Why Regulators Are Watching Banks’ Exposure To Private Credit?
What is the current state or regulation of the sector worldwide? Why are bank regulators worried about banks’ increasing involvement in private credit?
As connections between regulated banks and lightly regulated private credit funds grow, regulators become increasingly worried about the potential risks these links might pose to the global financial system. However, the International Monetary Fund warned regulators in April 2024 that private credit presents risks that they might not fully understand. While banks are carefully monitored by regulatory agencies worldwide, credit funds are subject to much less scrutiny, and their activities remain largely hidden from banks overseers.
As a result, the IMF urges authorities to adopt a more proactive supervisory and regulatory approach to this rapidly growing, interconnected asset class. Although its report notes that regulation and supervision of private funds were significantly strengthened after the global financial crisis, the IMF stated that the rapid growth and structural shift toward private credit require countries to conduct a further comprehensive review of regulatory requirements and supervisory practices, especially as the private credit market or exposures to private credit become substantial.
The IMF report noted that several jurisdictions have already taken steps to improve their regulatory frameworks to better address potential systemic risks and investor protection challenges. Specifically, the report highlighted that the US Securities and Exchange Commission is making significant efforts to strengthen regulatory requirements for private funds, including improving their reporting standards.
The IMF also noted in its report that the European Union has recently amended the Alternative Investment Fund Managers Directive (AIFMD II) to include improved reporting, risk management, and liquidity risk management. It also states that AIFMD II has specific additional requirements for managers of loan origination funds concerning leverage limits (175% for open-end and 300% for closed-end funds) and design preferences, such as favoring closed-end structures and imposing extra requirements on open-end funds.
The fund further noted that regulatory authorities in other countries, including China, India, and the United Kingdom, have also strengthened the regulation and oversight of private funds. With the overall growth of the private funds sector, the IMF noted, supervisors have intensified their scrutiny of various aspects of private funds, particularly conflicts of interest, conduct, valuation, and disclosures. The Bank of England (BoE) has, for its part, instructed banks to strengthen their risk management practices regarding private credit. In a letter to certain institutions, the BoE’s Prudential Regulation Authority stated that its review of their practices had “identified a number of thematic gaps in banks’ overarching risk management frameworks that control their aggregate PE sector-related exposures.”
To address data gaps and enable accurate, comprehensive, and timely monitoring of emerging risks, the IMF recommended that relevant authorities improve their reporting requirements and supervisory cooperation on both cross-sectoral and cross-border levels. “Although the private nature of private credit remains crucial to market functioning,” the IMF report said, “regulators need access to appropriate data to understand potential vulnerabilities and spillovers to other asset classes or systemic institutions.”
As the IMF put it, “there are cross-border and cross-sectoral risks. Relevant regulators and supervisors should coordinate to address data gaps and enhance their reporting requirements to monitor emerging risks.”