The Bank of England has started stress testing the UK financial system’s exposure to private markets, estimating that banks have almost US$230 billion of exposure to private funds and corporates backed by financial sponsors, including private equity funds.
The central bank, which announced the move in its Financial Stability Report on December 2, notes that 17 leading UK pension funds had also, in May, committed to invest at least 10% of their defined-contribution default funds in private markets by 2030.
The Bank acknowledges that private markets are an important source of funding for business. But “while resilient to date, private markets have not been tested through a broad-based macroeconomic stress at their current size”, it says.
The report raises concerns over the proliferation of smaller credit ratings agencies potentially producing flawed ratings of private markets debt. Allied to this, it cites risks to UK insurers through rising use of funded reinsurance contracts and other channels and increasing use of funded reinsurance contract and other channels.
It also frets about the growth of private lending to artificial intelligence companies, saying that the potential bursting of an AI bubble underscore contagion risk across a wide range of banks and non-bank investors.
Speaking at a House of Lords committee two months ago, Andrew Bailey, governor of the Bank of England, highlighted the collapse of two US private credit-backed businesses.
He described the bankrupt companies – auto parts firm First Brands Group and subprime auto lending firm Tricolor Holdings – as potentially “the canary in the coal mine”. He evoked parallels with the 2008 global financial crisis.
First Brands may have borrowed as much as $50 billion via private debt against some assets worth between $1 billion and $10 billion.
The collapse of Tricolor amid fraud allegations, meanwhile, led Jamie Dimon, CEO of JPMorgan Chase & Co, to say that “everyone should be forewarned” over further potential losses on private credit deals.
Fears of a global financial crash triggered by private credit may, of course, be overblown. But in the circumstances, the central bank’s stress test looks, at the very least, prudential.
