Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch

The private credit market, in which specialized non-bank financial
institutions such as investment funds lend to corporate borrowers, topped
$2.1 trillion globally last year in assets and committed capital. About
three-quarters of this was in the United States, where its market share is
nearing that of syndicated loans and high-yield bonds.

This 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.

Outpacing other asset classes

Private corporate credit has created significant economic benefits by
providing long-term financing to corporate borrowers. However, the migration
of this lending from regulated banks and more transparent public markets to
the more opaque world of private credit creates potential risks. Valuation
is infrequent, credit quality isn’t always clear or easy to assess, and it’s
hard to understand how systemic risks may be building given the less than
clear interconnections between private credit funds, private equity firms,
commercial banks, and investors.

Today, immediate financial stability risks from private credit appear to be
limited. However, given that this ecosystem is opaque and highly
interconnected, and if fast growth continues with limited oversight,
existing vulnerabilities could become a systemic risk for the broader
financial system.

We identify a number of fragilities in our April 2024 Global Financial Stability Report.

First, companies 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.

The rapid growth of private credit has recently spurred increased
competition from banks on large transactions. This in turn has put pressure
on private credit providers to deploy capital, leading to weaker
underwriting standards and looser loan covenants—some signs of which have
already been noted by supervisory authorities.

Second, private market loans rarely trade, and therefore can’t be valued
using market prices. Instead, they are often marked only quarterly using
risk models, and may suffer from stale and subjective valuations across
funds. Our analysis comparing private credit to leveraged loans (which trade
regularly in a more liquid and transparent market) shows that, despite
having lower credit quality, private credit assets tend to have smaller
markdowns during times of stress.

Mark to Market Versus Model

Third, while private credit fund leverage appears to be low, the potential
for multiple layers of hidden leverage within the private credit ecosystem
does raise concerns given the lack of data. Leverage is deployed also by
investors in these funds and by the borrowers themselves. This layering of
leverage makes it difficult to assess potential systemic vulnerabilities of
this market.

Fourth, there appears to be a significant degree of interconnectedness in
the private credit ecosystem. While banks do not seem to have a material
exposure to private credit in aggregate—the Federal Reserve has

estimated that US private credit borrowing amounted to less than about $200 billion,
less than 1 percent of US bank assets—some banks may have concentrated
exposures to the sector. In addition, a select group of pension funds and
insurers are diving deeper into private credit waters, significantly upping
their share of these less-liquid assets. This includes
private-equity-influenced life insurance companies, as we discussed in a

recent report.

Finally, though liquidity risks appear limited today, a growing retail
presence may alter this assessment. Private credit funds use long-term
capital lockups and impose constraints on investor redemptions to align the
investment horizon with the underlying illiquid assets. But new funds
targeted at individual investors may have higher redemption risks. Although
these risks are mitigated by liquidity management tools (such as gates and
fixed redemption periods), they have not been tested in a severe runoff
scenario.

Overall, although these vulnerabilities currently 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.

Policy implications

It is imperative to adopt a more vigilant regulatory and supervisory posture
to monitor and assess risks in this market.

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.
Authorities should enhance cooperation across industries and national
borders to address data gaps and make risk assessments more consistent
across financial sectors.
Regulators should improve reporting standards and data collection to
better monitor private credit’s growth and its implications for
financial stability.
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.