Speech
Good morning. My name is Lee Foulger and I am the Director of Financial Stability, Strategy and Risk at the Bank of England. I’m grateful to AFME and DealCatalyst for the invitation to speak to you today.
I would like to use my time to set out our approach to financial stability, and where non-banks and in particular private credit markets fit within it.
Framework for assessing how non-bank risks can affect UK financial stability
The Bank of England has a statutory financial stability objective, and the Financial Policy Committee, established following the global financial crisis, is the UK’s macroprudential authority charged with the role of identifying, monitoring, and mitigating systemic risks. The FPC seeks to ensure the financial system is resilient enough to be able to serve households and businesses in both good times and also in stress.
Since the financial crisis, non-banks, or the system of market based finance as we call it, has grown significantly both as part of the UK financial system but also globally, now accounting for around half UK and global financial sector assets. It also matters more to the real economy, for example, it contributed to nearly all of the c.£425 billion net increase in lending to UK businesses from 2008 to 2023. That means it is important that, alongside banks, the non-bank system can absorb, and not worsen, any shocks that may arise.
But assessing risks in the non-bank sector is challenging given its international nature and the diversity of business models or types of activity. And further by challenges in gathering the data needed to build a picture of the sector and risks.
We set out our framework for doing this last year in a Financial Stability in Focus report.footnote [1] Within this framework we consider two types of vulnerabilities. The first of those are ‘microfinancial vulnerabilities’ – these are risks inherent in the business models of market participants, that they must manage and for which it is generally in their own interests to get right. These include risks such as maturity and liquidity mismatch, which arise when assets are less liquid or have longer maturities than liabilities, potentially leading to the need to liquidate assets rapidly in a stress. Or leverage, which can help to increase potential returns or hedge those risks, but which can also amplify losses and exacerbate liquidity issues in difficult market conditions.
These business model risks are first and foremost for firms to manage, and in some cases are overseen by market conduct regulators. However even if well managed individually, their collective impact when hit by shocks can inadvertently weaken other firms, spread stress throughout markets, and potentially disrupt the supply of financial services to the real economy. As we have learnt from previous crises, managing your own risks isn't always sufficient to protect against the wider risks to financial stability.
The second type are ‘macrofinancial vulnerabilities’. These are risks inherent to the structure of markets, or the collective behaviour of individual firms within them. They include issues such as market concentration, jumps to illiquidity, correlation and interconnectedness.
For example, high market concentration can amplify price moves and increase the risk of disruption, especially where firms’ liquidity demands are large compared to the system’s ability to supply. For example, liability driven investment (LDI) funds are significant holders of long-dated and index-linked gilts. In September 2022, when these funds faced a correlated stress, there were few buyers of the gilts they needed to sell, which created the potential for ‘doom loop’ dynamics.footnote [2]
Jumps to illiquidity can happen when rapid increases in demand for liquidity overwhelm the capacity of markets to absorb it, resulting in amplified price moves and market dysfunction. This can be exacerbated by unwillingness or inability of dealers and other intermediaries to expand their balance sheets to absorb the demand. This was evidenced by the volatility in US overnight repo rates in September 2019, when the Federal Reserve had to take action to restore market stability.
Correlations can happen when common positions of participants amplify price moves, such as when falling asset prices force those with similar trading strategies to sell assets, leading to further price falls. This can cause direct and indirect losses to other institutions, potentially leading to tighter financial conditions for households and businesses.
Interconnectedness across markets, when combined with opacity, can result in losses being transmitted to counterparties in a sudden or surprising way, driven in part by the lack of certainty on overall positions held in the market. For example, during the financial crisis, the interconnectedness and lack of transparency of derivative markets amplified shocks in the financial system. In private markets, these interlinkages could include, cross-investing between investors and funds, with some large fund managers exposed to other private credit and private equity funds.
Figure 1: How vulnerabilities in market-based finance can affect financial stability.
Vulnerabilities and transmission channels to financial stability
Footnotes
- Source: Bank of England
These vulnerabilities can impact UK financial stability through three main channels
(Figure 1):
Firstly, through systemically important financial markets which are integral to the real economy. Disruptions to these markets would impact the cost or availability of finance for UK households and businesses. The LDI episode highlighted how issues in the non-bank sector can impact government bond markets, impacting the pricing of credit to household and businesses.
Secondly, through systemically important financial institutions such as banks, which could impact the availability or cost of credit. For instance, banks engage in repo and derivative transactions with hedge funds through their broker-dealer operations; a sudden fall in asset values could leave banks' exposures insufficiently collateralised. This scenario could result in losses for banks, and cause a spillover to the real economy through reduced credit provision.
The last channel is through interruptions in vital services, including payment and settlement systems. These can halt critical economic activities undermining the stability of the financial system.
Where do private credit markets fit in?
Over recent years, private credit has become an increasingly important source of funding for some corporates and other asset classes such as real estate, both in the UK and worldwide. This has provided an alternative source of financing for corporates, including those that might have otherwise found it difficult to secure finance through public markets or from banks.
The availability of private credit can be beneficial for economic activity and innovation. By providing finance where traditional means fall short, it can support investment and growth opportunities. And to the extent that private credit substitutes for bank financing, it can contribute to the diversification of financing sources. In many ways lending via private markets is likely to be lower risk from a financial stability perspective than had the lending been undertaken by the pre-GFC banking system.
Leveraged lending, high yield bond and private credit markets account for around a quarter of all market-based finance globally. And leverage lending and private credit taken together have roughly doubled in size over the past decade. Within that, we estimate that private credit has grown even faster - four-fold since 2015 to around $1.8 trillion, though given the limited data available the true market size could be much larger. Much of that growth has been during a sustained period of low interest rates. However, since the start of 2022 interest rates have increased substantially, and markets are not expecting a return to the levels seen in the recent past for the foreseeable future.
