Private credit is a known unknown financial risk

As financial conditions continue to tighten and the threat of a recession looms, it’s unknown how well the private credit sector will perform, according to a new report from Moody’s Investors Service.

The rating agency said financial stability risks have risen recently due to increased stress on the banking sector amid higher interest rates. That’s raised the question of whether other parts of the financial sector may face stresses that spread or amplify the risks to financial stability.

In particular, Moody’s said the private credit sector — where asset managers lend directly to businesses — could be a source of stability risks.

While this segment has so far held up in the face of higher interest rates and tougher economic conditions, its resilience “will be tested further in 2023 as already tight financial conditions tighten further, alongside the rising risks of spillovers from banking stress and an anticipated economic downturn,” it said.

The report noted that private credit has grown significantly in the past few years. Coupled with less transparency and laxer regulation than in the traditional banking sector, Moody’s said, the sector “could harbor risks that are not currently visible.”

For instance, declining asset quality in the private credit market could spill over to other parts of the financial sector by generating losses that cause investors to liquidate assets, driving down the value of those assets.

Similarly, liquidity risks in the private credit segment could spill over to other markets, the report said.

“For instance, if [private credit] funds are subject to maximum leverage limits, lending losses resulting from an economic downturn could force a sale of assets when those limits are hit,” it said.

However, the lack of data on the private credit market — including an absence of insight into loan concentrations, credit quality and default trends — “means that we cannot meaningfully assess the scale of this risk,” it said.

There’s also limited data on the risk of liquidity-driven fire sales, it noted.

“Absence of data on the size and profile of the private sector limit our ability to anticipate the extent of the spillover risks from private credit in such a scenario,” it said.

“Those risks clearly exist, and we understand some of the channels by which they might crystallize. But much would depend on the behaviour of entities exposed to private credit and on the emergence of wider links across the financial sector that are not evident today,” it added.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.