Partnerships between banks and private credit firms could lead to unforeseen shocks in the market, the EU banking watchdog has warned.
The European Banking Authority’s (EBA) latest risks report noted the rise of private credit in the bloc, thanks to regulatory changes and the high interest rate environment.
The EBA said that EU banks are setting up “explicit partnerships with non-bank lenders” to remain involved in lending activities that they would prefer to take off their balance sheets due to regulatory capital requirements.
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“Partnerships are beneficial to both banks and non-banks as they combine the banks’ strengths in infrastructure, experience, risk management and regulatory issues with non-bank partners’ strengths in customer acquisition, product development and user experience,” the report said. “However, they also establish channels through which shocks can be transmitted to banks in ways which may not be fully foreseen by the banks’ stakeholders and counterparties.”
Additionally, the EBA noted that banks can shrink their balance sheets in high-risk-weight activities and compensate it with short-term lending to non-bank institutions, which gives them a lower risk weighting.
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Non-banks – which are significant holders of bank-issued debt securities – could then post banks’ bonds as collateral in the secured borrowing transactions with banks, which the EBA said creates both on- and off-balance-sheet links between the two types of lenders.
“Such two-way links in bank-issued debt securities would give rise to a funding liquidity risk for both parties of the transaction,” the report said.
The EBA called for greater transparency among non-bank lenders and said that their risk management and loan origination standards “might also require further scrutiny”.
It said that regulators and other authorities need to have a particular focus on the direct and indirect linkages between banks and non-bank lenders, and that better data is needed to identify those links.
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“Both on and off-balance-sheet linkages may allow non-banks to indirectly access the public safety nets through banks, such as central bank liquidity facilities, that at present are exclusively available for regulated credit institutions,” the EBA said.
“It is important that the clients of non-bank lenders are fully aware that these players — although typically less leveraged than banks and often funded by long-term investors in closed-end structures — are not protected by the same emergency facilities as credit institutions.
“All in all, close monitoring of these developments and cooperation between regulators, supervisors and central banks are necessary to ensure that the risks in private credit are fully identified and appropriately dealt with.”
