Rewiring The Financing Machine

Executive Summary

The corporate credit ecosystem is undergoing a major evolution, bringing both significant benefits and risks. Most analyses focus on important individual components of this transformation, such as the rise of private credit funds. However, a sound understanding of how risk allocations are being restructured requires a broad and integrated view of the market. We provide a framework for understanding evolving business models and assessing both the benefits and potential problems arising from this rewiring. This holistic view is necessary for financial institutions and policymakers to foster sustainable growth.

Nonbanks like private capital firms and hedge funds are taking market share from banks. They have become significant players in credit origination and distribution through direct lending, as well as the issuance of structured products like collateralized loan obligations. They have expanded liquidity via exchange-traded funds and cross-asset hedge fund strategies. This evolution is improving credit availability as it expands options for investors and borrowers while reducing certain types of risks. For example, liquidity transformations are reduced when “permanent capital” sourced from insurers and pension funds can be deployed against long-term assets. We focus on the United States, which has the largest and most developed nonbank sector, but the trend toward increasing credit expansion outside the regulated banking sector is happening globally.

These changes must be considered holistically as they share a common underlying exposure — corporate credit. Different products vary in their liquidity and risk profiles, but innovation and competition are blurring the lines between products, complicating risk assessments and comparisons. Banks and various types of nonbanks are ever more interdependent, while nonbanks are becoming increasingly concentrated and diversified.

Growth is at the top of the agenda for banks and nonbanks; corporate credit can help fuel this growth. Demand for this broad universe of fixed-income products is expected to expand as an aging population raises allocations to investments that promise steadier returns. Alternative asset managers are betting on increased demand from a wide range of investors, but private wealth and retail clients are likely to have a higher liquidity preference than long-term investors such as insurance companies and pension funds. Meanwhile, recession risk means the supply of investable opportunities may not keep up with demand. If demand from investors outstrips supply, competition could lead to a lowering of standards and greater use of opaque structures.

We recommend focusing on five key questions to balance the benefits and risks of this market evolution. First, what short-term liquidity promises are being made? If products targeting private wealth and retail investors introduce more short-term promises, then the benefits from reduced liquidity transformations may be reverted. Alternative asset managers have begun to expand their offerings of liquid credit instruments. A trend currently at the fringes but worth watching is nonbanks providing credit lines and contingent funding to corporates.

Next, how are financial chains evolving and are they becoming more leveraged? Today’s securitized products don’t exhibit the kind of excessive leverage that helped trigger the 2008-2009 global financial crisis, but that has been driven by market practice, not regulation. Funds use various strategies to increase leverage, and the amount of financing they obtain has recently grown. These multiple layers of exposure, along with a lack of transparency, make it difficult to accurately assess the associated risks.

Additionally, how large are exposures to corporate credit and nonbanks? Given the wide variety of increasingly interconnected products, all avenues of exposure need to be considered comprehensively. Banks may have lost market share in corporate credit, but they are major lenders to nonbanks and are the primary providers of contingent funding for both nonbanks and corporates. Insurers and pension funds are key investors in closed-end private credit funds.

Next, will novel high-quality assets perform in a crisis? Higher quality assets, desirable for regulated financial entities, are often created through securitization, as is the case for collateralized loan obligations. Increasingly, they are also being achieved by using legal structures to make more senior or stronger claims on corporate assets. Some of these structures are untested and could lead to more credit risk than expected.

Finally, how might a crisis play out, and what entities will have the capacity and risk appetite to become buyers in a crisis? Nonbanks have become more critical for market liquidity, but they lack the support channels from central banks that banks enjoy. There are also questions about whether banks or nonbanks have greater incentives and means to provide credit support to firms in a prolonged crisis.

The hard-learned lessons of the global financial crisis must not be forgotten. Asset managers must meet the demand for credit products by building the capacity to analyze and manage risk in preparation for the next credit cycle. Regulated institutions, in particular, have been fueling and benefiting from the growth in corporate credit — but if they are not careful of the potential buildup of systemic risk, they could be stuck holding the bag. Adapting regulation and supervision will take time. In the meantime, it is critical that executives and investors proactively enforce market discipline. They should demand transparency into funds and leverage and conduct more stress testing that allows mapping out of risks.

Policymakers should recognize that alternative asset managers play multiple roles in relation to other nonbanks, as fiduciaries, competitors, and owners. With efforts already underway to close data gaps to have greater visibility and oversight into these changes, policymakers must be forward-looking about potential interconnections, especially with the possible expansion of products into less sophisticated investor bases. Further, financial stability is not the only concern, as these changes to market structure also have implications for monetary policy, market integrity, and distributional concerns around access to credit and to investment opportunities. In the best case, nonbanks can support credit expansion with greater efficiency and safer risk distribution. 