Corporates that borrow through private credit markets, along with leveraged loan and high yield bond markets, are likely to be more challenged in a higher interest rate period. The floating-rate debt structure of private credit agreements makes them vulnerable to challenges around debt servicing and refinancing in a higher rate environment. To date, private credit market participants have reported low default rates despite the tougher macro environment. But in the past year, highly leveraged borrowers have experienced a significant decline in their interest coverage ratios.
It is therefore important, as it is for all parts of the financial sector and real economy, to understand how the transition to a higher rate environment will affect the private credit markets and in particular whether and how the business model risks in the sector will interact with the macro vulnerabilities I talked about earlier.
The sorts of business model risks we are focused on include the refinancing of existing debt in the context of higher rates, valuations, risk management approaches, liquidity and leverage, and what the impact of these might ultimately be on systemic markets and institutions important for the provision of credit to households and businesses.
For example, some market participants have indicated that refinancing practices aiming to support firms smooth the impact of tighter financing conditions may act to delay or mask the financial vulnerability of the underlying corporates. ‘Amend and extend’ (A&E) is increasingly common, in which lenders agree to push back a loan’s maturity, often in return for a higher yield and tighter financial controls. 'Payment-in-kind’ practices are also becoming increasingly common, where borrowers with low liquidity issue new debt in order to meet interest payments.
These measures can help to smooth the impact of tighter financial conditions. While individually rational, they put a premium on robust approaches to risk management and collectively could increase the risk of defaults materialising further down the road.
As interest rates have risen, so has the riskiness of borrowers, which all else equal should impact valuations. The majority of fund portfolios are typically valued quarterly and remain above their public-market peers with some investors left possibly over-allocated to private markets due to this dispersion. Lagged or opaque valuations could increase the chance of an abrupt re-assessment of risks or to sharp and correlated falls in value, particularly if further shocks materialise.
Risk management of private credit investments may also be made more difficult by the illiquid nature of the asset class. And some private credit funds may have a degree of liquidity mismatch between their investments and the redemption terms of their investors.
The significant interlinkages between private credit markets, leveraged lending, and private equity activity make them vulnerable to correlated stresses. Private credit and leveraged loan markets are interlinked given their floating rate nature and links to private equity activity (Figure 2). Private credit exposures are largely held by a range of institutional investors. Leveraged loan and private credit markets exhibit some overlap in investor bases. Given the illiquidity of private credit assets, there is a possibility that investors may opt to sell other, comparatively more liquid assets, such as leveraged loans or high-yield bonds to reduce their credit exposures.
Figure 2: Highly leveraged corporates are reliant on a variety of funding sources, including from private credit, private equity and leveraged loans
Footnotes
- Source: Bank of England
If material enough, these risks materialising could trigger a broader reduction in risk appetite that spills over to UK financial stability through financial markets, impacting on financing conditions for UK businesses.
While the leverage deployed appears relatively low, the underlying investments are relatively higher risk and we lack sufficient data to fully understand their resilience in stress. In addition to the leverage on the underlying exposures, private credit funds may also use leverage to enhance returns through borrowing from banks and markets, via subscription lines or secured lending against the fund’s assets.
The different levels, structures and layers of leverage within the firms, funds and system wide make it challenging to assess aggregate leverage across the market. And it is difficult to identify the extent to which any losses could spill over to banks and investors, and the interconnectedness to systemic institutions. For institutional investors, losses may dampen their risk appetite for corporate credit more broadly. UK insurers could also be indirectly exposed due to their growing interconnectedness with non-UK reinsurers, which have increasing exposures to highly leveraged corporates.footnote [3]
Conclusion
The increasing role played by non-bank finance in the provision of credit is a feature of the financial system, not a bug, and a welcome feature if undertaken on a sustainable basis. It has grown particularly strongly following the global financial crisis alongside the tightening of regulations for the banking system, and a period of unusually low interest rates globally.
The shift in the risk environment, including greater geopolitical risks, more subdued economic growth, and tighter financing conditions will pose challenges to the non-bank sector and specific challenges to private credit markets, both in terms of the way risks are managed and because the underlying borrowers and the specific business models are likely to be increasingly challenged in this environment.
Past stresses have demonstrated how in favourable market conditions business model risks can build up and interact with system wide vulnerabilities in a way that can impact credit provision to households and businesses and impact upon systemic institutions and markets when conditions worsen.
Assessing the extent of the risks, or in which scenarios they might crystallise is easier said than done. There are significant challenges with obtaining reliable data to monitor the risks in private credit markets. We have so far used a combination of market intelligence and data analysis to inform our thinking – but welcome further engagement with market participants.
Recently, the Securities and Exchange Commission in the US has adopted new reporting requirements for private funds and separately, the Financial Conduct Authority in the UK has announced its intention to review valuations in these markets, all of which should help to improve our understanding of developments in the sector and any potential financial stability risks. Going forward, the FPC will continue to closely monitor risks from private credit and interconnected markets, drawing on market intelligence and the data sources available and will publish further assessment of these risks in our Q2 Financial Stability Report in June.
Thank you for your time.
I’d like to thank Georgia Waddington and Charlotte Buckingham for their assistance in drafting these remarks. I would also like to thank Andrew Bailey, Yuliya Baranova, David Baumslag, Sarah Breeden, Owen Clark, Bradley Hudd, Joshua Parikh, George Pugh, William Rawstorne, Dooho Shin, Simon Stockwell and colleagues at the FCA for their helpful input and comments. The views expressed here are not necessarily those of the Monetary Policy Committee (MPC) or the Financial Policy Committee (FPC).