The International Monetary Fund (IMF) has warned of a “number of fragilities” in the global private credit market, even as the sector continues to soar in popularity.
In the IMF’s annual Global Financial Stability Report, published today, it stated that the $2.1 trillion (£1.7 trillion) market, which has been pursued for investors for its high returns and flexibility, may soon pose a “systemic risk” for the financial system.
“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,” explained the Washington-based institution.
Now, private credit has swelled to an unparalleled size, as retail investors have poured into the market and banks have been eager to capitalise off the high returns offered by the sector.
Around three quarters of the private credit market is in the United States, where its market share is coming close to that of high-yield bonds and syndicated loans.
This increased popularity has pushed increased competition from banks for large transactions, putting pressure on private credit recipients to deploy capital, which the IMF warned were “leading to weaker underwriting standards and looser loan covenants”.
These companies relying on private credit tend to be smaller and carry more debt, making them more vulnerable to rising interest 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 report warned.
Meanwhile, the pricing of private loans is a key risk in the IMF’s eyes, as since the loans rarely trade, they can’t be valued using market prices, and must instead use shaky risk models that probably aren’t accurate.
An analysis of private credit found that despite having lower credit quality, private credit assets tend to have smaller markdowns than normal leveraged loans during times of stress.
A downturn could also affect banks and pension funds could have concentrated exposures to private credit, which could be a problem due to the “significant degree of interconnectedness in the private credit ecosystem”, the IMF said.
“Severe data gaps make monitoring these vulnerabilities across financial markets and institutions more difficult and may delay proper risk assessment by policymakers and investors,” it added.
If the sector’s fast growth continues, and regulators don’t start taking a more active role in supervising it, it could soon become a “systemic risk for the broader financial system”, the IMF concluded.