A System Rewired

United States corporate credit markets have expanded significantly, growing 75% to $11.2 trillion in the last decade. The rapid rise of private credit — financing to corporates provided by alternative asset managers — has garnered headlines and policy attention within credit markets, but it is not the only growth story. Leveraged loans, which are loans to companies with a large amount of debt or poor credit histories, have been around since the 1980s and have had a recent resurgence, nearly doubling since 2013. These two segments provide nearly 20% of corporate credit. Meanwhile, corporate bond volumes have continued to grow as they are increasingly packed into ETFs and traded electronically.

These changes rely on alternative asset managers increasingly taking on roles previously dominated by banks. In corporate bond markets, hedge funds play a growing role in market liquidity through more active trading and market-making. Further, private capital firms are both originating and structuring credit. For instance, specialized funds purchase syndicated term loans from banks, securitize them, and sell debt and equity tranches mainly to institutional nonbank investors through collateralized loan obligations (CLOs). Private credit funds go one step further and originate loans directly, a form of bilateral lending that is commonly referred to as “direct lending.”

This rewiring has created a more diverse and interconnected landscape for companies and investors. Well-functioning corporate credit markets are critical for businesses to invest in growth and innovation and for investors who need safe, steady streams of cash flows with quantifiable risk. Understanding the drivers and connections within corporate credit is vital to mapping its impact on the economy.

Drivers of change

A combination of factors is driving this rewiring. Banks have de-risked in response to regulation and their own lessons learned from the 2008-2009 global financial crisis (GFC), creating a gap, particularly in the riskier parts of the market. Banking regulations adopted following the crisis, such as revised Basel Committee standards, increased bank capital requirements and liquidity ratios, constraining banks ability to make new loans. In the US, the Volcker Rule restricted banks from engaging in proprietary trading, which, along with increased capital requirements, decreased banks’ ability to make markets. Likewise, capital requirements made managing CLO funds uneconomical to banks, while the Volcker Rule imposed limits on underlying investments made by CLO funds if they were to be held by banks — limits partially loosened under regulatory guidance in 2020.

Additionally, the roughly decade-long period of extraordinarily low interest rates and ample liquidity meant that funding advantages that banks get from deposits were a less significant source of competitive advantage relative to nonbank originators.

Investor demand for different types of corporate credit has only grown. The period of low interest rates led to a search for yield, and the COVID-19 stimulus added further liquidity to markets. As fewer firms are issuing publicly traded debt and those that do are going public larger and later, exposure to middle markets has become a more important source of diversification for investors. Meanwhile, institutions like banks and insurers that must satisfy regulatory requirements have a strong demand for investment-grade assets. Investors have also become more willing to hold illiquid instruments in the private market for their relatively high yield spreads because growing electronic trading has reduced spreads in the public bond market.

Nonbanks have developed competitive advantages beyond simply taking space vacated by banks. Nonbanks benefited from post-GFC talent migration away from banks, while access to growing amounts of real-time information has helped level the playing field between banks and nonbanks. Visibility into post-trade data increased transparency of prices and market data, and a wide variety of data brokers also increase the available information on firms.

While equities have long enjoyed robust trading in public markets, corporate bonds have only recently enjoyed newfound liquidity. Hedge fund bond holdings have been on the rise, as technology improvements have enabled the deployment of multi-asset strategies and portfolio trading, creating new high-yielding opportunities in public markets. Corporate bond exchange-traded funds (ETFs) have also grown significantly, fivefold in the last decade. This allows investors to deploy new strategies because ETFs trade on equity market infrastructure and have more hedging mechanisms available. Broadly, this has tended to reduce yields in public debt markets, leading some investors to search for alternative sources of alpha.

Private capital firms have found that competitive edge in origination. Private credit funds have developed tailored processes that can provide more flexible terms than banks. For example, their deals can combine elements of both debt and equity, and the equity stake can provide an incentive to be more flexible if the borrower runs into trouble. On the funding side, private credit funds have discovered, and fostered, a strong desire by pension funds and insurers to buy longer-term credit instruments that pay above-market rates in return for a loss of liquidity. These funds can also be more agile than banks, providing speed of execution that many borrowers value.

Nonbanks also have found advantages in distribution and securitization. While banks pulled back post-GFC from structured entities, private capital firms and hedge funds saw an opportunity in CLO markets. Private capital firms tap into their relationships with institutional investors to market and distribute CLO tranches. These assets combine higher yield and lower default rates compared to corporate bonds, as CLOs have less exposure to very low-rated firms, a focus on securitizing only senior debt, and the ability to defer interest payments on junior tranches. Meanwhile, the underlying instrument for many CLOs, leveraged loans, trade over the counter among institutional investors. As a result, hedge funds have significantly increased their exposure to leveraged lending since 2013, boosting their share of outstanding leveraged loans from an estimated 15% to nearly 25% by 2023.

