Shares plunged in the US and Europe this week over shadow banking fears. Photo / Getty Images
The frenzied stock market sell-off that gripped the US and UK this week was fuelled by fear as much as fact. Investors saw what could easily be the tip of an iceberg, and nobody knows quite what lies beneath.
Two car parts suppliers with multibillion-dollar debts in the private credit market have gone bust amid allegations of fraud, and two regional US banks have uncovered a clutch of irredeemably bad loans.
But with Jamie Dimon, the JP Morgan boss, earlier warning that more “cockroaches” might scuttle out of the $3tn (£2.2tn) black box that is the private credit market, many investors weren’t prepared to wait and see if these were one-off problems.
“No one really knows if this is the full story,” says James Reilly, of Capital Economics. “So it just makes sense to take some of your chips off the table. We’re seeing a broad flight to safety as investors work out what is going on.”
Among the companies hit by the FTSE sell-off were the asset managers ICG and Schroders, which are seen as more exposed to the private credit market. But it also hit the big banks, most of which are now neck-deep in the private market themselves.
The International Monetary Fund (IMF) warned this week that banks now have about $4.5 trillion of exposure to the “shadow banking” sector, a sum exceeding the size of the entire British economy.
Throw in a bout of geopolitical turmoil – which, with Donald Trump in the White House, is never far off – and the IMF says up to a fifth of banks could be in some kind of strife.
Kristalina Georgieva, the IMF’s managing director, said this week that the potential for a crisis to emerge from the world of non-bank financial institutions “keeps me awake every so often at night”.
Banks have been on a tight leash since the 2008-09 financial crisis, which has opened up space for the less constrained non-banking institutions. Wherever edgier borrowers have struggled to get conventional loans, and whenever investors have wanted higher, if riskier, returns, the private credit players have flooded in.
And as the playing field has become bigger and more crowded, some of those players have taken bigger risks.
“A desire to win in a competitive market sometimes leads to shortcuts,” Marc Rowan, Apollo Global Management’s boss, told a Financial Times summit this week. “In some of these more levered credits, there’s been a willingness to cut corners.”
Georgieva’s worry is that the lack of regulatory restraint has allowed the non-bank lenders not only to take bets that could be too risky, but also without ever letting in any outside light shine on to their activities.
“People are spooked,” says John Hardy, a strategist at Saxo Bank. “As Jim Chanos, the famed short seller, said, ‘In the private credit and private equity space, opacity is a feature, not a bug.’”
“We just don’t know what’s going on there. We just have to infer it from news stories, and from these seizures that are happening, because pretty chunky-sized operations are going belly-up. So people are like, ‘OK, wait – how big is this? How big is this problem?’”
Private credit funds are often illiquid, which means it is hard for investors to buy or sell their holdings. If fears develop about the funds’ viability, investors will try to sell, or redeem, their holdings.
The illiquidity might leave them able to sell only at a large loss. To prevent this, the private credit fund manager might try to block or delay redemptions.
This creates an incentive for investors to get out at the first sign of danger. And that reflex rush to the exit can create a more general sense of panic.
The IMF noted that the increasing participation of everyday, or retail, investors in the private-credit market could increase this risk of “herd behaviour”.
In the stampede, investors – including the banks – may need to sell other more liquid assets, like stocks and bonds, to cover their losses. These other assets will also likely be offloaded at fire-sale prices, and suddenly losses begin to spread across the market.
It means a few bad apples could end up threatening to upset the whole cart.
“If the problems in the illiquid markets persist and grow, they may start to become a systemic risk, forcing the Fed and other central banks to intervene,” analysts at Panmure Liberum wrote in a note to clients.
That scenario still felt quite distant until two regional American banks, Zions Bancorporation and Western Alliance Bancorp, revealed that they had found bad loans on their books. There has also been increased activity in the repo market, where banks go for cheap emergency cash.
Saxo’s Hardy speculates that the high-profile collapse of private market-funded auto parts suppliers Tricolor and First Brands Group has prompted credit officers at banks to start scouring their ledgers more closely for any problems.
“Their behaviour becomes more cautious. And that shift in behaviour, in a classic credit cycle, triggers the further contagion,” he says.
The bank revelations also evoked memories of the 2023 collapse of Silicon Valley Bank, another regional US lender. But Silicon Valley Bank was brought down by rising borrowing costs, whereas now interest rates are falling.
The US economy is also in decent shape – which many economists say ought to limit the number of defaults and bad loans, even if banks and private markets have become looser in their lending practices.
But John Waldron, the president of Goldman Sachs, warned this week that the US was “a two-speed economy”.
On the one hand, there’s an AI-driven boom that is enriching the top end of town. But on the other, rising living costs and falling real wages are still weighing on ordinary Americans.
Corporate defaults could easily increase among businesses such as First Brands, whose customers are concentrated at the struggling end of the spectrum.
There could also be greater risk of defaults among borrowers who depend on imported goods, and whose profit margins are thus being squeezed by Trump’s tariffs.
Trump has already signalled that he may need to ease the tariffs on auto parts suppliers, and promised Fox News on Friday that he would patch things up with China.
He may soon revert to piling pressure on Jerome Powell, the chairman of the Federal Reserve, for more, and bigger, interest rate cuts.
On the other side of the Atlantic, investors will be watching anxiously. “The concern is whether European lenders might also be tied to overstretched US corporate borrowers,” says Johann Scholtz of research firm Morningstar.
“Defaults often cluster late in the cycle, and these cracks could signal that stress is spreading to Europe also.”
The general view is that the ructions in the private markets are unlikely to shake the global financial system to its core. But once fear runs amok, there are no guarantees.
“The Fed and other central banks can in theory provide liquidity by accepting these private loans as collateral for liquidity injections in affected funds,” Panmure Liberum’s analysts said.
But they finished with a warning: “We are old enough to have been around in the run-up to the financial crisis of 2007 and 2008 and we are fully aware that we could have written similarly comforting lines ... back then.”