers wish that.  And I accept that in many circumstances there will be merit in the excerpts from the LSB guidance quoted above. But there will be times when asset financiers need to act quickly to protect their position and the asset. My plea is rather that some well-informed discussion and consultation needs to take place among all appropriate parties, including the FLA and BVRLA, before regulatory principles from one area are applied without tailoring to another area, in this case asset finance. Otherwise, there is a risk that a huge source of funding for UK SMEs will be unintentionally reduced.


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