December 10, 2024 - The Financial Stability Oversight Council (FSOC) addressed its financial stability concerns for private credit in its 2024 annual report published late last week. The report incorporates a call out box entitled “Private Credit: Financial Stability Considerations” to discuss perceived risks related to opacity, liquidity, and interconnectedness with banks and insurers, echoing several of the same points made previously. While pointed, the discussion is not as alarmist as discussions on private credit in recent reports from some of the European-based regulators.
Even as data availability remains a priority, it appears that FSOC is recognizing the modest leverage and low redemption risk that exists in private credit, which it continues to define as “direct lending by nonbank financial institutions to businesses.” The LSTA uses similar language to describe “private corporate credit” (PCC).
Still, in the report, FSOC singles out a few areas of interest that it hasn’t previously taken under its purview. We walk through them and FSOC’s respective recommendations below.
Interconnectedness of insurers: The attention to the relationship between insurers, PE and PCC is not new but is increasingly in regulators’ sights. As we’ve noted, a discussion about these dynamics was also featured in the Bank of England’s November Financial Stability Report.
Interestingly, the FSOC report suggests that the life insurance sector has been increasing its use of nontraditional liabilities, like greater borrowing from capital markets and from FHLBanks. FSOC argues that the sector has become more interconnected, internally and with the rest of the financial system. It points out that PE-backed insurers have acquired blocks of life insurance and annuity businesses through their offshore reinsurers, a practice that limits the ability of regulators to provide oversight and address evolving risks at the firm or holdco level.
FSOC recommends that the Federal Insurance Office (FIO), the National Association of Insurance Commissioners (NAIC), and state insurance authorities further evaluate the potential impact of the structural changes within the insurance industry on systemic risk. It encourages state insurance authorities and the NAIC to work toward greater disclosure of private market investments and offshore reinsurance in financial reporting, and to consider whether enhancements to ratings assessment of/risk-based capital charges for these assets should be required.
Significant risk transfers (SRTs): We have seenglobal regulators give more airtime to SRTs of late as SRT activity has picked up. SRTs were also highlighted for the first time in the IMF Global Financial Stability Report in October. FSOC says the role and structure of these risk transfers are evolving although some contractual features may mitigate risk (e.g., they may be collateralized or prefunded), and that it would be appropriate for regulators to continue to monitor the market as it develops.
Revolver commitments: The report raises the concern that portfolio companies seeking liquidity to service their debt may draw the undrawn portion of their revolving credit facilities provided by direct lenders, which would then potentially draw on their own revolving facilities from banks. This liquidity concern has been articulated before in the context of the interconnection between PCC and banks and resulting contagion. FSOC does not offer a recommendation on this point and does acknowledge that banks take a conservative risk management approach to lending to funds.
FSOC says that it continues to support enhanced data collection on private credit to provide additional insight into the potential risks associated with the rise in private credit, including potential improvements in the reporting by banks and insurance companies on their exposures to private credit and improved reporting on Form PF. We will continue to provide updates on existing and new proposals related to these types of disclosures.