Evolving landscape for investors

As nonbanks strive to meet the demand for corporate credit, a diverse landscape of investment opportunities has developed, spanning a wide range of credit quality, liquidity, and strategies. While most high-yield bonds are unsecured, both leveraged loans and private credit direct lending are typically secured against the borrower’s assets. Private credit has facilitated direct investor exposure to the middle market while offering a product with tighter covenants relative to bonds and leveraged loans. These funds are closed-ended, with shares that are not easily tradable. The resulting “illiquidity premium” is part of what provides higher yields than leveraged loans or high-yield bonds. Leveraged loans provide less premium over high-yield bonds than private credit. Still, with the increasingly popular CLO structures, investors can increase their returns on leveraged loans if they are willing to buy lower-rated tranches.

Large institutional investors, particularly insurers and pension funds, are adapting to the diverse financial landscape through various strategies, from increasing direct holdings to allocating more funds to alternative asset managers. The relationship between private capital and insurance firms, in particular, has grown increasingly intertwined. Some private capital firms have even purchased insurers outright, a move that serves dual purposes: It grants private capital firms access to insurer balance sheets while providing insurers with long-term assets to match their liabilities.

The largest asset managers are expanding their reach as they diversify the strategies they offer to end investors. Over the past several years, traditional asset managers have been acquiring alternative asset managers and vice versa, giving rise to a new label for these firms: diversified asset managers. It is not uncommon to see a combination of mutual funds, hedge funds, private capital funds, and other retail products offered by the same firm. Bringing this massive breadth of investing options under one firm is convenient for investors, but it also contributes to concentration, as the 20 largest US asset managers control over 40% of the country’s assets under management (AUM).

The rapid growth of bond ETFs and business development companies (BDCs) — closed-end funds investing in private debt that are often publicly listed — indicates growing interest in expanded corporate credit options from retail investors, even if they can’t access the same range as large institutions. Bond ETFs have grown fivefold in the last decade, reaching $750 billion at the end of 2022. Similarly, publicly traded BDCs have nearly tripled in the past decade, reaching almost $150 billion at the end of 2023. While mutual funds still hold a larger share of the bond market and are double the size of bond ETFs, their share has declined as investors move to alternatives.

Evolving landscape for companies

Companies are also benefiting from these more diversified funding sources and terms. Nonbank originators have supported companies with business models less likely to receive bank financing, such as those with high levels of debt but large operating margins in IT and life sciences. While spreads are higher for private credit, there are advantages in speed of execution and flexibility of terms. These advantages are available not only at the outset of a private credit deal, which tends to close much faster than a bank loan, but throughout the loan life cycle. Private credit lenders have flexible mandates that allow them to extend maturities, provide additional equity capital, or renegotiate terms as needed. However, not all companies have benefited from expanded financing options, especially as most private credit deals are with private-equity-sponsored corporates.

Direct lending may also improve the alignment of financial incentives between originators and investors. In contrast to the originate-to-distribute model of commercial banking, in which lenders make loans to later sell them, private credit firms have developed an “originate-to-suit” model. Originate-to-distribute has been criticized, as originators may have fewer incentives to screen and monitor borrowers because they pass credit risk onto investors. By contrast, in the originate-to-suit model, asset managers are also responsible for ensuring the investor’s suitability for the asset. Private credit funds also tend to maintain a closer relationship with their borrowers (for example, seeking board representation) and can more easily refinance or negotiate to avoid defaults. Diversity in debt holder composition has helped companies increase their resiliency to credit shocks in public bond markets, and these additional options could further enhance flexibility.

Shocks And Grounding

The rewiring of corporate credit through the growing role of nonbank institutions like private capital firms and hedge funds has introduced benefits beyond the expanded options for investors and firms discussed above. These changes remove some credit risk from the banking system and decrease risks associated with banks funding long-term loans with short-term deposits. However, this does not mean a “debanking,” as banks continue to play a crucial role in this evolving landscape.

Despite these improvements, new channels for crisis can emerge. Risk distribution improvements depend on the assumption that risk can be assessed and appropriately managed, which becomes more challenging as products proliferate based on a common underlying exposure — corporate credit. Market participants and policymakers need to be on the lookout for a reemergence of pre-GFC dynamics, in which interconnections across the system produce chains that may obscure risk rather than reduce it.

Improvements in risk distribution

Perspectives differ on whether financial risk can genuinely be reduced or merely shifted and redistributed to institutions and balance sheets better able to manage it. Innovations in corporate credit are, at a minimum, supporting risk distribution, reducing reliance on liquidity transformations through better matching of borrower and investor needs.

For example, direct lending facilitates better maturity and liquidity matching for borrowers and lenders. Alternative asset managers are increasingly selling debt to investors that may be willing to hold it to maturity, like insurers and pension funds. These arrangements reduce the mismatches that have triggered past crises, such as when banks fund long-term loans or bond holdings with short-term deposits. Insurers and pension fund investors can also reduce their “reverse maturity transformation,” as these longer-dated assets better align with their commitments. Alternative asset managers refer to this approach as tapping a permanent source of capital. Unlike bank deposits, this funding is either not subject to run risk from end investors or has structural impediments to runs. These shifts also come with their own challenges for these large stewards of capital. The lack of price discovery and supervisory pressure to monitor asset performance, paired with the opacity of borrowing firms, make valuation more difficult.

