The private credit market “warrants closer watch” amid rapid growth of what the International Monetary Fund said was an “opaque and highly interconnected segment of the financial system.”
The fast-growth asset class could “heighten financial vulnerabilities given its limited oversight,” according to a blog post published on April 8 and co-authored by Charles Cohen, an adviser in the IMF’s monetary and capital markets department; Caio Ferreira and Nobuyasu Sugimoto, deputy division chiefs in the financial supervision and regulation division of the monetary and capital markets department; and Fabio M. Natalucci, a deputy director in the monetary and capital markets department.
About three-quarters of the more than $2.1 trillion in assets is in the U.S., representing a market share that is nearing that of syndicated loans and high-yield bonds. The fast-growing market has seen institutional investors “eagerly” investing in strategies that, although illiquid, offer high returns and less volatility, the blog said.
While there are significant economic benefits associated with providing long-term financing to corporate borrowers, the migration of lending from regulated banks and public markets, to more opaque 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,” the IMF said.
The blog said immediate risks from private credit “appear to be limited,” but warned that “if fast growth continues with limited oversight, existing vulnerabilities could become a systemic risk for the broader financial system.”
The IMF identifies a number of fragilities in the second chapter of its April 2024 Global Financial Stability Report. The blog, however, outlined the fragilities as including that companies that tap the private credit market tend to be smaller and hold more debt than those using 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 blog said.
The IMF also identified increased competition from banks on large transactions, which in turn has pressured private credit providers to deploy capital. That has led to “weaker underwriting standards and looser loan covenants,” the blog added.
Further, the lack of trading in private market loans means valuations using market prices are not possible, with assets often marked quarterly using risk models instead meaning they “may suffer from stale and subjective valuations across funds.”
Other concerns highlighted in the blog include the “potential for multiple layers of hidden leverage within the private credit ecosystem,” which raises concerns given the lack of data; and that there seems to be a “significant degree of interconnectedness in the private credit ecosystem.”
With these concerns in mind, the IMF said it is “imperative to adopt a more vigilant regulatory and supervisory posture to monitor and assess risks in this market,” encouraging authorities to consider a more active supervisory and regulatory approach.
