December 4, 2024 - The Bank of England (BoE), the Federal Reserve (Fed) and the International Monetary Fund (IMF) recently published their semi-annual financial stability reports (FSR). As they are likely indicators of the areas on which regulators will focus their agendas in the near-term, we continue to monitor these reports for changes in the coverage of and tone about nonbanks and private corporate credit (PCC). Below, we provide key takeaways.
BoE: In its June 2024 FSR, the BoE discussed the link between banks, insurers, private credit funds and private equity (PE) firms. The November report considers the systemic risk posed by PE firms owning life insurers. This relationship implicates PCC as PE firms are increasingly allocating PCC loans made to their portfolio companies to their insurance subsidiaries directly or through capital-efficient structures. The report argues that this activity not only drives a shift toward riskier nonpublic credit but also introduces the type of risks that emerged in mortgage-backed securities in the global financial crisis.
Separately, the report looks at the resilience of market-based finance (i.e., capital markets activity), which captures nonbank financial intermediaries (NBFIs) including insurers, hedge funds and private finance firms. It notes that outstanding market-based debt accounts for about 56% of total U.K. corporate debt, with nonbank loans comprising 16% of the total. (The BOE defines nonbank corporate loans as lending by securities dealers and insurers, non-monetary financial institution syndicated loans, asset finance provided by the non-bank sector, and direct lending funds.) NBFI leverage remains a focal point in the assessment of market-based finance resilience. We note that the vulnerabilities highlighted in the report around leverage are exemplified in the context of hedge funds rather than private credit funds (and leverage is used differently across these funds); however, it is clear that leverage whether at the asset or fund level will continue to be a point of interest for the BoE.
As noted in the report, the Financial Stability Board (FSB) is developing recommendations to help regulators identify, monitor and mitigate the risks associated with NBFI leverage and will publish a consultation report – originated slated to be issued by year-end 2024 – in the coming months.
Additionally, the November FSR summarizes the findings from the BoE’s first-ever system-wide exploratory scenario (SWES) exercise, which tested the U.K. financial system’s resilience by evaluating 50 participants’ responses to a hypothetical stress scenario in which a rapid and significant shock to interest rates and credit spreads triggers substantial losses and margin calls. The BoE developed the exercise to better understand the risks to and from NBFIs and the behaviors of NBFIs and banks in stress. From the exercise, the U.K. authorities drew six financial stability conclusions, including that recent improvements in resilience of certain nonbank sectors could deteriorate over time, amplifying market shocks; repo resilience is critical for supporting core markets in stress (given banks are unlikely to meet additional repo financing demand from NBFIs); and the corporate bond market could quickly become illiquid in stress reducing its effectiveness as a source of financing.
Importantly, the exercise informs the U.K. authorities in their work to address vulnerabilities in market-based finance internationally through the efforts led by the FSB (including the forthcoming policy proposals on nonbank leverage referenced above).
Fed: As in its April FSR, the Fed highlights in the November report that roughly 60% of the total outstanding debt of U.S. nonfinancial firms backs privately held small and middle market firms, noting that vulnerabilities for these borrowers increased throughout 2Q24 (as reflected in higher leverage and lower interest coverage ratios). The Fed additionally points out that private credit has grown to account for 7% of total outstanding nonfinancial corporate debt.
Similarly focused on NBFI leverage, the Fed’s FSR indicates the rate of bank credit commitments to NBFIs dropped substantially in 2023 (after showing strong growth in 2021 and 2022) and the rate was similarly lower through 2Q24, with the growth driven by loans to structured finance. Notably, utilization of credit lines at business development companies and private credit funds shrank between 2Q23 and 2Q24. Also mentionable, the report affirms that banks continue to experience low delinquency rates on loans to NBFIs.
IMF: Unlike the April global FSR, in which it dedicates a full chapter to the risks of private credit, the IMF’s October report simply reiterates that private credit vulnerabilities are rising, including the increase in the use of leverage across NBFIs and the lack of data to address it. It also reasserts the IMF’s position that in light of the potential macro criticality and realization of private credit, authorities may consider adopting a more intrusive approach to supervision and regulation.
New in the October report is a call out box on synthetic risk transfers (SRTs). The fact that SRTs are spotlighted is particularly relevant, given the IMF attributes more than 60% of the SRT market to private credit funds. Related to this point, the report suggests that SRTs could increase financial stability risks through interconnectedness to banks stemming from the leverage provided to private credit funds that buy credit-linked notes issued by other banks.
