Is the next financial crisis lurking in the shadows? 

The shadow banking system is back in the spotlight. Hedge funds and private credit vehicles are huge in size, and their ties to banks have deepened to the point that trouble in that market could jolt the wider financial system, regulators are warning.

Moody’s Analytics is among those sounding the alarm. In the summer, it published a study saying the ever-strengthening ties of the private credit market to banks and insurers could make it a “locus of contagion” in the possible event of the next financial crisis.

A few months later, the International Monetary Fund echoed that concern, urging tougher oversight of hedge funds, private equity, and credit funds, saying it could amplify downturns and transmit stress to banks and the wider economy.

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The warnings come as regulators examine the recent failures of First Brands Group and Tricolor—two US borrowers that relied heavily on asset-based loans—to see whether their collapse points to a deeper weakness in the private credit market.

The issue is that many major banks have built up large exposures to hedge funds and other non-bank institutions that lend to companies such as First Brands and Tricolor and face far less regulatory oversight than banks. The IMF estimates that banks in the US and Europe have about $4.5 trillion tied up with hedge funds and private lenders, about 9 percent of their total loan books.

The Washington-based multilateral lender also noted that several major banks now have exposures to non-bank lenders that exceed their tier-one capital—the core buffer meant to absorb losses in a downturn.

Some regulators have also called for tougher oversight of private credit funds; however, I do not believe broad new regulation is necessary. These firms already require licenses, which gives regulators a clear path to monitor their activity.

Still, the recent collapses of First Brands, a heavily indebted car parts maker, and Tricolor, a subprime automotive lender, have shaken confidence in the market and left several big banks, including Jefferies and UBS, nursing losses.

The main risk is not with the companies that borrow but with the funds that finance them.

Bank of England governor Andrew Bailey has warned that these failures highlight how risky private credit has become, with “alarm bells” ringing over complex loan structures that he said echo those seen before the 2008 financial crisis.

However, in my view, the situation today is different. In 2008, banks bundled risky mortgages into opaque securities that hid the scale of bad debt. Private credit is more direct: lenders make and monitor their own loans to specific companies. 

But the market remains opaque overall. Valuations are sporadic, credit quality is difficult to judge, and the web of links between funds and banks remains poorly understood.

Slowing returns

The slowdown in private credit returns has also worried some investors as another possible sign of stress, but it more likely reflects the fact that the market is maturing.

Blackstone, the world’s largest private capital group, recently said private credit’s period of mid-teens yields is over, giving way to more modest returns as falling rates and thinner margins eat into performance.

But the sector continues to attract deep-pocketed investors, including insurance and pension groups. Gulf sovereign wealth funds, too, are turning to private credit. Many investors see it as a more reliable source of income than public bonds.

The challenge now is for the sector to stay disciplined. As returns fall, the temptation to chase higher yields grows, making prudent lending more important than ever.

That requires regulators to strike a balance: rules firm enough to protect the system but flexible enough to keep credit flowing to companies that have struggled to borrow from banks.

The boom in private credit has been driven by rules introduced after the 2008 crisis that forced banks to tighten lending standards. Private credit funds, which are under far looser supervision, stepped in to fill this gap.

What is needed is firm oversight, not another wave of new rules. Basel III—the global framework that sets how much capital banks must hold—already gives regulators the tools they need. In my view, its flexible risk models are more than capable of capturing private credit exposure.

The warning from the IMF about banks’ exposure is serious, but it should not be seen as a prediction of the next crisis. Banks are far better capitalized and more tightly regulated than they were before 2008.

But the system itself has become more interconnected, and that brings a different kind of risk. The danger is that regulators do not fully understand how these connections work. The solution is not to push private credit back into the banking system, as some regulators have warned, but to make it more transparent and easier to monitor.

Do that, and the next financial crisis may not begin in a bank. But it need not begin in the shadows either.

Arturo Bris is the director of the IMD's World Competitive Centre