By Amol Agrawal
Financial systems around the world keep finding ways to create new kinds of financial intermediaries. The latest entrant to this financial intermediaries club is “private credit”.
What is private credit (PC)? Research by International Monetary Fund (IMF) defines PC as “non-bank corporate credit provided through bilateral agreements or small ‘club deals’ outside the realm of public securities or commercial banks”. Finance aficionados will immediately relate PC to private equity or PE, where similar “club deals” provide equity capital to the corporates. In fact, a non-bank firm specialising in private finance can 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), the regulations started tightening on public banking and equity markets also became unstable. The investors and receivers of funds started gravitating towards private credit. Between 2008 and 2020, the PC market grew five times from $0.4 trillion to $2 trillion.
One major lesson from the GFC is to watch out for all such exponential growth in financial market segments, especially in the non-bank category. There is a tendency in financial markets to flock towards the new idea ignoring all the risks. Even more worrisome is how the risks from one segment spread to another in a flash. GFC itself showed how fires from the housing finance market spread to the entire financial system. There is a straightforward lesson for PC markets. While the public credit (banking) system is designed to disclose information to the regulators, the PC by definition is a private affair. Information asymmetry is at the heart of all financial crises where the regulator and the public do not know what is cooking behind the scenes.
IMF research has cautioned that PC has become the new public risk in the financial town. 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, we have had non-banking finance companies (NBFCs) that have provided a form of PC. However, the Reserve Bank of India (RBI) and other regulators have constantly made efforts to regulate NBFCs. PC, as of now, is seen as a set of unregulated pools of capital that provide credit to firms. In fact, PC exists due to the regulatory arbitrage as it does not require a NBFC licence to give credit to interested entities.
PC has entered Indian economy via something called alternative investment funds (AIF). AIF is defined as a “privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it 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 saying that entities regulated by it (banks and NBFCs) were investing in AIFs. These AIFs in turn are providing private credit to the businesses, which have direct loan exposure to the regulated entities. The RBI asked all its regulated entities to liquidate their holdings in AIFs. The entities that are unable to liquidate shall be required to make 100% provisions on any such investments.
The case in India shows how regulatory arbitrage works even within regulated entities. The RBI-regulated entities first invested in Sebi-regulated AIFs, which in turn invested the funds in the very companies that had loan exposure to the regulated banks. It is this very complex maze of interconnected transactions between financial entities that worries regulators. One bad transaction has the potential to spill over to the entire financial market. Having said that, the RBI and other regulators would have to be on a constant vigil to understand new forms of interconnected lending and risks associated with them.
Apart from the RBI, one is regularly seeing other central banks and regulators studying and regulating PC markets.
To sum up, PC has emerged as a new form of financial intermediation which has the potential to threaten financial stability. Even though PC appears new, in reality it is like old wine in a new bottle. Indian financial history has seen many intermediaries, starting from traditional moneylenders and indigenous banks to presidency banks and Indian joint stock banks. Nationalisation converted private banks to public sector banksm which had different objectives. The reforms of 1991 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 several fintechs. The RBI classifies nearly 10,000 NBFCs in 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 keeps evolving and creating new intermediaries. Despite much finance and many financial intermediaries, there are still cases of financial exclusion and demand for cheaper finance, leading to the creation of new intermediaries. PC is the latest addition to the list.
Amol Agrawal, the author teaches at Ahmedabad University
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