Securitized products allow investors to target specific risk exposures and manage concentrations across industries, geographies, and loan types. In corporate credit, CLOs have become the dominant structured product. Unlike collateralized debt obligations (CDOs), which played a pivotal role in the global financial crisis, CLOs fared well in the crisis, and there are those who argue they are even more robust today thanks to better capitalization and stronger collateral. CLOs are backed directly by diversified corporate loans, not other structured products, avoiding the “leverage on leverage” pitfall that plagued CDOs. Most CLOs have limited their collateral purely to leveraged loans, given that banks — the largest buyers of senior tranches — face restrictions on the types of CLOs they can buy. Yet while CLOs have thus far avoided the mistakes of CDOs, market discipline, not regulation, has held CLOs to a higher standard. Supply and demand for credit exposure will determine how these lightly regulated products continue to evolve.

Banks now have many opportunities to selectively de-risk. Selling leveraged loans to nonbanks and buying back the highest-rated CLO tranches is just one way banks optimize returns while reducing risk. Providing financing to nonbank lenders can also be less risky than investing directly in a portfolio of loans, especially if the nonbank is well-capitalized and the financing is more senior. This is equivalent to “tranching” — if the banks held the underlying loans, they would get the whole exposure, including first losses. Synthetic risk transfers, where banks essentially pay nonbanks for insurance to cover loan losses, are another growing trend to help banks reduce risk-weighted assets. On the other hand, transferring risk outside the regulated banking system makes it more challenging for regulators to detect the accumulation of systemic risk.

Specialization in risk-taking can itself support market liquidity. The willingness to trade in times of crisis and uncertainty depends not only on balance sheet capacity but also risk appetite. During the March 2020 COVID-19 crisis, bond markets experienced significant turmoil and reduced liquidity. Open-ended fixed-income funds faced significant selling pressures, and dealers did not expand their market-making in response, citing challenges in managing internal risk appetite and balance sheet limits given the extreme uncertainty of the time. Likewise, pension funds and insurers, typically considered to be end investors, did not act countercyclically to buy cheap assets due to their own temporarily lowered risk appetite. Risk-taking nonbanks entered the market, including distressed debt funds that atypically bought longer-duration investment-grade bonds. Hedge funds also increased their bond positions, and dealers with stronger relationships with hedge funds were more likely to continue market intermediation. This ability to support market liquidity requires, however, that these nonbanks are not themselves the focal point of crisis.

As a critical complement, this increased risk-taking is using less liquidity transformation. While open-ended fund structures are immensely popular among mutual funds, credit fund managers tend to utilize closed-end fund structures. Hedge funds are increasingly employing longer lock-up periods, with about 45% of net asset value (NAV) having a more than one-year lock-up and only 5% being redeemable in a day. In cases where liquidity transformation is the business model, recent innovations may present some advantages. Corporate bond ETFs, unlike equity ETFs, sample their benchmarks instead of replicating them precisely. Trading over equity infrastructure on a portfolio basis changes the economics of market making, and the ease by which trades can be hedged opens ETF markets to different sets of participants. During the COVID-19 turmoil in March 2020, bond ETFs continued to trade (albeit at widened bid-ask spreads) while many of the underlying bonds essentially stopped trading. However, it is important to note that most investment funds are still open-ended, including money market funds, which saw significant runs in the 2008 crisis.

Continued importance of banks

The evolution of risk redistribution outside of traditional banking does not diminish the importance of banks. Instead, it is reshaping their business models. Properly priced, banks can make solid profits serving nonbanks in various ways, as evidenced by the competition to work with them.

Bank funding is critical to most nonbanks and goes beyond just corporate credit. Banks play a central role in many phases of private capital transactions through the provision of finance, even coordinating and participating in the origination of loans. In the United States, global systemically important banks (G-SIBs) provide nearly 90% of lending to hedge funds, with hedge fund borrowing more than doubling in the last decade. Other major nonbanks that rely heavily on bank funding include special purpose vehicles, finance companies, and broker-dealers. While the true extent of bank-nonbank interconnections is challenging to assess, banks are undoubtedly still vital players.

In many ways banks have benefited from the expansion of nonbanks into corporate credit. In CLO markets, banks earn fee income from selling the underlying loans and buy back the higher rated tranches while avoiding the riskier equity. The rise of NAV loans and subscription finance to private capital has provided a revenue source for banks beyond the traditional leveraged buyout (LBO) financing popular with private equity firms. With hedge funds expanding their activities in credit markets, especially through multi-asset strategies, the opportunity in prime services is set to grow.

Potential channels for crisis

The function of the financial system is to match those with funds to invest with those who have good uses for funds. This matching process is complex, as many of those with money also want to preserve access to their funds and not have them locked up. Different financial transformations help address this: Maturity transformations allow short-term funds to be invested into longer-term assets, allowing investors to withdraw their funds or roll over the debt. Liquidity transformations provide the promise of immediately available money at a pre-specified price. Finally, credit transformation utilizes the fact that investors have different risk preferences by issuing claims with various risk/return profiles (for example, senior secured debt, junior unsecured debt, and equity).

