Rapid growth in private credit has created vulnerabilities

Globally, private credit lending has expanded rapidly and become increasingly connected to the broader financial system. Complex structures, limited transparency and the fact that private credit is untested in a downturn make it difficult to predict how the sector might amplify shocks.

Private credit is lending by non‑banks through privately negotiated loans. Globally, it has helped fill financing gaps for medium‑sized businesses not well served by banks or public markets. It has also increased competition in credit markets. Strong investor demand has allowed private credit to expand into larger loans and a wider set of borrowers.

But limited transparency makes it difficult to see where vulnerabilities are building and how losses could spread. And signs of strain have emerged internationally. For example, the high‑profile bankruptcies of several US firms financed by private credit have raised questions about underwriting standards. Growing links between private credit funds and banks could allow stress in the sector to spread to the broader financial system.

Because private credit is still largely untested in a downturn, these dynamics could amplify shocks in ways that are difficult to predict.

In Canada, private credit lending to businesses remains limited, and exposures of Canadian institutional investors appear manageable. But the potential for spillovers through global markets and financial institutions reinforces the need for continued monitoring.

Complex structures and a lack of transparency make risks hard to assess

When the private credit market was expanding rapidly, funds were under pressure to invest the large amounts of money that were flowing into the asset class. This may have led to lower lending standards than would otherwise be expected.

The quality of underwriting is difficult to assess because private credit is much less transparent than public markets, particularly when investments are made through funds. Information on the underlying loans is often limited, and because these loans do not trade regularly, verifying their actual value can be challenging—especially during periods of stress. This makes it hard for investors and authorities to distinguish isolated credit losses from signs of widespread weakness.

Complex structures can add to these challenges. Private credit loans can lead to a buildup of debt at several levels—the borrower, the fund and the investor. These structures can also link private credit funds to banks and other parts of the financial system in ways that are difficult to trace. This complexity can make it hard to see where risks are growing and how losses could spread if economic conditions were to worsen.

Limited transparency can also amplify market reactions when sentiment shifts. If investors cannot clearly assess where losses are concentrated, they may assume that problems in one segment exist more broadly. This could lead to a more widespread decline in risk appetite, tighter financing conditions and reduced credit availability for businesses that rely on private credit or related debt markets.

Private credit is becoming more connected to the banking sector

Banks provide loans to private credit funds for both liquidity and funding. The most common form is subscription loans, which are secured by the financial strength of a fund’s investors.1 These loans are used by private credit funds to bridge the period between lending and raising capital from investors. In contrast, when a bank’s lending is secured only by underlying loans from private credit funds, the bank’s exposure to risk increases. This is because the bank’s potential gains or losses depend directly on how those underlying loans perform.

Nonetheless, banks are typically protected from losses because funds hold large equity cushions.2 This means fund investors would absorb losses before banks do. Defaults would likely need to be severe before banks are affected. Still, complex structures and limited transparency can make it difficult to assess which banks are most exposed and the extent of their exposures. In periods of stress, markets could penalize banks perceived to have material exposures to the sector even if actual losses remain contained.3

Stress in global private credit could spill over to Canada

Most private lending happens outside Canada, so domestic vulnerabilities are limited. But Canadian institutional investors, such as pension funds and life insurance companies, do engage in a form of private credit by lending directly to businesses in Canada and abroad. Because these direct loans offer a clear line of sight into the businesses and a high degree of control, they are less risky than investments in opaque private credit funds.

In addition, institutional investors have long investment horizons and tend not to rely on short‑term funding. This means they are less likely than other investors to face pressure to sell assets quickly during periods of stress.

More broadly, losses or uncertainty in private credit markets could lead global investors to pull back from related debt markets and exposed financial institutions. This could result in a tightening of global financing conditions. While direct risks to Canada appear manageable, these potential spillovers warrant continued monitoring of the sector.

Endnotes