The International Monetary Fund (IMF) has recently issued a warning regarding the potential for a new financial crisis due to risky lending by “shadow banks”. These non-bank financial institutions have been engaging in opaque and high-risk private credit activities, which have proliferated in the current era of historically low interest rates.
According to the IMF, these activities pose systemic risks to the tune of $2.1 trillion, as companies that are deemed too large or risky for traditional commercial banks, but too small to go public, have increasingly turned to non-bank funds for quick, flexible, and confidential borrowing.
However, this burgeoning sector operates under relatively lenient regulation, and the IMF has cautioned that a severe economic downturn could quickly expose its vulnerabilities, resulting in a sharp deterioration in credit quality, defaults, and significant losses. The impact of this would not be confined to private lenders but would extend to public and private pension funds that have been investing in these private funds.
The IMF’s warning follows the Bank of England’s concern regarding financial stability risks posed by private equity, with particular emphasis on the value of assets held by private equity firms and the loans extended against them, which are connected to commercial banks and investors.
The IMF highlighted the interconnectedness between private equity and private credit, with private equity firms involved in around 70% of private credit deals. Some of the largest “shadow bank” lenders include funds run by Apollo, Blackstone, KKR, and Carlyle Group, which have been behind major private equity deals in recent years.
While immediate financial stability risks from private credit might appear limited, the nature of these risks remains unclear due to the opaque and highly interconnected nature of this sector, which could potentially become a systemic risk for the broader financial system if not adequately supervised and regulated.
The IMF strongly urged regulators to adopt a more proactive approach in supervising and regulating the private credit sector, emphasizing the need for a comprehensive review and further strengthening of regulation and supervision of private funds.
In a separate report, the IMF also cautioned the Bank of England about the risks of maintaining interest rates too high for too long, particularly with a high share of UK homeowners having taken out fixed-rate mortgages, leaving them vulnerable to a sudden increase in mortgage payments when their fixed-rate deals expire. The IMF expressed concern that such a scenario could lead to a significant drop in consumer spending, posing a threat to the economy.
With nearly 90% of UK homeowners opting for fixed-rate mortgages, the impending expiration of these deals for 1.6 million mortgage holders over the next year could result in increased mortgage payments, especially with the Bank raising interest rates from 0.1% to 5.25% in 2022.
The IMF cautioned that policymakers may be underestimating the potential impact of higher mortgage rates on the economy and that a sudden increase in defaults could lead to financial instability. Consequently, there is a need for central banks to carefully consider the broader implications of their monetary policy decisions, particularly in the context of the impending wave of mortgage rate resets.