Banking Crisis

Booming Private Credit Poses Risks, Not Yet Systemic – IMF

Tom Burroughes Group Editor London 10 April 2024

Booming Private Credit Poses Risks, Not Yet Systemic – IMF

As regularly noted by this news service, private credit is an asset class that increasingly features in wealth management conversations. Hundreds of billions of dollars have flowed into the space over the past 15 years. International regulators are starting to be concerned.

The International Monetary Fund has fired a warning shot about the size and potential vulnerabilities of the private credit market – a sector that has ballooned in recent years. The sector is forecast to reach $2.8 trillion at the end of 2028.

More than a decade of ultra-low interest rates (until recently), tighter capital regulations on banks after the 2008 financial crash, and structural changes to finance, have sent capital flooding into private credit. Sometimes the sector is dubbed “shadow banking” – although there is nothing particularly obscure about it. 

And, as this news service reports, private credit remains a popular area for family offices and advisors to high net worth and ultra-HNW clients (see examples here and here).

The Washington DC-headquartered IMF set out its stance in its April Global Financial Stability Report.

Regulators fear that while the traditional banking sector has been reined in by laws such as the Dodd-Frank legislation (2010), and tighter Basel capital rules, a flow of capital into private routes potentially undermines the point of these regulations.

The IMF has proposed a variety of measures to contain risks. 

“Authorities should consider a more active supervisory and regulatory approach to private credit, focusing on monitoring and risk management, leverage, interconnectedness, and concentration of exposures,” the IMF said in a paper yesterday.

“Regulators should improve reporting standards and data collection to better monitor private credit's growth and its implications for financial stability,” it continued. “Securities regulators should pay close attention to liquidity and conduct risk in private credit funds, especially retail, that may face higher redemption risks. Regulators should implement recommendations on product design and liquidity management from the Financial Stability Board and the International Organization of Securities Commissions.”

The IMF noted that the market emerged about three decades ago as a financing source for companies “too large or risky for commercial banks and too small to raise debt in public markets.”

“In the past few years, it has grown rapidly as features such as, speed, flexibility, and attentiveness have proved valuable to borrowers. Institutional investors such as pension funds and insurance companies have eagerly invested in funds that, though illiquid, offered higher returns and less volatility,” it said. 

Explaining causes of possible trouble, the IMF said firms that tap the private credit market tend to be smaller and carry more debt than their counterparts with leveraged loans or public bonds. “This makes them more vulnerable to rising rates and economic downturns. With the recent rise in benchmark interest rates, our analysis indicates that more than one-third of borrowers now have interest costs exceeding their current earnings,” it said. The growth of private credit has encouraged more competition from banks on large transactions, putting pressure on private credit providers to deploy capital, leading to weaker underwriting standards and looser loan covenants.

The IMF said it has already identified signs of such practices in the system.

While not directly about private credit, the demise last March of Silicon Valley Bank, Signature Bank and First Republic, along with that of Credit Suisse, reminded financial markets of fault lines that remain. The rise in interest rates since the pandemic has shone a bright light on some of the financing deals struck in the past decade.

Recent returns data on private credit has been strong, encouraging inflows to the sector.

Source: IMF

Politicians are also concerned. 

In November last year, the US Senate Committee on Banking, Housing and Urban Affairs also raised red flags about the market. On 29 November, US Senators Sherrod Brown (Democrat-Ohio), chairman of the committee, and Jack Reed (Democrat, Rhode Island), a senior committee member, urged regulators to assess the “potential risks posed by the growing private credit market,” according to a statement on the committee’s website.

“It is imperative that bank regulators thoroughly assess all types of risks to our financial system, including risks posed by the private credit industry. In light of these concerns, we urge you to use the full extent of your regulatory authority to assess the potential risks that private credit may pose to the safety and soundness of our banking system,” the senators wrote.

Private credit is big business. According to EY, in a January 2024 reported entitled Private Debt – An Expected But Uncertain “Golden Moment”?, the private credit space has surged from $280 million of assets under management to $1.5 trillion in 2022 (it cited figures from Pitchbook). Private credit makes up about 12 per cent of the global alternatives market. According to a report issued in 2021, US banks and securities firms were responsible for more than 70 per cent of the loan issuance on the primary market for corporate loans in 1994, compared with 10 per cent in 2020. As EY went on to note, research firm Preqin forecasts that private credit will nearly double in size reaching $2.8 trillion by the end of 2028. 

In its report, the IMF added: “Overall, although these vulnerabilities currently they do not pose a systemic risk to the broader financial sector, they may continue to build, with implications for the economy. In a severe downturn, credit quality could deteriorate sharply, spurring defaults and significant losses. Opacity could make these losses hard to assess. Banks could curb lending to private credit funds, retail funds could face large redemptions, and private credit funds and their institutional investors could experience liquidity strains. Significant interconnectedness could affect public markets, as insurance companies and pension funds may be forced to sell more liquid assets.

“The cumulative effect of these links may have significant economic implications should stress in private credit markets result in a pullback from lending to companies. Severe data gaps make monitoring these vulnerabilities across financial markets and institutions more difficult and may delay proper risk assessment by policymakers and investors,” it said.

Bank of England and others

In late January, the Bank of England spoke about the role of private credit and its own task in ensuring financial stability. A senior official said: "The increasing role played by non-bank finance in the provision of credit is a feature of the financial system, not a bug, and a welcome feature if undertaken on a sustainable basis."  Last July, the European Union's member states, and the EU Parliament, agreed draft rules to curb leverage in the private debt space. 

The market is global. In Asia, to give one example, the private credit market has grown by almost 30 times in the last two decades, from $3.2 billion in 2000, to over $90 billion in June 2022 (source: Monetary Authority of Singapore, 29 March 2023. 

(Editor’s note: The wealth sector has been bombarded with arguments about the merits of private credit, and private market assets more generally. A few days ago, we carried this interview with Hightower, for example, in which the merits of such assets were described. Clearly, given the need for advisors to serve clients’ best interests, there cannot be any naïve thinking about this topicand the sector cannot ignore potential issues over the fees that firms can earn by pitching private market investments to clients. For anyone who wants to comment about this, email tom.burroughes@wealthbriefing.com.)

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