Bank of England launches groundbreaking private credit stress test
The Bank of England has launched its first ever stress test of the fast-growing private credit industry, in a bid to establish how the opaque sector would respond to a range of economic and financial shocks.
The undertaking, called a ‘system-wide exploratory scenario exercise (SWES)’, will work with some of the industry’s biggest players to war-game a host of market conditions, probing their plans for a downturn in economic conditions.
The test will also seek to unearth whether the collective behaviour of private credit firms – also known as non- or shadow banks – poses a system-wide threat to the wider economy, and seek to get a handle on the extent and manner of the industry’s relationship with traditional lenders.
Private credit funds – which are similar to private equity firms but use investor capital to issue long-term debt to portfolio companies, as opposed to taking up a stake – have been coming under increasing scrutiny from regulators after a string of high-profile collapses.
The sector has enjoyed astronomic growth since the aftermath of the 2008 financial crisis, but has evoked concern among regulators over the opacity of its reach in the economy and growing fears of lax underwriting standards. Fears were exacerbated earlier this year after three US-based firms – car parts maker First Brands and auto-lenders Primalend and Tricolor Holdings – collapsed under ballooning debts, some of which were owed to shadow banks.
The SWES exercise promises to be similar to the temperature checks it does of the banking sector, which seek to establish the safeguards traditional lenders have in place to prevent a bout of contagion sparking a financial crisis. But unlike its biannual dissection of the banking sector, private credit is not yet fully regulated by the Bank of England, meaning the sector is not obliged to take part.
Private credit heavyweights take part in Bank of England test
Still, almost all of the burgeoning industry’s biggest players will take part. On Wednesday, Morning Wire revealed the likes of Goldman Sachs, Carlyle Group and ICG had all signed up to participate in the inaugural exercise, alongside the likes of Blackstone, Ares and Apollo. The Bank said a third of the UK’s buyout companies by market cap were involved in the inaugural test.
“Private equity and private credit play an increasingly valuable role in helping UK companies to innovate, invest and grow,” said Sarah Breeden, the Bank of England’s deputy governor for financial stability.
“To keep delivering those benefits, we need a robust understanding of how risks might flow through the financial system in a stress. This exercise provides a unique opportunity to work collaboratively with firms to build that system-wide understanding together.”
As regulators clamped down on banks’ loose lending practices in the wake of the global financial crisis (GFC), the private credit sector ballooned from a niche corner of finance to one of the fastest-growing and most lucrative practices.
Over a decade where the return on bonds and traditional lending was held back by ultra-low interest rates, shadow banks lent to companies that legacy lenders could not, generating higher returns over a longer timeframe.
The sector grew rapidly, attracting institutional money, and led many non-banks to take out debt with traditional banks to leverage their investments. The links between the private credit firms and investment banks – and the potential for a industry-wide crash to permeate into other corners of finance and the wider economy – will be a key element of the stress test.
The exercise will consist of two rounds, officials said, testing “system-wide interactions and amplification effects, while also probing “key sensitivities”. It will mostly be carried out next year, with initial findings released in 2026, and a final report published in 2027.