Leading financial voices have expressed alarm over the fast rise of the $2.1 trillion private loan industry. This commentary analyzes the potential for systemic financial risks to be triggered by the opacity, leverage, and illiquidity of private credit, and it questions whether Wall Street is sleepwalking toward another collapse.
In May 2024, JPMorgan Chase CEO Jamie Dimon warned that the private credit boom could become a major risk to financial stability, stating, “I expect there to be problems. If things go wrong, there could be hell to pay.” (Bloomberg) His concerns reflect an ongoing discussion on Wall Street: is private credit a beneficial growth of capital markets, or is it a potential subprime mortgage crisis in the making? Private credit, with over $2.1 trillion in assets under management and increasing, has emerged as one of the fastest-growing sectors in finance. (IMF) However, its opacity, high leverage, and illiquidity have raised concerns among regulators and institutional investors. The issue now is not if this market will experience stress, but whether it could lead to a wider liquidity crisis similar to that of 2008.
The private credit market has expanded significantly, evolving from a lesser-known asset class to a $2.1 trillion industry as of early 2024, according to the International Monetary Fund (IMF). Previously viewed as an alternative investment strategy mainly used by hedge funds and private equity firms, private credit has emerged as a significant player in global finance, drawing interest from pension funds, insurance companies, and sovereign wealth funds. The rapid expansion of this largely unregulated sector, despite offering higher yields than traditional fixed-income assets, has raised concerns about the potential for triggering the next financial crisis. Analysts caution that private credit exhibits notable similarities to the subprime mortgage market prior to 2008, especially regarding risk opacity, high leverage, and market interconnectivity.
Private credit is non-bank lending where debt is generated outside public markets. Unlike corporate bonds or syndicated loans, these securities are privately arranged, which makes them very appealing for borrowers wanting freedom. Post-2008 banking rules that tightened capital requirements on conventional lenders under Basel III (Bank for International Settlements) help to explain the accelerated expansion of this industry. (BIS) Private credit organizations filled the void left by banks mandated to limit their exposure to riskier lending, providing finance to middle-market businesses who could otherwise find it difficult to obtain money. Since 2010, the IMF projects private credit has increased at a compound annual rate of nearly 13%, well above conventional lending markets. (IMF)
Though attractive, the private credit explosion carries major dangers. The market’s lack of transparency is a major worry. Unlike publicly listed debt, private credit runs in an opaquer area with little disclosure obligations. Often, investors and authorities lack knowledge of the financial condition of underlying debtors. Many loans are quite leveraged, which aggravates this issue. According to the Bank for International Settlements (BIS), more than 60% of private credit deals have leverage levels over six times EBITDA, a level that would have been deemed too dangerous for conventional bank loans before the financial crisis. (BIS)
Private lending markets have also seen a rise in covenant-lite loans. Now almost 90% of new leveraged loans, these loans impose little financial limitations on borrowers (S&P Global). Although they provide borrowers some freedom, they lower lender protections and hence cause more financial volatility. This pattern reflects the decline in lending criteria observed during the subprime mortgage crisis, when banks granted loans to applicants with little examination, therefore helping to cause the final collapse.
Another significant risk is liquidity mismatches. Unlike public debt markets, which allow for easy buying and selling of securities, private credit investments are highly illiquid. Funds typically have lock-up periods of 5 to 10 years, meaning investors cannot withdraw their capital during times of market stress. If economic conditions worsen, higher default rates among borrowers could create a liquidity crunch, forcing private credit firms to sell assets at distressed prices. Morgan Stanley (Morgan Stanley) recently warned that if interest rates remain high for an extended period, the combination of rising borrowing costs and falling asset valuations could lead to a wave of defaults in the sector.
These hazards are further exacerbated by the interconnectedness of private credit with the broader financial system. Over the past decade, pension funds and insurance companies have become some of the largest investors in private credit, with pension fund allocations to the asset class doubling from 5% to 10%. (Preqin)If a significant private credit fund experiences distress, it could cause shockwaves to ripple through these institutions, affecting retirees and policyholders who are oblivious of their exposure to such risky investments.
Regulators have initiated an investigation. The IMF identified private credit as a potential systemic risk in its April 2024 Global Financial Stability Report. The IMF cautioned that the rapid expansion of private credit in an unregulated environment could result in financial vulnerabilities akin to those observed in shadow banking before 2008. Some policymakers are advocating for heightened oversight, contending that private credit should be subject to capital requirements and stress testing comparable to those imposed on banks. Nevertheless, industry leaders oppose efforts to regulate the sector, contending that private credit enhances market efficiency and provides essential liquidity to businesses.
The critical question is whether private credit will follow the trajectory of subprime mortgages, i.e., expand unchecked until it becomes a systemic hazard. Even though some analysts contend that the market is more resilient than publicly traded debt due to its reliance on private negotiations and long-term capital commitments, others caution that the market’s lack of transparency, high leverage, and illiquid structures are a potential financial time bomb. The risk is that the liquidity crisis in private credit could propagate throughout the financial system in the event of an economic downturn, potentially precipitating a more extensive crisis.
The rapid expansion of private credit is strikingly identical to previous financial excesses that resulted in significant systemic crises. The global markets were nearly brought to a halt in 1998 when Long-Term Capital Management (LTCM) collapsed due to excessive leverage. This event necessitated a $3.6 billion intervention conducted by the Federal Reserve (Columbia Law School). Similarly, the banking system was nearly destroyed in 2008 because of the cascading defaults that resulted from the expansion of subprime mortgage backing securities. Private credit is currently operating under similarly fragile conditions: it is profoundly interconnected with institutional investors, lightly regulated, and highly leveraged. History indicates that the consequences of an increase in defaults and a decrease in liquidity could be extensive.
Jamie Dimon’s warning should not be dismissed without consideration. Although private credit has not yet reached crisis levels, it possesses all the characteristics of a financial upheaval that is imminent. Regulators and market participants must act immediately to prevent this asset class from becoming the focal point of the next financial crisis, as corporate debt loads are increasing, interest rates remain at restrictive levels, and liquidity risk is on the rise.
About the Author
Kanan Mammadov is a graduate student in Finance at George Washington University, with a focus on investment banking, corporate finance, and global economic risk. His commentary on international finance and economic policy has been featured in platforms such as the International Institute for Sustainable Development, Modern Diplomacy, and U.S. News & World Report.
