Federal Reserve Research: Banks Providing Credit to Private Credit Constitutes "Systemic Risk"

Invisible Bomb? The Deep Connections Between American Banks and Private Credit Institutions May Trigger the Next Round of Systemic Risk.

On May 21, the latest research report released by the Boston Federal Reserve shows that the private credit industry, led by institutions such as Blackstone, Apollo, and Ares, has established increasingly close ties with traditional banking, which may pose systemic risks to the U.S. financial system during an economic downturn.

Boston Federal Reserve economists José Fillat, Mattia Landoni, John Levin, and Christina Wang warned in the report: "The extensive connections between banks and the private credit market may be concerning, as these connections indirectly expose banks to high risks associated with private credit loans."

It is reported that the U.S. private credit market has experienced explosive growth in recent years, expanding from $46 billion in 2000 to approximately $1 trillion in 2023, with particularly rapid growth after 2019.

This phenomenon is essentially a result of regulatory arbitrage in the post-2008 financial crisis era. After banks were restricted from directly providing high-leverage loans, they turned to fund private credit funds engaged in such business, thereby circumventing the strict regulations imposed on traditional banking.

In addition, the head of the Kuwait Sovereign Wealth Fund recently warned that the private equity industry faces severe challenges. As previously mentioned by Wallstreetcn, in the post-pandemic era of slowing transactions and IPOs, private equity funds find themselves sitting on a large amount of assets but struggling to find exits. For the private equity model that relies on asset exits to realize returns, this poses a survival crisis.

Bank Funding Fuels the Expansion of the Private Credit Market

Rating agency Fitch reported earlier this week that as of the end of March this year, bank loans to non-bank financial institutions (including private equity firms and private credit funds) have surged to approximately $1.2 trillion, a 20% increase compared to the same period last year.

The Boston Federal Reserve's research report confirms an increasingly evident fact: Regulatory requirements and banks have jointly helped drive the booming development of the private credit industry after the 2008 financial crisis.

The report states that the regulatory requirements implemented at that time restricted banks from lending to highly leveraged companies or those with insufficient cash flow to repay debts. As a result, banks turned to provide funding to private credit funds that took on these loans, thereby fueling the explosive growth of the industry.

Analysis indicates that banks no longer directly bear the risks but instead indirectly participate in high-risk lending by providing funding to private credit funds, creating a state of regulatory arbitrage. This evolution shows that despite numerous financial reforms implemented after 2008, capital can still find ways to evade regulation

Simultaneous Withdrawals May Trigger Systemic Crisis

The Boston Federal Reserve pointed out in a report that one of the main risks faced by banks comes from the revolving credit lines they provide to private credit investment funds. These credit lines allow funds to withdraw hundreds of millions or even billions of dollars at any time to underwrite private loans for businesses. Economists at the Boston Federal Reserve warned in the report:

"To cope with adverse macroeconomic shocks, if enough private credit lenders withdraw bank credit lines, their reliance on bank liquidity may pose a systemic liquidity risk to the banking industry."

It is noteworthy that the Boston Federal Reserve acknowledged that the financing provided by banks to private credit funds is still considered safer than the leveraged buyout loans offered before the 2008 financial crisis. Currently, bank loans to funds are supported by dozens or hundreds of smaller loans, minimizing their risk to any single business.

Additionally, it is worth noting that the Boston Federal Reserve also pointed out that the credit lines provided by banks to private credit funds often fall under these funds' "most senior liabilities," meaning that banks would only incur losses under "severely adverse economic conditions, such as a deep and prolonged recession."

Kuwait Sovereign Wealth Fund Chief Sounds Alarm on Troubled Private Equity Industry

According to reports, at the Qatar Economic Forum held in Doha on May 21, Sheikh Saoud Salem Al-Sabah, head of the Kuwait Investment Authority (KIA), which manages $1 trillion in assets, pointed out that the private equity industry has struggled for years to return funds to investors. He warned:

"The private equity industry is very troubled, especially in large acquisitions, venture capital, and the rise of continuation vehicles, which is a very concerning signal."

Due to the persistent valuation gap between buyers and sellers, many private equity funds find it difficult to monetize assets through sales or IPOs.

The so-called continuation vehicles allow these companies, known as general partners (GPs), to retain their best-performing assets beyond the usual term. These vehicles enable acquisition funds to generate returns during periods when most investors (limited partners) are in urgent need of recovering funds, and this trend makes it difficult for the industry to raise new capital.

Furthermore, Wall Street Journal previously mentioned that according to Bain & Company data, by the end of 2024, the private equity industry holds approximately $3.6 trillion in unrealized value across 29,000 unsold portfolio companies. Last year, the proportion of funds allocated to investors relative to net asset value fell to a record low of 11%, while the long-term average is about 25%.

Egyptian businessman and billionaire investor Nassef Sawiris stated in an interview with the Financial Times on May 5, "The private equity industry has passed its golden age... they cannot exit. Exiting is too difficult."