The Systemic Risk Lurks in Private Credit (Shadow Banks)
What credit markets are telling us that equity markets are not?
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The signs of economic distress are often first visible in the credit markets, such as difficulties with loans and financial defaults. In contrast, the equity market lags in reflecting these issues.
Financial crises come out of periods of overheated credit markets. We try to track crises using a measure of overheating that we developed and call the “Red-zone.” The Red-zone is a combination of credit expansion and high asset prices. -Robin Greenwood.1
Credit Markets and the 'Red Zone'
In the context of credit markets, the "red zone" refers to a combination of credit expansion and high asset prices, which, when present, can be a strong indicator of potential financial crises. This zone signifies an overheating of credit markets, suggesting a high risk of future defaults and market instability.
Frothy stock markets occur when investors become overly excited about companies (such as SPACs and AI-driven tech valuations) and are overly focused on the potential upside. Frothy credit markets are when people stop worrying about the downside (think of ‘extend and pretend’ in CREs*, auto loan, BNPL, etc).
Credit Expansion and the Shadow Banks
Since 2008, there has been a period of rapid credit expansion2 in some areas, including private credit - a credit extended by non-bank lenders. This expansion has been driven by factors such as low interest rates and a desire for higher returns, resulting in a substantial increase in the size of the private credit market.
We have written several research papers on Shadow Bankers.3
The Devil Is in the Private Credit
After 2008, the traditional bankers retreated from servicing riskier loans to consumers. So, the traditional banks began to have an indirect relationship with the Shadow Bankers - who are not under the purview of the regulators. Again, we have discussed this in detail - check the footnotes.
The global private credit market was valued at approximately USD 2 trillion as of 2024.1 The US private credit market is estimated to be worth around $1.6 trillion. This market has seen significant growth in recent years, with some sources indicating a potential doubling to $3.5 trillion by the end of 2028. This growth is driven by increased demand from borrowers and a shift away from traditional bank lending.
Why Borrowers Use Private Credit Instead of Banks?
Borrowers seeking funding through private credit may not have easy access to traditional bank lending or the ability to sell corporate bonds. Borrowers that don’t have an extensive credit history or have limited access to bank financing and debt markets, such as startups and small to medium-sized enterprises, can turn to private credit for funding.
The problem here is the ease of access to a highly unregulated and unaccountable predatory credit market.
Risks of Private Credit Investing
Credit Risk. Like many traditional fixed income investments, private credit investments are subject to default risk should a borrower fail to meet the terms of their loans.
Market and Cyclical Risk. Some borrowers may be more negatively impacted by economic cycles which may impact their ability to meet the terms of their loans.
Less Transparent Than Public Markets. Proper due diligence into loans and investments is needed when lending via private credit, which is often lending to non-public companies.
Private Credit Is Often Illiquid. While investors earn an illiquidity premium, the trade-off is illiquidity risk and investors may not be able to sell their investments easily.
Interest Income May Fall If Rates Fall. Given private credit instruments may be issued with a floating rate coupon structure, in periods of consistently falling rates, the income streams from the instrument may decline as the coupon is reset to the prevailing market rate or a pre-set floor within the terms of the loan structure.
Risk of Regulatory Changes and Added Oversight on Private Credit Deals. While the individual private credit loans face less regulatory oversight than traditional loans given they do not need to comply with traditional regulatory requirements, there still remains potential regulatory scrutiny towards the industry. Changes in lending regulations and/or policies could negatively affect private credit’s growth and origination deal flow.
The Systemic Risk
Private credit has delivered high returns with relatively low volatility.
However, the ease of availability in the private credit market has held consumers - think of personal loans, car loans, student loans, etc.. and corporations hostage.