Risks in the private credit market?

Almost 20 years have passed since the last financial crisis. Historical analysis indicates that another financial situation may be around the corner, and that several factors may accelerate an economic and financial meltdown.

No one really knows what will cause the next financial crisis. Some market analysts fret about the rapid growth of private credit, which boomed following the 2008 financial crisis. That’s when regulators cracked down on traditional banks and forced them to hold more capital – a financial cushion against riskier loans.

Private credit firms bene­fitted from ultra-low interest rates over the last two decades, which made it easy to borrow vast sums from traditional banks, which could then further fund their ventures.

However, many insurance companies, pension and investment funds have their own private credit operations.

The so-called private credit markets refer to financing provided to large businesses outside regular bank lending and the issuance of publicly traded shares and bonds. It is part of the shadow banking sector, which is too often unregulated. From a niche industry that emerged in the 1980s, offering private loans to businesses, it has now grown to the point that it worries central bankers and even the International Monetary Fund.

Global watchdogs are unlikely to succeed in bringing oversight and regulation to this market

Unlike banks, which back loans with customer deposits, private credit firms’ loans are supported by funds raised from private investors, including pension funds, insurers and high-net-worth individuals. 

While small retail investors are not directly at risk from a possible burst of the private equity bubble, the fact that private equity markets have become increasingly intertwined with the traditional banking industry, with lenders in Europe significantly exposed to private credit firms, is worrying.

Bank of England governor Andrew Bailey says ‘alarm bells’ are ringing over risky lending in the unregulated private credit market after the failure of US car parts maker First Brands and subprime auto lender Tricolour.

Speaking to peers on the House of Lords Economic Affairs Committee, Bailey drew parallels with the run-up to the 2008 financial crisis. He argues: “We certainly are beginning to see what used to be called slicing and dicing and tranching of loan structures going on, and if you were involved before the financial crisis, then alarm bells start going off at that point.”

The private credit market’s success hinges on “regulatory arbitrage,” meaning it gains a competitive edge and poaches business from weaker regulation.

Kalyeena Makortoff is a banking correspondent of The Guardian. She recently argued: “Unlike banks, private credit firms do not have to build up capital that can absorb losses when loans sour, or even disclose the risk on their books. They have less scrutiny and expense as a result, meaning they can issue loans faster and to a wider range of businesses, with the potential to reap greater financial rewards than heavily regulated banks.”

Advocates of the private credit industry argue that both borrowers and investors benefit from this market’s lack of proper regulation. Pension funds and insurance companies can diversify their assets, especially as interest rates remain low and traditional financial products offer poor returns. They praise the speed with which private credit facilities are approved, in contrast to the lengthy processes of conventional banks.

So, is tighter regulation of private credit the answer to this risky scenario? Global watchdogs are unlikely to succeed in bringing oversight and regulation to this market, as US President Donald Trump is actively trying to scrap financial regulation to provide businesses with the credit they want.

Some analysts even believe that we are more likely to see regulations on traditional banks being made less onerous so that they can compete more effectively with their unregulated rivals.

Sarah Breeden, the deputy governor of the Bank of England, highlights the private credit market “interconnections” with mainstream banks and identifies the reasons for sounding the alarm bells on private credit. She argues: “We can see the vulnerabilities here, the opacity, the leverage, the weak underwriting standards.”

Experience teaches us that when a financial crisis erupts, it is usually ordinary taxpayers who foot the bill. The bulk of private credit funding comes from institutional investors such as insurers, asset managers and pension funds, who are looking to invest billions of dollars and euros in retirement cash, which can be locked in for extended periods.

Is this one reason why so many ordinary people still shy away from investing in private pension products or collective investment schemes?