(March 12): The collapse of Market Financial Solutions Ltd (MFS), a UK mortgage lender accused of widespread fraud, has intensified concern over a growing problem in finance — what happens when lending is pushed out of the regulated banking system and into the shadows.
The firm, which borrowed more than £2 billion from heavyweights including Barclays plc and Banco Santander SA, claimed to be one of the UK’s biggest providers of short-term bridge loans until its Feb 25 demise. Yet MFS operated largely beyond the purview of regulators primarily because it did not issue conventional homeowner loans or hold customer deposits, even though firms of its kind are capable of inflicting costly damage to mainstream lenders who do.
Less regulated firms like MFS have been “able to make higher-risk loans — to which banks then gained exposure in order to participate in the higher returns,” said Ellen Gallagher, a partner at law firm Vardags. “The problem for the regulators is that this then becomes a game of cat and mouse with ever more complex structures being designed in order to escape regulatory constraints.”
MFS’s owner, Paresh Raja, has denied wrongdoing and has said he has not been the beneficiary of a shortfall in funds.
Market Financial Solutions Ltd operated largely beyond the purview of regulators primarily because it did not issue conventional homeowner loans or hold customer deposits, even though firms of its kind are capable of inflicting costly damage to mainstream lenders who do.
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MFS’ collapse is the latest credit shock to rattle both banks and private lenders. Similar accusations of wrongdoing surfaced last year in the failures of US auto parts supplier First Brands Group LLC and subprime auto lender Tricolor Holdings LLC.
Banks are subject to a raft of checks and balances, including interrogations about their controls, governance and their ability to withstand shocks. By comparison, little is known about the underwriting standards of non-banks operating in more exotic segments of the lending market, including in bridging finance and complex commercial mortgages that larger banks either cannot, or will not, offer directly.
The general opacity around non-bank lenders is complicated by the fact that, in the UK, there is no standard way to supervise and regulate them. Non-banks which carry out certain types of lending — like owner-occupier mortgages — are overseen and authorised by the Financial Conduct Authority (FCA). The supervision of non-bank lenders is also a perplexing issue globally, with no standard international framework.
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Non-banks active in more specialist lending are usually required to register with the FCA and comply with money laundering rules — but not always. If lending isn’t carried out frequently or profitably, the firm may be exempt. Non-bank lending carried out by insurers is monitored by those insurers’ supervisors.
MFS’s backers thought their loans to the London-based firm were underpinned by distinct tangible collateral. A raft of fraud allegations including the alleged double-pledging of assets, has rocked those assumptions. Apollo Global Management Inc’s Atlas SP Partners, Jefferies Financial Group Inc, Wells Fargo & Co, Castlelake LP and TPG Inc are also among those exposed.
Lower oversight
MFS’s entry in a register held by the FCA shows it was overseen purely for compliance with anti-money laundering regulations, a lower level of oversight than non-bank lenders who offer traditional owner occupier mortgages and must comply with some rules on financial strength and governance. To be sure, fraudulent activity of the kind MFS is accused of can go unchecked at much larger and more tightly supervised institutions.
The Bank of England’s (BOE) Prudential Regulation Authority (PRA), meanwhile, only directly oversees and interrogates the governance and financial resources of large lenders that also hold deposits.
The PRA has recently been exploring vulnerabilities in the non-bank sector through risk analysis, but its focus is on shocks that threaten the stability of the overall financial system, cut off or restrict the flow of funding to the economy, or jeopardize the safety of depositors’ cash.
The central bank is however conducting a ground-breaking data-collection exercise to war-game how non-banks might respond to financial stress, amid growing concern over the growth of the US$1.8 trillion private credit sector.
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The so-called stress test — the second iteration of the BOE’s System Wide Exploratory Scenario (SWES) — is set to probe how banks and non-banks would respond to a severe but plausible global downturn. So far, around 40 firms of varying sizes are expected to participate though it is unclear what, if any, policy changes might follow. The BOE has said it will report some interim findings later this year before publishing the full results in January.
Still, as non-bank lenders have grown in collective importance, global watchdogs including the Financial Stability Board have repeatedly called for greater clarity on how their activities intersect with regulated financial institutions. Given a general de-regulation trend in finance led by the US, there’s little political backing globally now for a fresh round of rule-making.
That leaves market participants in more arcane parts of the market with little recourse when things go wrong. Rob Dalling, partner at Jenner & Block, said that unregulated finance means a lower degree of protection for consumers.
“Very often with the collapse of an entity which is not itself regulated, the spotlight falls on lenders, auditors and other firms which are accountable to regulators,” Dalling said.
According to its filings, MFS and some of its affiliated companies were audited by a handful of small high street accountants, rather than a Big Four accountancy firm who would broadly be expected to audit a group of this size.
Accounting firms who worked with MFS include north London-based Berkeley Finch and Magus Chartered Accountants in Westminster. Both firms didn’t respond to emails seeking comment.
A spokesperson for the Institute of Chartered Accountants in England and Wales said its disciplinary by-laws prevented it from commenting on matters related to professional conduct.
“Where such consideration results in disciplinary action being taken then a public announcement will be made,” the spokesperson said.
A spokesperson for the Financial Reporting Council, which regulates larger accountancy firms auditing sizable or publicly important companies, said the watchdog was monitoring the situation.
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