Is Private Credit Inviting Financial Crisis in US?

The financial industry has gone through some revolutionary changes and diversification with hybrid and sophisticated products particularly in the USA during the last three decades.

This development has opened multiple avenues of business with potential growth. But, at the same time, it has placed the industry on a highly risky pivot.

Although there is stringent regulation, the diversification in multiple avenues exposes multilayer risks. The situation is such that if one avenue is tightened, the other avenue explodes.

What is likely to happen in the US financial sector, where banks were put under strict regulation after the subprime mortgage meltdown, but private credit is now about to explode?

Private-credit companies are non-depository financial institutions, which mobilise funds from the affluent segment of the society, equity companies and loans from commercial banks, and then lend to small, medium, start-up, software and technology companies. Private credit has now become the talk of America. 

As per media reports, many private credit companies have resorted to understating their exposure to software companies which are severely impacted following AI rollover.

They fear spreading high exposure in software may cause a contagion impact in the whole financial market.

Reportedly, four large private-credit companies, which include Apollo Global Management, Ares Management, Blackstone and Blue Owl Capital, have officially reported less exposure to software companies than their actual stake.

One local media analysis found that four large private credit companies have 25% exposure in the software sector, as opposed to their official reporting of 19% exposure in this sector, which is a clear instance of understating their risky exposure. 

As per reporting requirements, non-depository financing companies, which are involved in private lending to business firms and start-up companies operating in different sectors, are required to submit reports depicting sectorial exposure, e.g., software, healthcare, education, auto industry, technology, etc.

However, the methodologies applied by private-credit companies in categorising sectorial exposure vary from company to company.

Although some private-credit companies strictly follow the independently developed Global Industry Classification Standard, most follow different methods. So, the methodology followed by private credit companies to categorise their exposure is not uniform.

Funds lent to a software company can be categorised as a loan to another sector or vice versa. When the software sector was booming, the private credit was also enjoying tremendous growth, and understating or overstating the exposure was not a concern at all.

Since AI rollover in various sectors at a larger scale has been rapidly replacing the applications of most software companies, this sector has been exposed and is thus categorised as a high-risk portfolio. 

However, many private-credit companies have been denying this speculation and saying that they believe the fears about loans in software companies are overblown and that they are confident about the quality of their portfolios.

Although their source of funds lent to various sectors of the economy is not public, many of the impacts of their loan portfolios will not spare the deposit-taking commercial banks, which might have heavily lent to the private credit companies.

If private credit really explodes, there will be a contagion impact in the entire financial industry, of which commercial banks may be the worst hit.

Because of stringent regulation, monitoring from regulators and a strong capital base, banks are in a much better position and resilient to withstand the shock of a private credit explosion, yet many banks may have to sustain significant losses owing to this financial chaos.

As media reported, investors, analysts and experts are assessing the banks’ lending volume to the nonbank financial institutions, particularly private-credit companies, which have recently experienced substantial withdrawals.

Experts opine that loans disbursed to the software companies are at high risk of no recovery due to the massive disruption of this sector’s business due to the full-scale AI rollover.

The fear of banks’ suffering losses has already been reflected in stock market performance, as many banks’ stocks have underperformed in recent trading.

During the current year's trading, the KBW Nasdaq Bank Index is down by around 6%, whereas the S&P 500 has experienced around a 4.5% decline. 

After the financial crisis in 2008 caused by the meltdown of subprime mortgages, banks were put under stringent regulation.

Most banks changed their lending strategy, diverting their loan portfolios to the private-credit companies, non-depository financial institutions, mortgage lenders, consumer lenders and private equity funds, instead of directly lending to the end-user companies.

Through this lending manoeuvring, commercial banks were able to keep their credit business growing with a sharp rise in banks’ exposure to non-bank financial institutions.

The banking sector in the USA has reportedly raised its loan portfolio from $1.1 trillion three years ago to $1.9 trillion in non-bank financial institutions, which mostly include private credit companies.

Sensing the massively rising exposure in private-credit companies and consequences thereof, the US regulators have put close watch on banks’ portfolios, compelling them to disclose more details about their nonbank lending.

The way the situation is moving, if private credit collapse cannot be avoided, there is a possibility that another financial crisis after the subprime mortgage scandal is imminent in the USA.

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The writer is a certified anti-money laundering specialist and banker based 

in Toronto, Canada. He can be reached at