This matching process is inherently risky because it must contend with two key challenges: (1) increasing the supply of money and assets to fuel productive economic activity and (2)contending with moments of crisis, when market participants all want access to their funds at once in some trusted form of money. These two challenges require a delicate balance, as financial activity in good times gives rise to chains of finance that produce high-quality assets thought of as “money substitutes” — that is, they are believed to have a stable value, but may come into question in bad times. This is one of the main reasons central banks are liquidity providers of last resort: The demand for money peaks in a crisis. If the financial system were always to safeguard liquidity for the very worst event, it would have too much liquidity locked up during regular times and would underinvest in the economy.

This is why banks hold a special place in the financial system, constrained and protected by a massive apparatus of regulation and supervision. Deposits are themselves one side of maturity, liquidity, and credit transformations. Banks issue deposits and expand available liquidity for economic activity, with deposits treated as having stable value given policy tools such as deposit insurance and the expectation of central bank support. But banks are constrained in issuing deposits by a combination of business judgement and regulatory requirements.

While nonbanks will perform only one or two financial transformations, they can come together in a chain of connections to produce money substitutes. The global financial crisis imparted critical lessons on how systemic crisis can unfold: Obscure channels of financial transformations produce a variety of assets billed as high quality. As financial institutions acquire these high-quality assets in place of lower-rated investments, they can free up capital and increase their financing for the nonbanks producing such assets. Exposure to these assets accumulates in excess, building up systemic risk that has not been priced in (or understood). The risk becomes especially concerning as exposures build up for financial institutions that have a short-term critical function, for example, providing contingent funding for other institutions or playing a role as a market maker. Channels that helped fuel the growth of these assets come to a halt during a crisis, and exposed financial institutions cannot execute their critical function, with potential further knock-on effects.

During the financial crisis, subprime mortgages were aggressively originated and bundled into mortgage-backed securities, CDOs, and other instruments, then further bundled into more complex products. This growing universe of securities received inflated ratings from credit agencies due to flawed models that didn’t recognize the buildup of concentrated risk. Exposures accumulated on bank balance sheets, both explicitly and implicitly, through guarantees and credit lines to nonbanks producing these securities. When housing prices declined, and defaults increased, the actual risks of these securities were exposed, leading to a credit freeze, institutional failures, and a global economic crisis. This series of interlinked practices and misaligned incentives ultimately brought the financial system to a halt.

It’s critical to assess the extent to which similar dynamics might recur today, especially as a diversity of products are being originated based on the same systemic exposure to corporate credit. In essence, the collateral base for private money substitutes has expanded significantly from real estate to a wide range of corporate assets. This base is procyclical by nature. Suppose there’s a crisis in the corporate sector. If liquidity chains depend on the corporate sector’s underlying value, that value will collapse when it is most needed to supply funds back into the real economy.

Avoiding Buildups

So far, these innovations in corporate credit do not appear to have created undue risk. Both the Federal Reserve and the International Monetary Fund (IMF) point out that private credit funds specifically do not pose a systemic risk, given that they engage in limited liquidity and maturity transformation with minimal leverage. The risks to lenders, typically institutional investors, are deemed moderate due to these funds’ secured nature and modest borrowings. More broadly, longer-term lock-ups across private credit, hedge funds, and most BDCs, further help mitigate the potential amplification of market stress via forced asset sales during crises.

However, the demand for corporate credit products — and therefore the supply of funding to private credit funds — is expected to rise significantly in coming years, and it’s unclear if available investment opportunities can keep pace. An aging population will likely increase allocations to fixed-income products. Simultaneously, alternative asset managers are targeting a broader investor base, including high-net-worth individuals and potentially retail investors. These newer investors will likely prefer more liquid assets, undoing some of the benefits of reduced liquidity transformations. On the supply side, the macroeconomic outlook is uncertain. A recent Oliver Wyman Forum survey of CEOs found that volatile inflation, high interest rates, and geopolitical instability are among business leaders’ top concerns.

This evolving landscape is intensifying competition among banks and nonbanks and increasing connectivity between once-distinct market segments. Private credit is beginning to target larger deals and firms, while large asset managers are restructuring themselves to expand corporate services. Direct lending is being used to refinance debt originated in syndicated lending markets and vice versa. Banks, facing new regulations under the Basel III endgame proposals, may further limit their activities, creating additional opportunities for nonbanks. On the other hand, banks have a renewed advantage in a high interest rate environment due to ready access to relatively low-cost deposit funding.

We highlight five factors to consider to balance the benefits and risks of this evolution.

