Rapid growth of private credit can create vulnerabilities that could become systemic: FSR

The rapid growth of private credit, its increasing interconnectedness with banks and Non-Banking Financial Intermediaries (NBFIs) and opacity can create vulnerabilities that could become systemic, cautioned the Reserve Bank of India.

In the latest financial stability report (FSR), the central bank noted that private credit, which is essentially provided by non-bank lenders to corporates on a bilateral basis, has grown four-fold over the last ten years, emerging as a major source of corporate financing among middle-market firms that have low or negative earnings, high leverage, and lack high quality collateral.

The size of the global private credit market is estimated at $1472.7 billion as at June-end 2023.

Private credit offers flexibility, quick execution and greater confidentiality. From a lender’s perspective, returns on these investments, though riskier, are consistently superior during prolonged period of low interest rates, attracting investors to these types of investments, RBI said.

While Banks are subject to prudential regulation and supervisory oversight, and finance raised in capital markets is subject to market discipline and price discovery, private credit faces no such constraints, per the FSR.

What FSR said

Referring to an IMF report, the FSR said the key dimensions through which risks via private credit could be propagated include: riskier borrowers than counterparts in traditional lending spaces who could generate outsized losses; investors, particularly insurance companies and pension funds, who could experience large capital losses with systemic implications; and private credit structures are becoming complex, adding multiple layers of leverage.

Further, liquidity risks get amplified by growing retail presence and higher redemption rights; and interconnectedness with other segments of financial system.

“Banks are increasingly accessing private credit market in ways that allow them to manage regulatory costs and generate fee-based income whereas insurers and pension funds are increasing their exposure to less-liquid investments.

“Meanwhile, private equity (PE) firms are increasing their ownership stakes in life insurance companies and banks are originating their own private credit deals using minority stakes in private debt funds and business development companies,” RBI said, adding data gaps also pose a challenge in monitoring of developments.

The central bank underscored that private credit is yet to be tested in a credit cycle downturn and sharp losses could lead to a loss of confidence in the asset class as a whole.