BREAKINGVIEWS-Private credit stress test is coming of age ritual

By Neil Unmack

LONDON, Oct 21 (Reuters Breakingviews) - The private debt world is learning that size brings scrutiny. The Bank of England is preparing the ground for a stress test of the $3 trillion market for bilateral loans, Bloomberg reported on Tuesday. The sector merits watchdogs' attention, thanks to recent blowups and links to banks and retail investors. UK Finance Minister Rachel Reeves’ desire to boost risk-taking is another reason for regulatory caution.

The idea of stress tests on private credit sounds odd to the market's proponents. The sector - dominated by players like Blackstone BX.N, Apollo Global Management APO.N, KKR KKR.N and Ares Management ARES.N - has historically seen itself as a safety valve. Funds typically use much less borrowed money than a bank would. They also tend to lock up investors’ cash for years, making the vehicles theoretically immune to a run.

The BoE couldn't be reached for comment when contacted by Reuters Breakingviews. But private credit stress tests would put the central bank at the vanguard of a likely wave of closer regulatory scrutiny of the fast-growing market. Recent credit blowups in the U.S. like First Brands, while not private credit related, have raised awareness of other "cockroaches", in the words of JPMorgan JPM.N boss Jamie Dimon. American lenders' exposure to non-bank financial institutions, a catch-all term that also includes hedge funds and other counterparties, totals some $1.2 trillion. That's 10% of overall loans versus around 3% a decade ago, Fitch Ratings reckons.

The evolution of private credit, meanwhile, also increases the risks. Lenders are increasingly seeking to tap retail investors, using funds that offer greater ability to withdraw money on short notice. The bigger these so-called evergreen vehicles become, the greater impact they could have on financial markets if investors hurriedly pull their cash. System-wide data on liquidity risks, however, is patchy.

Stress testing may not be easy, even if the BoE opts for a top-down anonymised approach rather than naming and shaming firms. A comprehensive view of private credit would require regulated groups like banks and insurers to disclose potential losses assuming a spike in defaults, and for funds to also test portfolios' liquidity and concentration risks. Much of this analysis is already done in-house, according to one private credit manager. Yet a true picture could require collaboration from regulators across sectors, and in different jurisdictions. The BoE's past experience shows that identifying risks isn't enough to stamp out excess: it was an early warner of the dangers building in Britain due to pension funds’ zeal for leverage, but was unable to prevent a gilt market collapse in 2022.

The UK’s current situation reinforces the case for action. Reeves is slashing regulatory red tape in the name of growth, and wants Brits to move money into higher yielding assets like private debt or equity. If the BoE can offer proof that alternative assets are safe, that would make things easier for Reeves' mission. If there are problems lurking beneath the surface, on the other hand, it's a good thing that the regulator is starting to dig.

Follow @Unmack1 on X

CONTEXT NEWS

The Bank of England is considering a “system-wide exploratory scenario” of the private credit market, according to a Bloomberg report on October 21.

The UK regulator will use a similar model to the 2024 review of risks to core UK financial markets, the report said citing a source.

The Bank of England was unavailable for comment when contacted by Reuters Breakingviews.