The European Central Bank has said it is looking “very carefully” at alternative real estate debt providers, identifying such lenders as a key risk to financial stability in the region.
The ECB’s vice-president, Luis de Guindos, made the comments at a press conference in Frankfurt on March 7, following the central bank’s announcement it is to keep all three ECB interest rates unchanged.
Asked whether the ECB saw vulnerabilities in the European commercial real estate market as a wider risk to the financial system, De Guindos said: “If you look at the figures, commercial real estate credit amounts to something close to 5 percent of the total assets of the European banks. But the problem is not the average… There are some banks that have higher exposure and a higher concentration of real estate in their portfolios and in their balance sheets. This is something we have been monitoring very closely.”
De Guindos added: “We have indicated several times that the exposure of the non-banks is much larger than the exposure of the banks. So, to repeat, this is something that we have been looking at very carefully and it’s one of the main risks for financial stability at present.”
Several other institutions have said they are increasingly vigilant over the non-bank sector, including the UK’s central bank. The Bank of England is currently monitoring risks from private credit markets, including lenders to real estate, and plans to publish its assessment of these risks in its Q2 Financial Stability Report, in June.
In a speech on January 29, Lee Foulger, director of financial stability, strategy and risk at the Bank of England, said: “Corporates that borrow through private credit markets, along with leveraged loan and high yield bond markets, are likely to be more challenged in a higher interest rate period. The floating-rate debt structure of private credit agreements makes them vulnerable to challenges around debt servicing and refinancing in a higher rate environment.
“To date, private credit market participants have reported low default rates despite the tougher macro environment. But in the past year, highly leveraged borrowers have experienced a significant decline in their interest coverage ratios.”
He added: “It is therefore important, as it is for all parts of the financial sector and real economy, to understand how the transition to a higher rate environment will affect the private credit markets and in particular whether and how the business model risks in the sector will interact [with] macro vulnerabilities.”
Valuation practices
The Financial Conduct Authority, a UK regulatory body, is also currently reviewing the valuation practices of private debt and equity managers, reflecting the growing concern that a lack of transparency in these vehicles has the potential to create broad vulnerabilities in the financial system.
Non-bank lenders have been increasing in number since the global financial crisis as banking regulations introduced in the wake of that systemic shock have constrained commercial bank lending. The size of the overall private credit market at the start of 2023 was approximately $1.4 trillion, compared to $875 billion in 2020, and is estimated to grow to $2.3 trillion by 2027, according to research from investment bank Morgan Stanley.
But Foulger said, during the January speech, the emergence of risks, both macroeconomic and geopolitical, presented non-bank lenders with specific challenges “both in terms of the way risks are managed and because the underlying borrowers and the specific business models are likely to be increasingly challenged in this environment.”
He explained: “Past stresses have demonstrated how in favorable market conditions business model risks can build up and interact with system wide vulnerabilities in a way that can impact credit provision to households and businesses and impact upon systemic institutions and markets when conditions worsen.”
Foulger concluded: “Assessing the extent of the risks, or in which scenarios they might crystallize is easier said than done. There are significant challenges with obtaining reliable data to monitor the risks in private credit markets.”
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