‘Shadow banking’ could lead to ‘credit bubble’

Standard & Poor’s estimates private debt sources – what it calls ‘shadow banking’ – can provide up to $25bn of project finance loans this year. However, it warns its ‘opaque nature’ carries certain risks.

Ratings agency Standard & Poor’s (S&P) believes private debt is becoming a significant force to be reckoned with in global infrastructure financing, but warns it carries some risks and faces obstacles to its growth as an asset class.

On the positive side, S&P highlights that ‘shadow banking’ – the ratings agency’s moniker for non-bank, institutional investor-led private debt – gained significant traction last year, with institutional investor interest in private infrastructure debt here to stay.

According to S&P, about one-quarter of all project finance lending last year in the US came from institutional investor-fuelled alternative debt sources, almost as much as the amount of project finance debt raised from the public bond markets. The ratings agency added that Europe, the Middle East, Africa and Asia Pacific were following a similar trend.

If that trend continues, S&P estimates that up to $25 billion of project finance debt will be sourced from the shadow banking sector this year.

But as positive as shadow banking is – S&P calls it “of great benefit” and says it “may help reduce the cost of borrowing for projects and introduce financial innovation into the marketplace” – the ratings agency warns that it poses several risks. 

“On the downside, our view is that the somewhat opaque nature of the shadow banking system could lead to a build-up of systemic risks within the infrastructure sector, as occurred prior to the global financial crisis of 2007-2009. To date, though, this has not been a major cause for concern,” admitted S&P credit analyst Michael Wilkins.

Shadow banking’s unregulated nature and lack of capital support from, for example, the central banking system can also “create opportunities for borrowers and lenders to pursue the cheapest, least transparent sources of capital,” S&P points out, adding: “Furthermore, we believe that it may result in creating incentives to maximise debt leverage, a process that has led, and may lead again, to systemic defaults and downgrades”.

However, shadow banking faces considerable obstacles to growth. These include a lack of tried and tested funding mechanisms, absence of performance data, and investors’ wariness to take on construction risk. Private debt is also seen as less flexible than bank debt, which can easily step margins up and down to deal with risks like construction.

For all these reasons, S&P argues banks will continue to be the dominant force in infrastructure financing, although it predicts that regulatory pressure on banks combined with yield-hungry institutional investors will continue to boost the private infrastructure debt market.