Short-term promises

Liquidity challenges are often what lead to a crisis. Interlocking promises of payments frequently become channels of transmission in times of stress, as failures to get paid trigger failures to pay. In this way, sudden liquidity demands can have a domino effect — from runs and interbank lending freezes to margin calls and credit line drawdowns. Shocks can propagate as institutions sell different assets to meet margin calls, stay within risk limits, or provide cash to their creditors, depressing asset valuations. This loop can then impact the real economy as funders respond by tightening lending, exacerbating a downturn. Given these potential risks, it’s crucial to understand the nature and extent of these promises, including who’s making them and to whom.

The conflicting promises to pay made to and by nonbank actors in the corporate credit ecosystem could become sources of volatility in times of stress. Not all nonbanks are equally vulnerable, as the nearer an entity’s structure is to being closed-end the more resilient it tends to be. As explored above, private credit funds with genuinely permanent capital are best positioned to weather storms — but a crisis will test whether that capital is truly permanent. It is critical to keep an eye on how these credit products are being used in the market and their possible interconnections. CLOs, for example, may demonstrate greater resiliency to runs in a downturn because they also do not promise redemptions. However, asset managers may be relying on CLOs for liquidity due to their ability to trade rather than redeem the instruments — which could still lead to falling prices and knock-on effects.

More uncertain liquidity promises originate from retail-oriented investment vehicles like BDCs, interval funds, and ETFs. This fast-growing sector caters to mass-affluent investors seeking both private credit returns and liquidity. BDCs, which mainly offer retail access to private debt, have tripled to over $300 billion since 2018. Interval funds, which allow periodic redemptions ranging from 5% to 25%, have grown 40% annually for a decade and now exceed $80 billion. Beyond existing leveraged loans and CLO ETFs, prominent asset managers are now planning to launch private market ETFs.

Nonbanks are also making liquidity promises to borrowers that could be strained in a downturn. For instance, private credit funds are expanding their offerings to include revolving credit lines that compete directly with banks, and revolving credit now comprises 9.5% of all private credit loans. Further adding to the complexity, private credit and syndicated lending are being offered to cash-strapped firms with terms that include payment in kind (PIK), providing them the ability to roll interest payments into the principal rather than deliver cash. This creates further liquidity management challenges that may reveal themselves only in a downturn.

Nonbanks may be able to meet unexpected outflows with contingent funding from banks, who serve as liquidity providers of first resort and can rely on central bank support in a crisis scenario. US banks have $2 trillion in committed lines to nonbanks, with average utilization rates at about 50%. Banks also play a contingent financing role for companies, that being one of the portions they typically retain in leveraged loan deals. These credit lines normally serve various narrow purposes, such as helping private funds manage capital calls with subscription credit. This type of support may not be available in a crisis.

Financial chains

While nonbanks don’t typically perform all the financial transformations that banks do, bank-like risk can reemerge through financial chains and layers of financial transformations. Structured products involve credit transformation, new vehicles make investments more liquid, and leverage adds maturity transformation, making for a trifecta of financial transformation. Of particular concern is the “layering” of leverage, or “leverage on leverage,” as financial chains become longer and add leverage at different points of interconnections. This can happen, for example, through fund finance, as nonbanks borrow against their assets and LP commitments; through the use of “synthetic leverage,” or creating leverage through the use of off-balance sheet activities like derivatives; or through financing via wholesale money markets. These layers of leverage increase opacity, making it more difficult for investors, regulators, and market participants to identify potential vulnerabilities. Moreover, the expansion of these financial chains makes the system more interconnected, increasing the chances of contagion and spillovers.

While generally less leveraged than banks, nonbanks do use leverage to support returns and generate liquidity for their investors. More broadly, the US Securities and Exchange Commission (SEC) reports that private market funds finance roughly half of their assets with borrowing. But this estimate may be misleading because private fund leverage can sit at various levels, including the underlying investments in the fund, other special purpose vehicles (SPVs), and the private capital firm itself. Notably, CLOs and hybrid fund structures are themselves forms of leverage that utilize SPVs to issue debt in order to finance the purchase of corporate credit assets. This type of leverage is often not included when accounting for private fund borrowings.

Borrowing at the fund level is referred to as “fund finance.” While this private market leverage is more prevalent in private equity, it also exists in private credit. A meaningful fraction of private credit funds make use of subscription lines, which are credit facilities secured by the funds’ capital commitments, a market sized at $750 billion. In private equity, both general partners (GPs) and funds buying stakes from GPs use debt to finance their shares, and there is no reason to believe private credit funds would be different. To the extent that private equity firms load their portfolio companies with debt, the $50 billion to $100 billion dividend recapitalization market can be seen as a form of leverage in the system beyond the substantial debt added through the LBO process itself. Dividend recaps add leverage to firms’ balance sheets to pay back limited partners who invested in the broader private equity fund.

