Private Credit Boom Raises Systemic Risk Concerns

The private credit market has grown from a niche corner of finance into a $2 trillion behemoth in barely a decade, and the speed of its ascent is beginning to alarm the very regulators whose tightening of traditional banking made the boom possible in the first place.

Private credit — lending by non-bank institutions such as private equity firms, specialist credit funds, and insurance-company affiliates — has surged as conventional banks, constrained by post-2008 capital rules, have pulled back from riskier corporate lending. The borrowers left behind have not disappeared; they have simply moved to lenders who operate with less oversight, less disclosure, and, critics say, less margin for error.

The opacity of these markets is the central concern. Unlike bank loans, which are subject to regular examination and public disclosure, private credit deals are negotiated bilaterally, valued by the lenders themselves, and reported to regulators only in fragments. "We are flying blind," said Genevieve Tran, a senior fellow at the Kensington Institute for Financial Stability. "We know the market is enormous. We do not know, with any confidence, where the risks are concentrated, how much leverage is embedded, or what happens when the cycle turns."

The types of borrowers flocking to private credit tell their own story. They are overwhelmingly mid-market companies — firms too large for a local bank loan and too small or too leveraged to tap public debt markets. Many are private-equity-owned businesses already carrying substantial debt from the leveraged buyouts that created them. Adding another layer of private credit on top of that existing leverage has, in some cases, produced capital structures that assume everything goes right. "These deals are underwritten for the sunny day," said Rohan Mehta, a restructuring partner at the law firm Ashworth Cole. "Nobody is stress-testing them for a prolonged downturn, because in a prolonged downturn half of them do not work."

Proponents of the industry push back forcefully. They argue that private credit provides a vital source of financing for the real economy, that the lenders are sophisticated institutions with long-term capital, and that the diversification away from bank balance sheets actually makes the financial system safer, not riskier. "The whole point of post-crisis reform was to move risk out of the banking system," said Claudia Reinhart, managing partner at Greystone Capital Partners, one of the largest private credit managers. "That is exactly what has happened. It is strange to celebrate the policy and then complain about its consequences."

There is something to that argument. Private credit funds typically lock up investor capital for years, meaning they are less vulnerable to the kind of sudden withdrawals that can bring down a bank. Their investors — pension funds, sovereign wealth funds, endowments — are, in theory, well positioned to absorb losses. And the direct, relationship-based nature of private lending can allow for more flexible workouts when borrowers get into trouble, avoiding the messy, multi-party negotiations that characterise defaults in public markets.

But the theory assumes that the investors who have poured money into private credit fully understand what they own — and that assumption is increasingly strained. Valuation practices in private credit are notoriously generous; because there is no public market to provide a price, lenders mark their own books, and the incentive to be optimistic is obvious. A Ledger analysis of quarterly reports from fifteen large private credit funds found that fewer than 3% of loans were marked below par, even as default rates in comparable public markets have risen sharply. "The marks are fiction," said one pension fund consultant, who spoke on condition of anonymity. "Not necessarily deliberate fiction, but fiction nonetheless. Nobody wants to write down a loan they originated and still service."

Regulators are beginning to stir. The Financial Stability Oversight Council flagged private credit as a potential systemic risk in its most recent annual report, and supervisors in both Europe and Asia have launched reviews of the sector's interconnections with the regulated banking system — connections that are more extensive than the industry's rhetoric of separation would suggest. Many private credit funds borrow from banks to lever up their lending, and many banks hold stakes in the funds themselves. "The wall between bank and non-bank is thinner than people think," Tran said. "In a stress event, the losses will not stay neatly on one side."

The debate, ultimately, is one the financial system has had before: whether the migration of risk from regulated to unregulated institutions represents genuine diversification or merely the relocation of danger to a place where it is harder to see. The optimists may be right that private credit is a healthier, more resilient way to finance the economy. But the history of finance is littered with innovations that looked like diversification on the way up and concentration on the way down. The next downturn will provide the answer. By then, of course, it will be too late to change the question.