The global financial crash of 2008 revealed the dangers of financial contagion. What began as a collapse in the United States sub-prime mortgage market rapidly evolved into a worldwide banking catastrophe.
Today, new concerns are emerging from the United States, centred on the rapid growth of the private credit market.
Recent high-profile failures within this sector have exposed potential weaknesses in lending standards and raised alarms about the sector’s opacity.
UK lenders cannot afford to treat this as a distant issue. The domestic financial landscape is deeply interwoven with non-bank financial institutions, both through direct investment and funding relationships.
The combination of high leverage in privately funded companies and a lack of transparency creates a blind spot, meaning that distress in this growing sector could swiftly impact the balance sheets of traditional UK banks, echoing the cross-border contagion dynamics of the past.
ALARM BELLS RINGING
The Bank of England recently expressed concerns about the private credit market with Governor Andrew Bailey and others stating that ‘alarm bells’ are ringing due to the riskier nature of borrowing in the sector.
The Bank also pointed out that there were parallels with the sub-prime mortgage crisis and they saw potential vulnerabilities including ‘slicing and dicing and tranching of loan structures’. It also referred to specific risks including weaker underwriting standards.
The recent collapse of three lenders in the United States was not caused by novel financial instruments but by a profound failure of basic oversight and controls.
These events prove that market participants can no longer rely on non-verified stamps of approval or indeed on reps and warranties from interested parties.
What is needed is an acknowledgement of the critical part due diligence plays and of the need to seek more demanding and verifiable proof – and that only comes from those that have relevant experience of deep dive assessments.
DECISIVE PROACTIVE STEPS
In this environment, a passive approach to risk is no longer an option. UK lenders must take decisive proactive steps to safeguard their institutions. The priority is to gain absolute clarity on all exposures to the private credit market and the non-bank sector.
This involves moving beyond traditional due diligence and additional considerations should include the implementation of mapping of counterparty risk and funding chains.
In response to the issue, the Bank of England has announced a voluntary exercise to test the links between private credit and UK banks, insurers, private equity firms and pension funds. This project aims to establish how the ecosystem would react under stress.
“This issue has not been brought into the spotlight by failures of any lenders in the UK market – yet.”
There is a lot for lenders who fund third parties to consider. There was a time when ‘funder reviews’ focused on re-underwriting and eligibility checks. Understandably Chief Risk Officers (CROs) are demanding more, seeking additional independent reassurance.
The private credit market has grown significantly since the 2008 crisis, in part due to the banks retreating from riskier lending following the imposition of stricter regulations.
The lenders’ role in that is important and supports the overall need for growth in the real economy.
We should also acknowledge that this issue has not been brought into the spotlight by failures of any lenders in the UK market – yet.
Indeed, the sector has seen several new players emerge with more inclusive lending strategies than some established providers.
We would ask the question – without them and their appetites to innovate and develop the market, what or who would replace them?