Rating agencies can facilitate leverage by providing standardized credit quality assessments, helping expand the pool of potential investors. Private credit funds and BDCs are also receiving credit ratings that attest to their role as high-quality investments, although the universe of rated entities is still small. While most of this information remains private, multiple rating agencies are issuing ratings to these funds, and public reports suggest that most of these funds are rated as investment grade. Rating agencies have also begun to rate fund finance products — the first one being subscription lines and at least one agency is also rating NAV loans. These ratings allow insurers to reduce capital charges against these loans and make it easier for private credit funds to issue them and for institutional investors to participate as lenders in fund finance. Credit rating assignments by banks are aligned to credit policy standards and are often more stringent than general credit ratings. Further, individual ratings do not reflect the correlation risks that investors will need to manage as they hold these products.

Derivatives are another means for nonbanks to gain leveraged exposure to corporate credit, including through novel methods like synthetic risk transfers (SRTs). Banks seeking to expand lending without raising new capital under Basel III constraints are turning to SRTs to free up balance sheet capacity. The SRT capital structure uses derivatives like credit-default swaps to offload the risk of mezzanine and first-loss tranches primarily to credit funds and other alternative asset managers. Beyond the synthetic leverage already present, market estimates suggest that between 10% and 50% of the $25 billion issued in SRTs in 2023 was financed through borrowing. Another common strategy for private funds is total return swaps, which allow them to gain exposure to a larger notional amount of credit assets than they could purchase outright. The OCC quarterly report on credit derivatives places the TRS market at roughly $200 billion.

However, hedge funds are by far the largest players in the world of derivatives. US hedge funds hold over $15 trillion in aggregate derivative value compared to only $150 billion among private capital funds. Macro and relative value funds have the highest synthetic leverage, but credit-focused funds that trade corporate debt have more than three times their NAV in gross notional derivative exposures. This translates into over $800 billion in credit derivatives among large US hedge funds today, as we also see credit hedge funds becoming the most in-demand strategy in 2024, according to a recent industry survey.

Financing through wholesale money markets appears limited. Corporate bonds in some repo markets are modestly on the rise but remain small relative to other uses. Notably, there’s no indication that top-rated CLOs are being used as collateral for repurchase agreements, obligations to central counterparties, secured borrowing, or as margin for derivative trades. However, if these products continue to expand, such uses could emerge. This would likely increase demand and create more complex financial interconnections.

Lastly, life insurers have been critical providers of leverage to alternative asset managers and are themselves more leveraged than banks. While private credit originally aimed to provide assets that matched the maturity of life insurance liabilities, we see life insurers beginning to use shorter-term funding to finance alternative and other investments. Leverage through nontraditional funding has nearly reached $400 billion, with nearly half being funding-agreement-backed securities (FABS), a deposit-type contract. The total number of FABS has doubled in the last four years, and there is limited publicly available information on who holds these instruments.

Accumulation of exposures

Banks and other critical financial institutions must maintain a holistic view of their exposure to corporate credit, including indirect exposures via nonbanks. As the nonbank sector grows in size and complexity, its interconnections with traditional banking have become a key concern for regulators and policymakers.

While direct exposures through credit lines, securities financing, and derivatives are easier to track, the full extent of banks’ vulnerability to nonbanks remains unclear. This opacity is primarily due to potential indirect exposures arising from common asset holdings — their value in a crisis heavily depends on whether nonbanks engage in fire sales. Further, nonbanks finance their activities from multiple sources, making it difficult for a single bank to see the complete picture. This lack of transparency enabled the widespread contagion of the 2021 meltdown of Archegos, a family office that caused over $10 billion in losses across six major banks. Had banks been more informed about Archegos’ positions and the interconnected exposures among themselves, they likely would have taken steps to mitigate their risk exposure. The challenges in mapping out exposures is further compounded by cross-border connections, with cross-border bank claims on nonbanks totaling $7.5 trillion in 2020. Of particular concern is the high concentration of lending exposure; in 2019, the FDIC found that just four large banks accounted for roughly half of all lending to nonbanks.

Yet banks are not the only critical financial institutions that face growing direct and indirect exposures to corporate credit. Insurers and pension funds are key investors in closed-end private credit funds, accounting for roughly $400 billion of the entire market. In 2021, pension funds were the largest investors in private credit funds, accounting for 31% of aggregate private credit fund assets, while insurers account for 9% of the market.

Insurers — and life insurers in particular — have been unique in their relationship to alternative asset managers as a range of partnership models have emerged. At one extreme, private capital firms have been purchasing life insurers, thereby gaining access to the insurer’s balance sheet while providing the insurer with long-term assets to match their liabilities. This has proved to be a popular approach. The AUM of US life insurers fully or partly acquired by private capital firms is nearly $600 billion, representing about 11% of the US life insurance industry. These PE-owned insurers allocate the same share of their cash and invested assets to investments in alternative assets as other life insurers, but have more than twice the share of holdings in structured products.

