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The failure of Tricolor, a car lender little known outside of its low-income customer base in a few US states, is a good moment to reflect on how modern banking works. Tricolor filed for bankruptcy on Wednesday, and is being probed by the US Justice Department over allegations of fraud. Thanks to the rise in so-called shadow banking, this mini-drama has maxi-implications for banks everywhere.
Tricolor offered high-interest loans to low-income consumers, notably in Hispanic communities in states such as Texas, California and Nevada. Since it isn’t a bank and therefore does not take deposits, it borrowed from institutions including JPMorgan, Fifth Third and Barclays, lent to car buyers, then bundled its auto loans as securitised bonds to sell to institutional investors. With the proceeds, it then paid back its own lenders, rinsed, and repeated.
The amounts involved at Tricolor were small in the context of the US financial system. Tricolor had about a $1bn credit line with its bank lenders. The $200mn loss that Fifth Third is contemplating compares to its $21bn of shareholder’s equity.
But the underlying process is part of a wider trend. So-called asset-based lending, which involves slicing and dicing such things as auto debt, student debt, aeroplane leases and mortgages, is a linchpin of the private credit revolution sweeping Wall Street. A report earlier this year from Fitch Ratings reported that US banks have currently $1.2tn outstanding to non-bank financial institutions, a 20 per cent jump year-over-year. Commercial loan growth in that same period was less than 2 per cent.
This makes sense for the banks, because post-2008 regulations force them to keep more equity aside to cushion losses on risky assets. Loans to novel institutions can be structured to be highly senior: Barclays estimates that warehouse loans soak up as little as 20 per cent of a bank’s equity capital compared to a loan made directly to the end borrower.
The question now is what Tricolor’s downfall means for the rest of the edifice. It may very well be an aberration. Fraud, if there is found to have been any, is always bad news for the defrauded, but it is impossible to entirely stamp out. Even the biggest lenders sometimes fall prey. JPMorgan, for example, acquired student financial aid platform Frank in 2021, only to find later that it had in effect been scammed.
More worrying possibilities are that the American consumer, notably the lower income segment that Tricolor served, is in rougher shape than imagined. Worse still would be any suggestion that speciality lenders who increasingly dole out auto loans, buy-now-pay-later loans and the like, are not being careful in their underwriting choices, and that their bank lenders haven’t been asking the right questions.
Banks themselves are at least far more fortified than 20 years ago. In the US, lenders have common equity tier-1 ratios of nearly 14 per cent, according to the New York Federal Reserve, compared with 8 per cent in the years before the financial crisis. So they are well placed to absorb losses. Their vigilance, one hopes, has been similarly bolstered. If so, Tricolor may be a helpful spur to step up their scrutiny, rather than a sign that it is already too late.
sujeet.indap@ft.com
