Private credit may lose some of its privacy

The European Union is pushing to bring more transparency to the booming private credit market as regulators worry its rapid growth could threaten the financial system.

The bloc agreed in February on new requirements for what investment funds have to disclose to regulators, and it recently proposed stress testing links between so-called shadow banks and the financial system. Banking regulators in the region, meanwhile, are leaning on traditional lenders to provide more information about where private credit shops get their own funding.

The efforts underscore the growing concerns among some authorities about the lightly regulated asset class, which flourished when stricter capital requirements forced banks to scale back riskier lending after the financial crisis. Recent high-profile failures such as the collapse of Rene Benko’s Signa group or the troubles of landlord Adler Group SA have highlighted how firms that loaded up on debt can spread losses in the financial system.

“The growth in private credit markets has us particularly concerned,” said Elizabeth McCaul, a member of the European Central Bank’s Supervisory Board, which oversees traditional banks. “The sector has grown so much that we should consider how to have some basic reporting made more readily available to supervisors.”

Private credit has remained largely outside the remit of financial regulators because the money used to extend loans typically comes from investors, not depositors. That means any losses only impact the returns for these investors. They don’t ripple through the financial system the way a run on a bank does if its balance sheet is in trouble.

But the growth of the asset class into a $1.7 trillion industry has fueled concerns that it may affect the financial system through other channels, for instance by allowing certain industries to take on unsustainable debt levels or by posing a risk to banks that lend to private credit firms. The International Monetary Fund dedicated a chapter of its April global financial stability report to “the rise and risks of private credit.”

While banks have been keen to get in on the action, some executives have also expressed reservations. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said last month that he expects problems to emerge and warned that “there could be hell to pay,” particularly as retail clients gain access to the asset class.

The EU in February agreed on a wider package of rules for asset managers that especially targeted direct lenders. As part of those rules, the bloc’s markets watchdog is currently in the process of drafting standards including for the disclosures on liquidity, leverage and holdings of funds including private credit shops. It will also lay out how national regulators can share data with other authorities. The granular data won’t be made public.

“Our aim is to reduce inconsistent and duplicative reporting requirements across different regimes, and to increase data sharing and reuse,” a spokesperson for the European Securities and Markets Authority said. The majority of private credit assets are managed in North America, meaning, a relatively small portion of the global market will be directly affected.

Critics say Europe’s plans for investment fund regulation will be costly and may overwhelm authorities with a flood of data, rather than showing them where risks lie. Lobbyists are pushing for Europe to align more closely with updated US standards known as Form PF, which they say offer regulators more information on leverage while stopping short of requiring funds to report all positions for all portfolios.

“Even the public markets are inefficient in sussing out risks that are there in plain sight,” says Jiří Król, deputy chief executive officer of the Alternative Investment Management Association, a London-based lobby group. “To think that a group of regulators is going to be able to do a better job than the entire market is not very realistic.”

While regulators in the US are relatively sanguine about risks stemming from the asset class, market participants have been looking for ways to trade private credit, a push that could enhance price discovery and transparency.

Authorities on both sides of the Atlantic have also indicated they plan to stress test links between non-banks and traditional lenders as they seek to get a grip on risks. Mairead McGuinness, the EU’s commissioner for financial services and markets, floated the idea last month, saying such tests would need to happen in a “system-wide manner” and involve “all relevant authorities from both bank and non-bank worlds.”

The Bank of England is already holding an exercise with more than 50 participants including banks, insurers, central counterparties, asset managers, hedge funds, and pension funds. Interim results are expected around the middle of the year and a report is due in late 2024.

Europe has set a 2026 target date to implement caps on leverage at private credit funds that cater to professional investors, while the disclosure requirements take effect a year later. But already, some banking regulators who spoke on condition of anonymity say they won’t go far enough. 

In a first step, the officials are pushing banks to come to grips with any risks they face from working with private credit. They’re also squeezing banks they oversee for information, for example on where the direct lenders source their equity, say the people familiar with the matter.

McCaul, who was Superintendent of Banks of the State of New York between 1997 and 2003, says her concerns about the non-banks are shaped in part by her experience dealing with the fallout from Long Term Capital Management, the highly-leveraged hedge fund that imploded in 1998. The Federal Reserve orchestrated a $3.6 billion bailout by banks and brokerages at the time to calm fears that the firm’s lenders and trading partners would be dragged down.

The starting point for understanding risks posed by private credit is for watchdogs to have data on exposures that banks and direct lenders have in common, McCaul said. She also cites a lack of information on the loans and the terms under which they are made as well as leverage in the system.

The stakes are high if there are ripple effects.

“We saw in the financial crisis that specific stability issues can arise for banks emanating from links to less-regulated sectors,” she said.