The International Monetary Fund has warned that risky lending by shadow banks could trigger a new crisis.
The Washington-based organization said that the “opaque private credit” of $2.1 trillion, which has boomed over recent years amid record low interest rates, poses “systemic risk”.
Companies that are too big or risky to be financed by commercial banks, and too small to list their shares in the stock exchange have increasingly turned towards non-bank funds for money to borrow quickly and confidentially.
The IMF stated that a severe recession could expose these vulnerabilities quickly.
In its Financial Stability Report, the IMF stated that “in a severe recession, credit quality may deteriorate rapidly, leading to defaults and substantial losses.”
This impact will be felt by more than just private lenders, as an increasing share of public pension funds and -funded private pension funds pour money into private funds.
The IMF has issued a warning just a few weeks after the Bank of England began examining the risks to financial stability posed by private equity.
Threadneedle street is concerned with the value of assets owned by private equity firms, how much has been borrowed against them, and how these loans have been linked to commercial banks and investors.
Private equity firms are backing some of Britain’s largest companies, including Asda and Morrisons.
The IMF notes that private credit is different from private equity.
Around 70pc private credit deals were attributed to private equity firms. Some of the largest “shadow banks” are funds managed by Apollo, Blackstone and KKR, which have been responsible for some of the most significant private equity deals in the last decade.
IMF stated that the immediate financial stability risk from private credit appears to be “limited”. The nature of the risks is not clear.
The report stated: “Given the opaque nature of this ecosystem and its high interconnectedness, if rapid growth continues without adequate oversight, current vulnerabilities could become systemic risks for the wider financial system.”
The opaque nature of the deals makes it difficult to estimate losses, which could lead to a new crisis.
It said that “significant interconnectedness” could have an impact on the public markets as pension funds and insurance companies may be forced into selling more liquid assets.
The IMF called on regulators to adopt a “proactive approach to supervision and regulation” in the sector. It added: “Regulation of private funds and their supervision was significantly strengthened after the global financial crises.
“Yet the rapid growth of private credit and its structural shift to private lending requires that countries conduct a more comprehensive review.”
Separately, the IMF warned that Bank of England could cause unnecessary harm to the economy by leaving interest rates high for too long.
The report noted that a high proportion of UK home owners who had borrowed at fixed interest rates were exposed to a shock mortgage when their agreements expired. This could lead to a drop in consumer expenditure, which is bad for the economy.
IMF stated: “Most Central Banks have made significant progress towards their inflation targets.” The discussion could suggest that, in the event of weak transmission, it is better to err on the side too tight.
“However overtightening or leaving rates high for longer could still be a greater threat now.”
In the UK, the share of people with fixed-rate mortgages is now one of the largest in the world. This has helped millions of borrowers to avoid the painful increase of rates.
According to the IMF, the share of British households that have chosen to fix their borrowing rates – typically for two to five years – has increased from around a quarter in 2011 to nearly 90pc by the end of 2022.
In the next year, around 1.6 million mortgages are scheduled to be refinanced to higher rates. The Bank raised interest rates last year from 0.1pc by the end of 2020 to 5.25pc.
IMF stated that policymakers in the world may be underestimating the economic impact of the current wave of rising mortgage rates.
The report stated: “Overtime, as mortgage rates reset, the transmission of monetary policy could become more effective, and thus depress consumption. The effects of this scenario on consumer spending could be greater than anticipated, even though central banks have already taken into account the possibility.
If defaults increase abruptly, financial instability may also result.