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Borrowers across many countries have increasingly sourced credit from outside the traditional banking system over the last decade, funded by nonbank financial institutions (or NBFIs) that have raised substantial capital from a variety of market participants. Private credit is a relatively small but quickly growing segment of nonbank financial assets, mostly in the U.S. and in certain areas of corporate lending.

As investors increasingly allocate capital across private markets, evolving macro-credit and financial conditions may require a need for greater transparency. In this edition of Private Markets Monthly, Global Head of Private Markets Analytics Ruth Yang interviews S&P Global Ratings' Nicolas Charnay, managing director and sector lead for financial institutions ratings in Europe, and Brendan Browne, managing director and sector lead for financial institutions in North America—about the growth, risks, and opportunities that nonbank finance and private credit bring to markets and financial stability.

Could you give us a sense of the growth in nonbank financial assets in recent years, and how big of a role private credit played in that story?

Nicolas Charnay, Sector Lead for Financial Institutions Ratings in Europe:  The past decade has certainly been shaped by growth in assets held by NBFIs—these now represent around half of global financial assets. Within this broad category, we focus on a subset of institutions which participate in credit intermediation activities. These nonbank credit providers also saw a rapid growth in their asset base. At the end of 2022, they held approximately $63 trillion in financial assets in major global jurisdictions, representing 78% of global GDP—demonstrably up from the $28 trillion and 68% of global GDP seen in 2009.

Brendan Browne, Sector Lead for Financial Institutions Ratings in North America:  At the same time, the private finance sector is estimated to equate to around 5% of total NBFI assets and 2% of total financial assets, at around $10 trillion-$12 trillion. Private equity makes up most of that, while private credit has an estimated size of about $1.3 trillion globally.

What role does nonbank credit intermediation play in shaping markets and financial stability?

Nicolas Charnay:  Overall, nonbank credit providers play an important role in many countries by providing a meaningful alternative to bank financing. They can offer solutions to fund long-term assets with matching liabilities. They also improve the efficiency and depth of financial systems by holding assets with maturity structures and credit characteristics that may be unattractive to traditional lenders.

Brendan Browne:  Regarding private credit, alternative asset managers (through the private credit funds they raise) and business development companies (which are mostly under external management) are significant and growing competitors—particularly for commercial speculative-grade and structured credit, by positioning themselves as options for funding sources beyond the broadly syndicated loan market and the high-yield debt markets. Facing limited prudential regulation, they compete on terms, structure, and execution, and can offer one-stop solutions to many borrowers. They've taken on a variety of assets, most notably leveraged loans alongside various types of senior and subordinated, secured and unsecured, uni-tranche, distressed, and highly structured and complex assets.

Private credit providers also add to the competition banks face. Consider how large banks in the U.S. originate and distribute most broadly syndicated loans: When private credit funds take share from the broadly syndicated loan market, they also eat into the fees that banks would've earned from origination and distribution. They additionally compete directly with banks for certain types of credit assets that banks sometimes hold on their balance sheets. Some banks in the U.S. have responded by expanding their asset management businesses, which may include private credit strategies, or by holding small amounts of private credit assets on their balance sheets. Rather than competing directly with the private credit funds, banks also have extended additional credit to asset managers, usually on a collateralized basis.

What are the main risks to watch for nonbank credit providers in general and private credit funds in particular?

Nicolas Charnay:  Nonbank credit providers face risks that are largely similar to those at banks: credit risk, liquidity risk, and leverage. Overall, we believe that they are not immune to the interest rate and economic cycles, and that the risks they face are on the rise amid tighter financing conditions.

That said, there is great heterogeneity in the nonbank credit space, so we need to assess the level of risk for each firm. While many can operate in markets without adding significant incremental risk, others can have elevated leverage, structural liquidity mismatches, and/or heavy credit exposures to potentially more risky borrowers. Given their relevance in certain regions or economic sectors, difficulties and/or deleveraging by some nonbank credit providers can also have ripple effects on the broader economy and financial system—Chinese shadow banks and their involvement in financing real estate projects is one prime example.

This growing relevance of nonbank credit intermediation, together with the fact that these institutions do not have access to emergency central bank funding in times of stress, in our view largely explain the increased scrutiny from banks and regulators.

Brendan Browne:  As for private credit funds, we have seen low rates, the Federal Reserve's quantitative easing, and a search for yield help these funds and business development companies raise capital. But now, the full effects of monetary tightening may not have yet materialized, and market volatility and a slowing economy could put pressure on the public and private debt and equity markets in 2024.

Private credit funds and business development companies have added dynamism and depth to commercial credit markets, and their permanent capital, long-term funding, and low leverage have helped alleviate liquidity, market, and systemic risks. At the same time, these entities contributed to the high leverage that many middle-market and large corporate borrowers have reported over the past several years, and their growing heft and limited transparency could pose a threat beyond their own investors and to the wider market.

Writer: Molly Mintz