Concerns are growing that the rapidly expanding private credit sector, now estimated at around $3 trillion, poses a potential systemic risk, echoing the shadow banking fears experienced before the Global Financial Crisis. Goldman Sachs CEO David Solomon's warning that "the credit cycle has not been repealed" highlights these anxieties. This sector, providing direct credit to non-financial corporations, has grown outside traditional banking and public markets.
The systemic risk of private credit is typically analyzed through three channels. The first is direct bank exposure, as banks provide increasing leverage to private credit funds, not primarily through direct loans but via liquidity provisions like credit lines and repo agreements. While current leverage is relatively low, making direct bank losses from private credit contained, the financial interconnectedness and potential for future leverage growth are concerning. Risks are not equally distributed among institutions, as demonstrated by the $5 billion-plus losses from the Archegos collapse for Credit Suisse, indicating that a single counterparty can cause significant damage even within a healthy industry.
The second channel involves banks' exposure to institutional investors like insurance companies and pension funds, which invest in private credit funds. If these investors face widespread losses in their private credit portfolios, they might seek liquidity support from banks. The third, more oblique channel, involves institutional investors reacting to negative shocks by selling other securities, such as gilts or Treasuries, to raise capital. If multiple institutions do this simultaneously, it could trigger significant market instability, similar to the UK's mini-budget crisis in 2022. The lack of transparency in private credit, in contrast to regulated public markets and banks, allows risks to accumulate away from supervisory oversight, making it difficult to assess the full impact of a potential squeeze.
While the current situation is not identical to early 2007, certain parallels in the trajectory are legitimizing concerns. Key institutional features of private credit, such as long investor commitment periods, minimal maturity transformation, and a focus on low-credit-quality borrowers struggling to get bank loans, are eroding. Private credit funds are increasingly seeking retail investment, introducing periodic redemptions, and turning to banks for funding to increase leverage. These developments, coupled with competitive pressures leading to deteriorating lending standards and a "race to the bottom" in due diligence, are narrowing the distance between current private credit structures and those that contributed to the GFC. Better disclosure of how private credit exposures are distributed across banks and investors is crucial to limit systemic risk.
