April 17, 2024 - This month, the International Monetary Fund (IMF) published its Global Financial Stability Report (GSFR). The report focuses on financial vulnerabilities and risks to financial stability. In the near term, the report found that “near-term financial stability risks have receded since the last GFSR” and despite the reported challenges in assessing the overall financial stability risks of private corporate credit – an area of specific focus in the GFSR – given the unavailability of data, financial stability risks in private corporate credit appear contained. The chapter of the report dedicated to private corporate credit (The Rise and Risks of Private Credit) readily acknowledges that private corporate credit has provided significant economic benefits during its 30-year existence by providing long-term financing to corporate borrowers.

Drilling into private corporate credit, the GFSR thoroughly outlines the risks and risk mitigants in this area (spoiler alert: private corporate credit is not a riskless investment, but historical losses have not exceeded similar markets) before highlighting what the authors believe could give rise to potential systemic risks. Notwithstanding the GFSR’s findings that private corporate credit does not pose systemic risks, the GFSR’s policy recommendations nevertheless “encourage [inter alia] authorities to consider a more intrusive supervisory and regulatory approach to private credit funds, their institutional investors, and leverage providers.”  The GSFR does not address in any detail what such an approach would look like.

In this piece we identify some key takeaways from the GSFR regarding 1) concerns over potential transmissible risks posed by private corporate credit; 2) the dynamic focus of the global official sector with respect to financial stability; and 3) the growing importance of data availability in private corporate credit.

Scope:  The relevant chapter in the GSFR focuses on performing private corporate credit which the report defines as “traditionally focused on providing loans to midsize firms outside the realms of either commercial banks or public debt markets.”

Line of Inquiry: What are the risks from borrowers, liquidity mismatches, leverage, asset valuations and interconnectedness in private corporate credit that threaten financial stability?

Conclusions: At present, financial stability risks appear contained. Private credit loans are funded largely with long-term capital, mitigating maturity transformation risks. The use of leverage appears modest, as do liquidity risks and interconnectedness. The GSFR does flag “meaningful vulnerabilities” including opacity to “stakeholders,” rapid growth and limited prudential (not regulatory) oversight.

• Opacity: Private corporate credit consists of loans to private companies. This characteristic necessarily means there will be less publicly available information than other markets. It does not mean that the market is opaque to its investors. Indeed, investors specifically negotiate for information rights tailored to their needs. There are also meaningful segments of the private corporate credit market, such as BDCs, that meet robust statutory reporting requirements quarterly.
• Growth: The exponential growth of private corporate credit is proving uncomfortable. Tied to concerns with opacity, the upward trajectory appears to largely fuel concern over the asset class. However, the size of the market by any measure does not come near that which would pose financial stability risks. While there may  in theory be an AUM number large enough to pose these risks, private credit’s limited leverage levels, exposure to banks and other interconnectedness temper concerns over market size.
• Limited Prudential Oversight: The private corporate credit market is highly regulated, however, not by the banking agencies. Prudential regulation in its current form has been tailored to the risks of the banking sector. Focusing on capital and liquidity requirements, prudential oversight is designed to reduce the risks of maturity transformation. The GFSR readily acknowledges that maturity transformation is not present in private corporate credit, and 81% of the funds involved are closed-end funds with a capital call structure and limited life cycle. Prudential oversight as currently understood seems ill-suited for this market.

Lingering Question: There has been a constant drumbeat of global official sector inquiry into private credit and nonbank financial intermediaries. (Click here for more.) What has been less constant is what exactly these bodies are looking to protect against. Is it systemic risk, often understood as risks to the banking system? Is it financial stability risk (per one of its many definitions)? Or, as raised now in the GFSR, is it a question of “macro-criticality,” i.e., the ability to amplify negative shocks to the economy?

Final Takeaway: The GSFR is the latest report to highlight the link between official sector concerns about the market to simply a lack of available data. The perceived opacity of private corporate credit is itself a concern. The GSFR recommends that authorities close data gaps and enhance reporting requirements for private credit funds and their investors and leverage providers. Whether those recommendations ever translate into new rules for market participants is unclear; however, it does stand to reason that more visibility for official sector bodies may lay their fears to rest.