- Key takeaway: Bank lending commitments to business development companies, or BDCs, increased from about $10 billion in 2013 to more than $50 billion by 2025. Even under a severe stress scenario, banks would generally be protected because they hold senior secured claims on BDCs, giving them first priority for repayment.
- Expert quote: "In a market where most activity occurs behind a veil of privacy, BDCs provide the only comprehensive, real-time insight into lending conditions." — Federal Reserve Bank of Boston report.
- What's at stake: The rapid growth and limited transparency of the private credit market has drawn increasing attention from both regulators and lawmakers.Body Text:
WASHINGTON — Bank lending commitments to a growing segment of the private credit market have climbed over the past decade, underscoring growing ties between banks and private lenders.
According to research published Wednesday by the Federal Reserve Bank of Boston, bank lending commitments to business development companies, or BDCs, increased from about $10 billion in 2013 to more than $50 billion by 2025. Actual credit utilization reached roughly $35 billion over the same period, the report said. Despite the growth, the report characterized banks' exposure as modest.
The report found that the technology sector accounts for a disproportionate share of BDC portfolios, particularly technology companies.
Unlike many other segments of the private credit market, which are often opaque, business development companies are publicly registered investment vehicles that must file regular reports with the Securities and Exchange Commission, providing greater transparency into their operations and finances.
The report, which examined SEC filings from 168 BDCs and focused primarily on the period beginning in 2022, found that BDC portfolios are concentrated in a handful of industries. Internet and software companies accounted for the largest share of the median BDC's portfolio by loan count, at about 20%. But the report warns that the figure conceals wide differences among individual BDCs.
"As noted, some BDCs have concentrated more than one-third of their lending in
technology sectors, creating substantial exposure to venture-backed and growth-stage companies," the report said. "Some of these borrowers likely are facing headwinds from disruptions caused by the reshaping of software business by artificial intelligence."Manufacturing and industrial companies, professional services firms and health care businesses round out the top five sectors, with each representing roughly 10% to 15% of the typical portfolio, the report said.
The report found that the use of payment-in-kind, or PIK, financing has increased steadily. Under a PIK arrangement, borrowers add unpaid interest to the loan principal instead of making cash interest payments each quarter.
"PIK usage is designed to allow growth companies to reinvest rather than service debt, but an increase in PIK usage across a lender's portfolio often signals that borrowers are struggling to generate sufficient cash flow," the report said.
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Despite the growth in bank involvement, the report characterized banks' exposure as modest. BDC-related commitments account for less than 2% of large banks' Tier 1 capital, limiting the potential impact of bad BDC loans on the broader banking system.
Even under a severe stress scenario affecting BDC portfolios, losses would likely not threaten bank solvency because banks generally hold senior secured claims on BDCs, giving them first priority for repayment, the report said.
"In a market where most activity occurs behind a veil of privacy, BDCs provide the only comprehensive, real-time insight into lending conditions," the Boston Fed's report said. "The concerning signs — rising deferrals, compressing spreads, and concentrated exposures — likely exist in some form across the broader private credit landscape."The report's sanguine take on bank exposure to private credit contrasts somewhat with that of the Financial Stability Board, a Basel, Switzerland-based international standard-setting body. In a report
"This web of interlinkages may create challenges for banks in effectively managing their direct and indirect risks," the report said. "Fragmented oversight increases the difficulty of identifying and addressing risks that may arise from these interlinkages."
The FSB report also said some banks struggle to aggregate exposures and conduct effective stress testing, particularly in complex arrangements involving private credit funds.The rapid growth and limited transparency of the private credit market have drawn increasing attention from both regulators and lawmakers. In a recent hearing before lawmakers, Fed Vice Chair for Supervision Michelle Bowman said bank lending to private credit and other nonbank financial institutions, or NBFIs, has increased for years, but regulators still lack a complete view of how those funds are being used.
