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The growth in magnitude and complexity of the nonbank financial institution sector over the last decade has reshaped Europe's financial system--providing meaningful diversification to funding avenues, increasingly interconnecting both banks and nonbank credit providers, and raising risks to financial stability due to these direct and indirect linkages.  

The fragmentation of countries and separate economies under the eurozone has posed complex challenges for private credit to navigate amid the rise of the nonbank financial institution (NBFI) market. Such borrowers have tended to be small-to-midsize enterprises, thus limiting the growth of Europe's private markets.

In contrast, the rise of the broadly syndicated loan (BSL) market in the region was partly due to most borrowers being large global corporations that benefited both from the eurozone and the rise of the euro. The effect of geographical constraints in Europe was less pronounced, and as a result both markets have experienced different pathways to maturity.  

Against this backdrop, the region's unique characteristics imply that Europe may be better insulated from cross-sector spillover effects and the propagation of systemic risks in the event of a market shock. The outright size of the market is smaller, and the fragmentation of the regions' market dynamics, alongside the historical dominance of local banks, naturally erodes those linkages between banks and nonbanks.

While we don't currently view the state of nonbank credit providers as a source of rating pressure for global traditional banks, the potential financial stability risks that the bank-nonbank nexus creates continues to be an area watched very closely by market participants and regulators alike.  

In this EMEA edition of Private Markets Monthly, S&P Global Ratings' analysts provide a regional view on the interconnectedness of banks and nonbanks to surface the key risks and opportunities that lie ahead for European markets.   

How Is Europe's NBFI Market Adapting Compared With Traditional Lenders Domestically And The U.S. More Globally?  

Nicolas Charnay, managing director & sector lead for European financial institutions:  The growth in size and complexity of the global financial system over the last decade is exemplified by the increasing role of NBFIs--such as alternative investment funds, asset managers, finance companies (fincos), broker-dealers, and structured finance vehicles--in intermediating credit and taking on bank-like risks.  

Yet in terms of size, the NBFI sector in Europe is substantially smaller than the U.S.'s. In the region's main countries (meaning Germany, France, and Spain), we generally see NBFIs holding less than 10% of total financial assets. The nonbank space is less developed in part because the capital markets in Europe are much less active due to the inherent architecture of the financial system. There is a lack of an underlying central bank system that potentially cushions the fallout from a credit down cycle, and different governing policies, operating, and legal frameworks that contribute to less support for securitization.  

However, there is no doubt that Europe's private credit market has grown significantly over the past decade in parallel with the rise of private equity--roughly totaling $400 billion and representing a new wave of financial disintermediation for the region. European private credit funds are gradually expanding their lending activities from midmarket entities to more credit classes and strengthening their relationships with banks.

But there is still room to grow. As an indication of private credit's relatively low comparative competition to European banks, this market is equivalent in size to a midsize bank in Europe.

Chart 1

Philippe Raposo, director for financial services:  Europe is not a unified market. Rather, it's defined by different economies at different stages of growth and development, governed by differentiated legal frameworks, and with varying levels of capital market maturity and sophistication. In this context, incumbent banks tend to dominate because they benefit from strong historical ties with their primary local corporates and governments. This status quo is only starting to shift in Europe's largest economies, where credit managers are investing their funds, and banks are mindful of their capital deployment. Overall, we believe any significant change in this dynamic could take years to materialize.  

To be sure, private debt funds have grown rapidly and amassed significant dry powder. Banks can play a role as these players look for opportunities to deploy their capital and engage with the NBFI sector to manage their exposures. In fact, we've seen significant announcements in that regard, for instance with the French bank Société Générale's partnership with asset manager Brookfield to launch an investment-grade private credit fund. While other banks might take a less institutional route in partnering with private debt funds, large corporate banks cannot ignore the growth of private capital. 

Phillipe Raposo:  The four largest credit providers in the NBFI market in Europe are investment funds, fincos, broker-dealers, and securitization vehicles. In line with the global trend, investment funds retain the lion's share of NBFI assets--accounting for roughly 75% of the total market. In Europe, these are led by homegrown players (such as the alternative arms of Amundi, AXA IM, and Partners Group) and by specialists (including ICG and Tikehau), but their total allocation to alternative assets combined would still be far from the capacity of a giant like Apollo. The finco markets are less developed in Europe, due to the dominance of banks in the region.  

This clearly differentiates Europe from the U.S. market, which has unique structures (like the business development companies that lend to the middle market) or securitizations (which are not commonly seen in Europe). Regarding the latter, Europe's middle market is almost exclusively an incumbent bank business, although we've just seen the first European collateralized loan obligation (CLO), which has opened the doorway for other managers. 

But an interesting tailwind is the recently announced increase in defense spending across the eurozone over the next few years. These efforts will require substantive financing, and that is an area where NBFI actors and private markets potentially have a bigger role to play.  

Will Edwards, director for financial services:  In Europe, electronic market makers (EMMs) are playing an increasingly important role in the system. Institutions like IMC Global, Optiver, and XTX are key players in terms of providing liquidity.

