News
The rise and risk of private credit – Opinion News
By Amol Agrawal
Financial systems around the world continue to find ways to create new types of financial intermediaries. The latest entry into this club of financial intermediaries is “private credit”.
What is private credit (CP)? Research by the International Monetary Fund (IMF) defines PC as “non-bank corporate credit provided through bilateral agreements or small ‘club deals’ outside the domain of government securities or commercial banks”. Finance buffs will immediately relate PC to private equity or PE, where similar “club deals” provide companies with equity capital. In fact, a non-bank company specializing in private finance can offer both PE and PC.
The PE and PC business started 30 years ago. However, PE recovered early as equity markets remained stable. After the global financial crisis (GFC), regulations began to become more stringent in public banking and equity markets also became unstable. Investors and recipients of funds began to gravitate towards private credit. Between 2008 and 2020, the PC Marketplace grew five times, from US$0.4 trillion to US$2 trillion.
An important lesson from the GFC is to be aware of all this exponential growth in financial market segments, especially in the non-banking category. There is a tendency in financial markets to migrate to the new idea, ignoring all the risks. Even more worrying is how risks from one segment spread to another in the blink of an eye. The GFC itself showed how fires in the housing finance market spread throughout the financial system. There’s a simple lesson for PC markets. Although the public credit (banking) system is designed to disclose information to regulators, CP, by definition, is a private matter. Information asymmetry is at the heart of all financial crises where the regulator and the public do not know what is happening behind the scenes.
The IMF investigation warned that PC has become the new public risk in the financial city. CP involves highly leveraged interconnected entities that may pose risks to financial stability. Banking regulators should pay attention to the growing risks of CP and review their regulatory systems to include such activities.
Where India Does it fit into the discussion? In India, we have had non-banking financial companies (NBFCs) that have provided a form of CP. However, the Reserve Bank of India (RBI) and other regulators have made constant efforts to regulate NBFCs. PC, as of now, is seen as a collection of unregulated pools of capital that provide credit to companies. In fact, PC exists due to regulatory arbitrage as it does not require NBFC license to extend credit to interested entities.
PC entered India economy through something called alternative investment funds (AIF). AIF is defined as a “private investment vehicle that collects funds from sophisticated investors, whether Indian or foreign, to invest them in accordance with a defined investment policy for the benefit of its investors”. AIFs come under the purview of the Securities and Exchange Board of India (Sebi).
In December 2023, the RBI issued a notification stating that entities regulated by it (banks and NBFCs) were investing in AIFs. These AIFs, in turn, provide private credit to companies, which have direct exposure to loans to regulated entities. The RBI has asked all its regulated entities to liquidate their AIF holdings. Entities that cannot liquidate will be required to make 100% provisions on any such investments.
The case of India shows how regulatory arbitration works even within regulated entities. Entities regulated by the RBI first invested in AIFs regulated by Sebi, which in turn invested the funds in the same companies that had lending exposure to the regulated banks. It is this very complex maze of interconnected transactions between financial entities that concerns regulators. A bad transaction has the potential to spread throughout the financial market. That said, the RBI and other regulators would have to be on constant vigil to understand the new forms of linked loans and the risks associated with them.
In addition to the RBI, we regularly see other central banks and regulators studying and regulating PC markets.
In short, CP has emerged as a new form of financial intermediation that has the potential to threaten financial stability. Although the PC looks new, in reality it is like old wine in a new bottle. Indian financial history has seen many intermediaries, from traditional moneylenders and Indian banks to Presidential Banks and Indian Equity Banks. Nationalization converted private banks into public sector banks that had different objectives. The 1991 reforms created new private sector banks and local banks. In 2013, the RBI licensed small finance banks and payment banks. Technology has led to the creation of several fintechs. The RBI classifies nearly 10,000 NBFCs into around 10 categories. Other countries will have their own history of financial intermediaries.
It is extremely fascinating to observe how the financial system resembles a living world that continues to evolve and create new intermediaries. Despite a lot of financing and many financial intermediaries, there are still cases of financial exclusion and the search for cheaper financing, leading to the creation of new intermediaries. PC is the latest addition to the list.
Amol Agrawal, the author teaches at the University of Ahmedabad
Disclaimer: Opinions expressed are personal and do not reflect the official position or policy of FinancialExpress.com. Reproduction of this content without permission is prohibited.