In recent years, India’s nascent private credit market has had a dream run. Non-banks found a sweet spot in funding mid-sized corporate borrowers who aren’t quite the favourite of traditional lenders due to their weak balance sheets and poor-quality collaterals.
These deals have made sense for both sides. Little surprise then that the market has grown more than four-fold over the past decade, as quick execution and confidentiality lured borrowers.
For private credit givers, mouthwatering returns, beating the traditional lending channels, meant an easy business proposition. New investors lined up, putting big money on the table. In the no-man's land between the big and legacy lenders, which are constantly on the Reserve Bank of India’s radar, and the Sebi-monitored capital market, the private credit market thrived.
The dream run may finally be coming to an end.
Red flags fluttering
On June 27, the RBI’s Financial Stability Report raised multiple red flags, calling the private credit market a systemic risk as many of the non-bank lenders are connected with the broader banking system.
The RBI primarily highlighted these concerns:
One, this category comprises riskier borrowers than counterparts in the traditional lending space and could generate outsized losses.
It means that the regulator is concerned that a credit collapse of these borrowers can have implications for the broader banking system.
Two, investors, particularly insurance companies and pension funds, could experience large capital losses with systemic implications.
It can have an impact on retail investors such as pensioners or customers of insurance companies in the event of a blow-up.
Three, private credit structures are becoming complex, adding multiple layers of leverage.
These complex, multi-layered lending structures and excessive leveraging have brought major financial crises, including the 2008 global meltdown.
Four, liquidity risks are amplified by the growing retail presence and higher redemption rights.
At the first hint of trouble, private credit investors would want to pull out their money, which can touch off a series of shocks for non-bank lenders, which make up a significant part of the non-banking ecosystem. The tremors will likely be felt by the larger banking system.
Five, the interconnectedness of the private credit market with the broader financial system.
In recent years, banks, too, have gotten a taste of private credit by originating their deals through minority stakes in private debt funds and business development companies.
“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 FSR report says.
What is also worrying the banking regulator is the opaque nature of the market and the difficulty in getting data.
“Data gaps too pose a challenge in monitoring developments. Finally, 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,” the RBI has said.
Why is RBI worried?
What would have drawn the RBI’s focus on private credit In India? Probably, the sharp, unchecked growth in the market as non-banking entities increases exposure to the private credit business.
According to an EY February 22 report, the private credit deal flow in India in 2023 surpassed the 2022 levels, with 108 deals valued at $7.8 billion, up from 77 deals worth $5.3 billion.
Stabilised interest rates in CY23, increased real estate private credit deal activity and large deals boosting overall value were among the factors cited for the growth.
“Over the last couple of years, we have seen private credit funds filling the vacuum created by the departure of NBFCs from the wholesale lending space relative to their levels of activity before CY18,” Bharat Gupta, EY India Strategy and Transactions Partner, said in the report.
In India, many companies found an opportunity in the private credit market. For instance, Mumbai-based Avendus has been active in the private credit market with around 120 plus deals disbursing around $1.6 billion from its balance sheet since its operations in 2010.
“In NBFC, we have been doing private credit kind of transactions only. It's a 100 percent wholesale lending structured finance NBFC. Over the last six or seven years, we would have done around 120 plus deals, and we would have disbursed more than half a billion dollars from our balance sheet,” Avendus Finance managing director and CEO Nilesh Dhedhi told Moneycontrol on May 31.
For the right reasons
The RBI’s concerns about the private credit market are valid and timely. Easy money to the less worthy borrowers is a recipe for a disaster. There is a need for a tight vigil. In the event of an economic downturn or a liquidity crunch, poor-quality borrowers will be the first to take a hit and the asset quality shock can have a cascading effect on the broader banking system, as seen in the past.
The central bank wouldn’t want to take a chance at a time when the banking system is finally past the worst of asset quality woes and now has record-low bad loans.
“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,” the RBI said.
What comes next?
The central bank typically voices concerns when it sees discomforting signals that warrant a closer look (such as growth in unsecured loans) and as a prelude to tighter norms.
The red flagging could mean that the central bank is weighing its options to come out with some kind of measures to ringfence banks and non-banks having exposure to the private credit market in the event of a liquidity crisis.
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