Private credit's push into retail opens new vulnerability, warns BIS

Private credit’s rush to attract money from retail investors is making the sector more vulnerable to the kind of liquidity mismatches found in traditional lenders, the Bank for International Settlements warned in a report on Tuesday.

Direct lenders usually provide long-term loans that match the duration of their funds, a setup that allows many in the industry to argue that private credit doesn’t pose systemic risk. But money managers have increasingly turned to structures that allow mom and pop investors to regularly redeem a portion of their investment, creating a potential problem if investors were to demand money back during market turmoil.

“The growing role of insurance companies and retail investors, as well as funds’ leverage and degree of portfolio concentration warrant monitoring,” according to the report. “This is especially relevant in light of growing interlinkages between banks and private credit.”

The report is the latest of a series of warnings from watchdogs, who are on the lookout for vulnerabilities in a rapidly growing industry that’s now home to investments worth $2.5 trillion, according to BIS estimates. The Financial Conduct Authority found last week that private market valuations can suffer from conflicts of interest, poor record-keeping and volatility smoothing.

Retail investors will be the fastest-growing source of capital for private assets through 2032, Bain & Co. forecast last year. Many funds will have to find a balance between the benefits of concentrating their lending to certain industries with the need for diversification, according to the BIS study, potentially diluting a competitive advantage. 

Greater diversification “may even become a regulatory requirement in some jurisdictions,” the authors wrote.

In a separate report, the BIS found that bond mutual funds face large outflows when market pressure on banks escalates, potentially contributing to a tightening in credit markets when traditional lenders are under pressure. That contrasts with bond ETFs and prime money market funds, where flows slow but don’t turn negative.

“Investor flows that lead funds to fire sales of assets would be of greater systemic relevance if they occur when market pressure on banks is already high,” the report concludes. “This is the case irrespective of whether the fund flows contribute to, or are a consequence of, the pressure on banks, or whether the two developments are the joint manifestation of external risk factors. Either way, financial stability is jeopardized.”