In discussions of how businesses borrow money, there used to be essentially two choice: firms could either issue bonds or borrow through banks. But during the financial crisis of 2008-09, as well as other episodes, it seemed that a number of banks were taking too much risk, which in bad times meant that their solvency was threatened and sometimes emergency action from the Federal Reserve was needed to keep them going. A wave of additional regulations on bank lending followed, to limit risky loans and bolster bank safety.
But as banks pulled back from lending, a number of businesses found it useful to borrow money elsewhere–specifically, via “private credit.” Fernando Avalos, Sebastian Doerr and Gabor Pinter tell the story in “The global drivers of private credit” (BIS Quarterly Review, March 2025, pp. 13-30). For additional background, the IMF devoted Chapter 2 of its semiannual Global Financial Stability Report in April 2024 to “The Rise and Risks of Private Credit.”
Avalos, Doerr and Pinter write: “Private credit funds have increased their assets under management (AUM) from about $0.2 billion in the early 2000s to over $2,500 billion today.” My personal rule is that quantities measured in trillions of dollars deserve some attention.
“Private credit” is usually set up as an investment fund, where investors put money in and borrowers–typically medium- and small-sized firms–get funding. The funds are “closed end,” meaning that they raise a fixed amount of money and then stop. Some of these funds just do direct lending; some offer more complex loans, which can include provisions for converting the loan into equity ownership in the firm; and some invest in the debt of “distressed” companies, which they can buy at a low price. The firms that borrow through private credit are, as one would expect, firms that aren’t able to borrow what they want through banks or bond markets. Thus, they can often be younger firms that don’t yet have the steady profits that risk-averse bank lenders are looking for.
Avalos, Doerr and Pinter write:
Most funds operate as closed-end structures that lock in capital for their life cycle, which typically ranges from five to eight years. They do not trade on exchanges and are not available to retail investors, which makes them illiquid and subject to lighter regulation. The life cycle of funds usually matches the average maturity of their loan portfolios … Some fund structures, however, offer investors more frequent redemption windows. An important example is BDCs in the United States, many of which list their shares on stock exchanges and are accessible to retail investors. They are subject to federal regulation and have disclosure requirements similar to those of mutual funds, providing transparency and investor protection. With over $300 billion in AUM [assets under management], BDCs represent 20% of the private credit market in the United States today. Attempts to bring retail investors into the fold have been a general trend in the private credit space.
If you aren’t a finance wheeler-dealer, private credit may seem like just another exotic fact about the economy. The lenders in private credit have, to this point, mostly been big firms with long time horizons, like pension funds, insurance companes, and sovereign wealth funds. The private credit funds often specialize in a certain type of industry or firm, and the managers of the fund often have deep knowledge about the industry and firms to which they are lending. In a way, the purpose of stricter bank regulation was to get riskier loans out of the banking system, so it shouldn’t be a surprise when such loans end up being organized in an alternative form.
But of course, financial regulators and international organizations like the International Monetary Fund and the Bank for International Settlements stay awake nights thinking not about how loan arrangements are working just fine in the present, but what the effects would be if such arrangements took a bad turn for the worse in the future–especially as retail-level investors with the ability to zoom in and out of markets become more common in this area.
For example, what if broader economic or financial conditions lead to a much higher risk of default in these funds? As a result, holders of these funds start trying to sell these not-very-liquid investments, and panicky selling drives down the price. Regulated pension funds and insurance companies–even some banks that invest in these funds–see that the value of their investment in these funds is falling. They start to draw on lines of credit and other sources of short-term funding, but with the increased risk and falling prices, those other sources of short-term funding start drying up. Yes, all of this is not at all a likely near-term scenario. But it’s why the IMF wrote last year:
Given the potential risk private credit poses to financial stability, authorities could consider a more proactive supervisory and regulatory approach to this fast-growing, interconnected asset class. … Several jurisdictions have already undertaken initiatives to enhance their regulatory framework in order to more comprehensively address potential systemic risks and challenges related to investor protection. The US Securities and Exchange Commission (SEC) is making substantial efforts to enhance regulatory requirements for private funds, including enhancing their reporting requirements. The European Union has recently amended the Alternative Investment Fund Managers Directive—commonly referred to as AIFMD II—to include enhanced reporting, risk management, and liquidity risk management. … Regulatory authorities in other countries (such as China, India, and the United Kingdom) have also enhanced the regulation and supervision of private funds. With the growth of the private funds sector in general, supervisors have also increased scrutiny over various aspects of private funds, particularly on conflicts, conduct, valuation, and disclosures.
Thus, the race between financial innovation and regulation continues to evolve.
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