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Private credit is currently intertwined with major banks and insurance companies, and a group of economists, bankers and US authorities have warned that it could become a “contagious presence” in the next financial crisis.
Researchers, former top advisors for Moody, Securities and Exchange Commission and the Treasury, discovered that private credit funds were caught in the banking system and “new linkages (that) new linkages introduce new modes of whole-body stress.”
“Their opacity and role in connecting financial networks more closely means they can disproportionately amplify future (financial) crises,” the group said in a study published by Moody’s analysis on Tuesday.
Private credit has been booming in recent years as restrictions were introduced following the 2008 financial crisis, leading banks to strengthen their lending standards. Generally, funds that are useful for businesses with high risk of debt burdens are subject to more lean monitoring than banks. This sparked concern as the sector grew.
The report written by Mark Zandy in Moody’s analysis, SEC’s Samim Gamami and former financial advisor Antonio Weiss are one of the most comprehensive analyses to date about how private credit will affect the broader financial system during a period of rapid market fluctuations.
Researchers relied on financial reports and the stock prices of publicly available middle market corporate lenders known as business development companies. They found that in recent moments of market stress, business development companies were more closely correlated with disruptions in other sectors than before.
“Today’s networks of interconnectedness in financial systems have a web of connections that are more dense than when the system acts like a “like a hub” model with banks at the heart of the network,” the report says.
Private credit companies claim that lending is better than banks. This is because it relies on capital from institutional investors with a long view of time, and is not subject to “operation” such as bank deposits, but can lead to widespread contagion at moments of panic.
“Banks are increasingly involved in individual credit and other non-banking financial institutions to allow them to shift away from the balance sheet while maintaining their partnership, fund finance and economic exposure to credit markets,” Moody’s analytical research states.
Like last month, the Boston Federal Reserve warned that banks were exposing themselves to new channels of risk by lending to private credit funds and other similar groups.
Fitch’s ratings said this week that “evolving products and asset classes require close surveillance and have not been much tested throughout the market cycle.”
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Moody’s analysis report said the private credit sector should share more public data on lending, and financial regulators should emphasize private credit in the overall “systematic risk monitoring.”
“The goal is not to curb the beneficial innovations private credit offers, but to shed light on its risks and connections, ensuring that the rapidly growing portion of the corporate finances and potentially other sectors are not blind spots.”
