ESRB looks at risks associated with private credit boom
The European Systemic Risk Board has highlighted the risks associated with the growing market for direct lending by investment funds and other non-bank financial institutions. The ESRB released the EU Non-bank Financial Intermediation Risk Monitor 2024 on 14 June, the ninth edition of the report.
Three main risks are identified for NBFI, sometimes referred to as shadow banks. Concerns are raised about disorderly market corrections that could lead to losses, heightened redemption requests, and liquidity issues for some investment funds holding illiquid assets such as real estate.
Secondly, the ESRB observes an increase in credit and liquidity risks as bond funds increase their investments in less liquid, lower-quality fixed-income securities. Thirdly, excessive leverage and interconnectedness are highlighted as potential causes of financial markets instability.
The ESRB fears that the structural vulnerabilities of non-banks, and cyclical risks, could amplify risks to the stability of the EU financial system, especially due to the impact of higher interest rates. Worsening financing conditions coupled with slower economic growth could increase credit risk, according to the 80-page report.
Real estate sector as a risk
Higher credit risk could lead to losses and put pressure on non-bank financial intermediaries engaged in liquidity transformation, especially those with direct exposure to interest-sensitive sectors such as real estate, or those relying on increased leverage.
Non-bank financial intermediation in private debt, private equity, and venture capital has grown so significantly that these segments have the potential to affect the stability of the entire financial system, the report states. „Should the rapid growth observed in private financing in recent years continue, the sector could become systemically.“
The ESRB is calling for greater transparency „to better understand how private financings create and/or transmit risks to financial stability.“ It emphasises the importance of information on the volume and quality of lending by non-banks, as well as data on their interconnectedness with the banking sector and institutional investors.
The ESRB notes that private credit is one of the fastest-growing areas of finance, filling the gap left by banks, and increasingly competing with traditional lenders. Hence, many supervisors see a need for regulation in this area.
While private financings facilitate diversification within the financial system, there is a risk that they contribute to „over-indebtedness and financial imbalances“. The ESRB also identifies risks associated with certain alternative investment funds (AIFs) and some UCITS funds pursuing hedge fund-like strategies.
