Bank of England asks shadow lenders on risk of downturn

Bloomberg

The Bank of England (BOE) has been meeting with direct lenders to gauge the industry’s resilience to slowing growth, according to two people familiar with the matter.
At least two of the biggest UK private credit funds met separately with members of the central bank’s financial stability unit in the past month, said the people, who asked not to be identified because the talks were private. The meetings were part of the BOE’s efforts to gauge potential sources of stress in an economic downturn, they said.
A representative for the Bank of England declined to comment on the matter.
Direct lenders are starting to supplant traditional institutions in a slew of financing deals in Britain, the European epicentre of the market. Earlier this year, a single fund granted a borrower $1.3 billion in one of the region’s biggest private debt transactions on record. That kind of muscle is prompting regulators to examine potential spillovers to the broader economy if troubles emerges during a slowdown.
“Regulators are tracking this development closely to make sure that they understand the underlying risk of direct lending and threat of contagion,” said Floris Hovingh, a partner and head of alternative capital solutions at Deloitte in London.
In its November report, the BOE’s Financial Policy Committee said it “will work to enhance the monitoring of the
potential liquidity demands and losses generated by non-bank leverage” and would consider further actions if “it is found that risks reach systemic levels.”
The number of funds offering private credit mushroomed over the past decade as more traditional banks pulled back from riskier lending and regulators sought to prevent a rerun of the financial crisis. Shadow lenders, which aren’t subject to the same regulatory scrutiny, now control almost $770 billion globally as of June 2018, up from $275 billion in 2009, according to a report from Preqin Ltd.
As capital floods into the industry and competition intensifies, more leverage has crept into deals. Standards have also become more lax. A recent study by law firm Proskauer Rose LLP showed that, of 68 private-credit transactions in Europe it worked on last year, 62 percent contained only a single covenant test. In 2017 the figure was 24 percent. Within the industry, practitioners see the concerns as misplaced.
“Our business model is well designed to continue to lend through a cyclical downturn,” said Max Mitchell, head of the direct lending team at Intermediate Capital Group in London. Committed capital means investors can’t pull money “overnight” like depositors of a bank, he said.
Nevertheless, the opaque nature of the funds, alongside their high-risk loans and explosive growth, have prompted UK officials tasked with ensuring financial stability to increase their scrutiny of the industry.
“I am not surprised the BOE is looking at private debt,” said Sebastien Galy, senior macro strategist at Nordea Investment Funds. “I too am looking for things that can go seriously wrong and one typical canary in the coal mine
is credit.”