UK Edition
Risky lending by “shadow banks” threatens to trigger a new financial crisis, the International Monetary Fund (IMF) has warned.
The Washington-based organisation said there were “systemic risks” posed by the $2.1 trillion “opaque world of private credit”, which has boomed in recent years against a backdrop of record low interest rates.
Companies deemed too large or risky for commercial banks and too small to float their shares on the stock market have increasingly turned to non-bank funds to borrow money quickly, flexibly and confidentially.
However, regulation in this corner of financial markets is relatively lax and the IMF said a severe economic downturn could quickly expose vulnerabilities.
“In a severe downturn, credit quality could deteriorate sharply, spurring defaults and significant losses,” the IMF said in its latest Financial Stability Report.
The impact would be felt beyond just private lenders as a growing share of public and private pension funds are pouring money into these private funds.
The IMF’s warning comes just weeks after the Bank of England launched a review into financial stability risks posed by private equity.
Threadneedle Street is concerned about the value of assets controlled by private equity companies, how much money has been lent against them and how these loans are linked back to commercial banks and investors.
Some of Britain’s biggest companies are now backed by the private equity industry, including the supermarkets Asda and Morrisons.
While private credit differs from private equity, the IMF noted that “growth in private credit has followed the rise in private equity”.
It said private equity firms were involved in around 70pc of private credit deals. Some of the biggest “shadow bank” lenders include funds run by Apollo, Blackstone, KKR and Carlyle Group, which have driven some of the biggest private equity deals over the past decade.
The IMF said the immediate financial stability risks from private credit appeared to be “limited”. However, the nature of these risks is unclear.
It said: “Given that this ecosystem is opaque and highly interconnected, and if fast growth continues with limited oversight, existing vulnerabilities could become a systemic risk for the broader financial system.”
It added that the opaque nature of deals made losses hard to assess, which could trigger a new crisis.
“Significant interconnectedness could affect public markets, as insurance companies and pension funds may be forced to sell more liquid assets,” it said.
The IMF urged regulators to take a more “proactive supervisory and regulatory approach” to the sector, adding: “Regulation and supervision of private funds was strengthened significantly after the global financial crisis.
“Yet, the rapid growth and structural shift of borrowing to private credit requires that countries undertake a further comprehensive review.”
A separate IMF report warned that the Bank of England risked leaving interest rates too high for too long, inflicting unnecessary damage on the economy.
It noted that the high share of UK homeowners who have borrowed at fixed rates left many exposed to a mortgage shock when their deals run out. This could trigger a sudden drop in consumer spending, which would be damaging for the economy.
The IMF said: “Most central banks have made significant progress toward their inflation targets. It could follow from the discussion that if transmission is weak, erring on the side of too much tightening is always less costly.
“However, overtightening, or leaving rates higher for longer, could nevertheless be a greater risk now.”
The UK now has one of the highest shares of people on fixed-rate mortgages in the world, which has helped to delay the pain of higher rates for millions of borrowers.
The share of British households who have opted to fix their borrowing costs – usually for two or five years – has climbed from around a third in 2011 to almost 90pc at the end of 2022, according to the IMF.
Around 1.6 million mortgage holders are scheduled to come off cheap fixed rate deals over the next 12 months and roll on to higher rates. The Bank has raised interest rates from 0.1pc at the end of 2021 to 5.25pc last year.
The IMF said policymakers around the world could be underestimating the impact of this wave of higher mortgage rates on the economy.
It said: “Over time, and as rates on these mortgages reset, monetary policy transmission could suddenly turn more effective and thereby depress consumption. Although central banks already incorporate this possibility in their decisions, the effects on consumption could still be larger than expected.
“Financial instability could also follow if defaults rise abruptly.”