Sophisticated algorithms and low-latency execution capabilities have given Europe's EMMs a solid position in global capital markets. In their next growth phase, we expect them to expand their presence in lit markets while deploying capital into new asset classes and less liquid products in over-the-counter (OTC) markets. This will be enabled by material funding from banks. 

Cian Chandler, chief analytical officer for structured finance:  Additional key considerations are capacity and scale. In Europe, alternative investment funds are much smaller than in the U.S. The overall securitization market is much less developed in Europe than the U.S. despite the various announcements and efforts on the policy side in past years. While some players like BNP Paribas, Credit Agricole, Société Generale, and HSBC are taking part, the market is not large enough to securitize or to sell onwards to funds--and by and large is a limited arena. 

The portion of GDP that is securitized in Europe is one-fifth of the U.S.'s, which has profound implications regarding access to capital. Having the U.S. government guarantee the mortgage-backed securities sector normalizes securitization across the board--and as a result, the CLO and asset-backed securities markets are able to respectively grow to $200 billion and $300 billion annually. On their own, they are multiples of the size of the total European market. In the U.S. there are entities the size of some of European banks, but in Europe they are hand-to-mouth from origination to distribution, so it is difficult to achieve scale.  

For any meaningful change to the European funding mix to occur, the region would need to see a change in the infrastructure of its financial system. Toward the end of last year, the European Commission launched a consultation to assess the effectiveness of the EU securitization framework introduced in 2019, with the aim to promote an EU securitization market that finances the economy without creating risks to financial stability. 

Securitization can play a crucial role in the development of European capital markets. By freeing up balance sheets, banks and nonbank lenders can increase lending to businesses and corporations while also providing another asset for investors. 

What Are Key Risks In The European NBFI Market?

Nicolas Charnay: 

By and large, the types of risk present in the NBFI sector in Europe are similar vis-à-vis the U.S.--spanning redemption, rollover, margin, and contagion risks. From a holistic perspective, there is a lower level of systemic risk in Europe just by virtue of the NBFI market being smaller.

According to our analysis, the European NBFI sector represents an average of 7.7% of total financial assets, compared with 16.3% in the U.S. Notably, nonbank assets in Ireland and Luxembourg are considered outliers (accounting for 49% and 25% of total financial assets, respectively) because they are booking centers for the entirety of the EU. While this may indicate the lesser level of interconnectedness between banks and nonbanks in Europe than elsewhere, this does not imply that there is an absence of systemic risk at all.  

Phillipe Raposo:  Several of the large asset managers in Europe (including UBS and DWS, among others) are all part of banking groups and are still part of the same umbrella, even though they might operate independently from core bank activities. In the event of market shock and contagion events, these funds may create significant reverberations for the bank itself. For example, the collapse of scandal-plagued subsidiary H2O asset management in 2020 raised questions about the overall credit quality and integrity of parent company Natixis, which forced its hand in the disposal of the asset manager.  

Furthermore, most banks' NBFI exposures are conducted through collateralized facilities, or AIF subscription lines backed by the fund's own investor. Banks have generally managed the risk on NBFI loans well through conservative structuring, collateral requirements, and diversification. But the rapid growth and close connections between traditional lenders and nonbanks could add to systemic risk and future asset quality challenges. 

Will Edwards:  Private credit funds appear less exposed to these funding and liquidity risks given their closed-end nature, meaning that equity investments from investors are locked in for the life of the fund. We see potential innovations that could result in higher redemption risks. For example, private credit funds could further expand their usage of funding facilities such as net asset value (NAV) financing--meaning lending secured on the net asset value of the funds--to support their returns. This could expose them to a degree of asset liability mismatch over time. Other features such as evergreen, open-ended retail investor participation could also weaken the funding profile of the industry. 

Chart 2

How Does European Regulation Shape Risk Mitigation For The Bank-Nonbank Nexus?

Nicolas Charnay:  AIFs are subject to a dedicated directive, which is more a framework of consumer protection than prudential oversight and does not address issues such as liquidity risks. Prudential rules are focused on banks and insurance companies, so risk mitigation comes through managing the exposure of banks to nonbanks.  

An issue for financial stability is nonbanks typically cannot access emergency central bank funding in times of stress--with the only exception being the Bank of England (BoE), which has analyzed how the actions and expectations of firms across the bank and nonbank space can lead to amplification and propagation of stress throughout the financial system in a recent systemwide exploratory scenario. In January, the BoE announced the Contingent Non-Bank Financial Institution Repo Facility (CNFR) for selected nonbanks (such as insurers or pension funds) to secure relief against adequate collateral. Activated in a stress scenario, this facility would allow eligible nonbanks to monetize their assets, rather than sell them in the market to meet liquidity needs, in the event of a crisis. Such new tools could prove a precious mitigant against financial stability risks, assuming that nonbanks are operationally ready to draw on them.  

As the private capital sector grows, we can see regulators and central banks increase their scrutiny and potentially take action to mitigate potential financial stability. This could take the form of greater prudential regulation for most systemic nonbank players and an increased access to some form of central facilities. 

Writer: Michelle Ho