The Reserve Bank of India has cautioned against surge in private credit with a potential interconnectedness between banks and non-banks could create systemic risk in the financial system. In the latest edition of the financial stability report, the regulator said that a downturn in the credit cycle could lead to sharp losses in such an asset class.
“The rapid growth of private credit, increasing interconnectedness with banks and NBFIs and opacity can create vulnerabilities that could become systemic,” the RBI said. “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.”
Private credit is provided by non-bank lenders to corporates on a bilateral basis, has grown four-fold over the last ten years.
It has emerged as a major source of corporate financing among middle-market firms that have low or negative earnings, high leverage, and lack of high-quality collateral.
“Private credit offers flexibility, quick execution and greater confidentiality,” the regulator said. “From 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.”
Private credit is not constrained by financing from banks that are subject to prudential regulation and supervisory oversight, or finance raised in capital markets subject to market discipline and price discovery, it said.
As per the regulator the key risks in this segment are that riskier borrowers as compared to those in traditional lending spaces who could generate outsized losses. Also, investors, particularly insurance companies and pension funds, could experience large capital losses with systemic implications.
The RBI also said that the private credit structures are becoming complex, adding multiple layers of leverage. Also, liquidity risks amplified by growing retail presence and higher redemption rights pose challenges.
“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,” the RBI said.
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. Data gaps also pose a challenge in monitoring of developments, RBI said.
