"Private Credit: Its Rise and Associated Risks"

Private credit has seen significant growth as an alternative financing source, appealing to both borrowers and investors. Its rise is driven by factors like traditional bank lending limitations and the search for higher yields. However, this growth comes with associated risks, including lack of transparency, liquidity issues, and potential for higher default rates. Understanding these risks is crucial for stakeholders involved in the private credit market to make informed decisions.

Between 2008 and 2020, the PC market grew five times from $0.4 trillion to $2 trillion.‍

Boston Brand Media brings you the latest  news - A key takeaway from the Global Financial Crisis is to be cautious of any rapid growth in financial market sectors. This is particularly important in the non-bank category.

Financial systems globally continuously innovate to develop new types of financial intermediaries. The newest addition to this group is "private credit."

What is private credit (PC)? According to research by the International Monetary Fund (IMF), PC is defined as "non-bank corporate credit provided through bilateral agreements or small 'club deals' outside the realm of public securities or commercial banks." Financial enthusiasts often associate PC with private equity (PE), as both involve similar "club deals" that supply equity capital to corporations. In fact, non-bank firms specializing in private finance often offer both PE and PC.

The PE and PC business started 30 years ago. However, PE caught on early as equity markets were stable. Post-global financial crisis (GFC), regulations tightened on public banking, and equity markets became unstable. Investors and fund recipients began gravitating towards private credit. Between 2008 and 2020, the PC market grew fivefold from $0.4 trillion to $2 trillion.

One major lesson from the GFC is to be wary of exponential growth in financial market segments, particularly in the non-bank category. Financial markets tend to flock towards new ideas, often ignoring the associated risks. Even more concerning is how risks from one segment can quickly spread to another. The GFC demonstrated how problems in the housing finance market could spread throughout the entire financial system. This provides a clear lesson for PC markets. While the public credit (banking) system is designed to disclose information to regulators, PC, by definition, is a private affair. Information asymmetry is at the core of all financial crises, where regulators and the public are unaware of the developments behind the scenes.

IMF research has cautioned that PC has become the new public risk in the financial sector. PC involves highly leveraged interconnected entities that can pose risks to financial stability. Banking regulators should pay attention to the growing risks from PC and review their regulatory systems to include such activities.

Where does India fit into the discussion? In India, non-banking finance companies (NBFCs) have provided a form of PC. However, the Reserve Bank of India (RBI) and other regulators have consistently worked to regulate NBFCs. Currently, PC is seen as unregulated pools of capital providing credit to firms. PC exists due to regulatory arbitrage, as it does not require an NBFC license to extend credit to interested entities.

PC has entered the Indian economy through alternative investment funds (AIFs). AIFs are defined as "privately pooled investment vehicles which collect funds from sophisticated investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of its investors." AIFs fall under the purview of the Securities and Exchange Board of India (Sebi).

In December 2023, the RBI issued a notification stating that entities it regulates (banks and NBFCs) were investing in AIFs. These AIFs, in turn, were providing private credit to businesses with direct loan exposure to the regulated entities. The RBI instructed its regulated entities to liquidate their holdings in AIFs. Entities unable to liquidate must make 100% provisions on such investments.

The situation in India illustrates how regulatory arbitrage can occur even within regulated entities. RBI-regulated entities invested in Sebi-regulated AIFs, which then invested the funds in companies with loan exposure to the regulated banks. This complex web of interconnected transactions between financial entities concerns regulators. One bad transaction can potentially affect the entire financial market. Consequently, the RBI and other regulators must remain vigilant to understand new forms of interconnected lending and associated risks.

Apart from the RBI, other central banks and regulators are also studying and regulating PC markets.

To sum up, PC has emerged as a new form of financial intermediation with the potential to threaten financial stability. Although PC appears new, it is essentially old wine in a new bottle. Indian financial history has seen many intermediaries, from traditional moneylenders and indigenous banks to presidency banks and Indian joint stock banks. Nationalisation converted private banks into public sector banks with different objectives. The 1991 reforms created new private sector banks and local area banks. In 2013, the RBI licensed small finance banks and payment banks. Technology has led to the creation of numerous fintechs. The RBI classifies nearly 10,000 NBFCs into around 10 categories. Other countries have their own histories of financial intermediaries.

It is fascinating to observe how the financial system resembles a living organism that continuously evolves, creating new intermediaries. Despite the abundance of finance and financial intermediaries, financial exclusion persists, and there is a demand for cheaper finance, leading to the creation of new intermediaries. PC is the latest addition to this list.

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Source: financialexpress‍