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Private credit is now so intertwined with big banks and insurers that it could become a “locus of contagion” in the next financial crisis, a group of economists, bankers and US officials has warned.
Researchers from Moody’s Analytics, the Securities and Exchange Commission and a former top adviser to the Treasury department found private credit funds have become enmeshed with the banking system, creating “new linkages [that] introduce new modes of systemic stress”.
“Their opaqueness and role in making the financial network more densely interconnected mean they could disproportionately amplify a future [financial] crisis,” the group said in a study published by Moody’s Analytics on Tuesday.
Private credit has boomed in recent years as regulations put in place following the 2008 financial crisis prompted banks to tighten their lending standards. Funds, which generally lend to riskier companies with significant debt loads, are subject to looser oversight than banks — something that has prompted concern as the sector has grown.
The report, written by Mark Zandi at Moody’s Analytics, Samim Ghamami of the SEC, and former Treasury adviser Antonio Weiss, is one of the most comprehensive analyses to date on how private credit would affect the broader financial system during a period of market upheaval.
The researchers relied on financial reporting and the stock prices of publicly listed middle-market corporate lenders, known as business development companies, as their proxy for the otherwise opaque private credit industry. They found that during recent moments of market stress, business development companies had become more tightly correlated with the turmoil in other sectors than they were previously.
“Today’s network of interconnections in the financial system is more distributed, with a denser web of connections than it had pre-crisis, when the system operated more like a ‘hub and spoke’ model with banks at the centre of the network,” the report said, noting that private credit firms, other speciality financial groups and insurers have taken a greater role in lending.
Private credit firms maintain they are better at lending than banks because they rely on capital from institutional investors with longer time horizons and not subject to “runs” such as bank deposits, which can lead to broader contagion in moments of panic.
“Banks are increasingly involved in private credit and other non-bank financial institutions through partnerships, fund financing and structured risk transfers that allow them to maintain economic exposure to credit markets while shifting assets off balance sheet,” the Moody’s Analytics study said.
The Boston Federal Reserve last month had similarly warned that banks were exposing themselves to new channels of risk by lending to private credit funds and other similar groups.
Fitch Ratings this week said that private credit’s “evolving products and asset classes requires close monitoring, with many untested through market cycles”.
The Moody’s Analytics report said the private credit sector should be required to share more public data on its lending, and for financial regulators to emphasise private credit in their overall “systemic risk monitoring”.
“The objective is not to stifle the beneficial innovation that private credit provides but to shine a light on its risks and linkages so that a rapidly growing part of corporate finance, and potentially other sectors, does not become a blind spot.”