High-quality assets

Among the accumulation of exposures, it is essential to track the dynamics of how high-quality assets are produced because they can fuel systemic risk buildup, as explained in the prior section. High-quality assets are in high demand from regulated financial entities, in large part due to regulatory requirements. Available investment-grade assets in financial markets have evolved significantly in recent years, driven by innovations in structured products, changes in credit markets, and the growing influence of alternative asset managers. These assets can be constructed through securitization. What’s novel in the latest market structures is that investment-grade assets are also being produced by ensuring more senior and secured claims on corporate assets, which is akin to securitizing the corporate balance sheet.

Securitization can be a powerful source of improved risk distribution but it has also been prone to misaligned incentives and mispricing of risk in the past. As discussed above, CLOs are the dominant structured product in corporate credit and have, to date, avoided some of the challenges of the past. CLOs have been on the rise and are estimated at $750 billion outstanding, and triple-A rated CLOs have experienced steady growth, as observed in the figure below. However, the total amount outstanding is still far below the market size of over $2.7 trillion reached by non-agency residential mortgage-backed securities during the global financial crisis.

As the structured product market grows, it is important to watch how underlying loans and structures evolve. Recent anecdotal evidence suggests that CLO demand has been outpacing supply. The dramatic rise of covenant-lite loans from 1% in 2000 to over 90% of the US leveraged loan market today suggests that CLOs may rest on a potentially riskier foundation than before. Furthermore, new kinds of CLOs are being structured with private credit loans rather than traditional leveraged loans. These “middle market” CLOs are more opaque because the underlying loans are not publicly rated — although many are assigned “credit estimates” — and they are growing quickly, reaching a market size of over $115 billion by late 2023.

Any novel securitization process warrants a closer look, especially re-securitizations, given their ability to concentrate risk as we saw during the GFC. One instance of this today is collateralized fund obligations, which use an SPV to bundle and securitize shares from various private capital funds. They are now buying stakes in CLOs and other syndicated loans as well. Other novel securitized products include private credit funds securitizing niche loans held in SPVs, and private credit feeder funds, which are separate SPVs attached to a single fund selling securitized LP shares in that parent fund. And while not the same as re-securitization, the emergence of CLO ETFs is another way these products are repackaged and resold with added financial transformations. It’s a tiny market at just over $10 billion, but growing quickly, and provides retail investors easy access to these increasingly complex structured products.

Outside of securitized products, the production of higher quality assets in private markets has been achieved by focusing on capital structures — accessing the senior-most debt of the company — and claims on collateral. This is part of what makes riskier middle market firms suitable for investments by insurers, which require high-quality assets. The reliability of these legal mechanisms is still being tested while further innovation piles on. Super senior structures have emerged (although seemingly rare) where the introduction of new debt creates a newly senior tranche, allowing one lender to surpass the priority of others with existing senior claims. The increased marketization of asset-backed lending is another step in this evolution. These loans offer first-lien claims on a firm’s assets, further distributing competing claims for seniority among investors. Notably, Barclays’ analysis notes that first lien creditors can often lose out to more junior debt holders who employ aggressive restructuring tactics prior to default. Seniority on claims is not always what it seems.

Dynamics in crisis

The dynamics of financial markets during crises are often unpredictable, especially as actors’ roles shift based on their capabilities, incentives, and regulatory constraints. Understanding potential dynamics requires mapping out which entities will have the capacity and risk appetite to become buyers or lenders during a crisis — which also critically depends on these entities themselves not being the focal point of a crisis.

A price collapse in corporate credit products can be exacerbated if market makers cannot continue making markets. Dealers are not ones to catch a falling knife, so they depend on the availability of investors willing to buy in such a market. As discussed in a prior section, the March 2020 bond market turmoil saw open-ended bond funds exacerbating the crisis while hedge funds and distressed asset funds provided support by purchasing discounted assets and corporate bond ETFs improved liquidity through facilitating trading. In private credit, the lack of tradeable markets impedes a potential run and ensures losses are kept with capable end investors. On the other hand, as new interconnection points are introduced, the risk of potential contagion increases.

Dynamics during a recovery could also change. Some believe that firms’ increasing reliance on nonbank lending could deepen a crisis, as nonbanks have historically been more likely to curtail lending relative to banks. This has been driven by nonbanks’ more transactional relationships with firms, which could be changing as alternative asset managers more actively cultivate relationship businesses. However, there is also the risk that nonbanks’ ability to provide support dries up under stress without direct channels for policy support. Further, working through the complex arrangements of debt subordination could lead to prolonged strife among nonbanks.

A Safer Future

Credit provision is crucial for global economic growth. While US firms hold 20% of assets in cash to insure against financing challenges, significant funding gaps persist for long-term projects. As a prime example, the G20 Global Infrastructure Hub projects an $800 billion annual infrastructure financing gap by 2040. The climate transition gap is even more stark — current annual flows of $1.3 trillion fall far short of the projected $9 trillion in annual need by 2030.

Nevertheless, credit expansion must be sustainable. The lessons of the global financial crisis must remain top of mind even if the world before 2008 may seem like the distant past. Asset managers must meet the demand for credit products by building the capacity to analyze and manage risk in preparation for the next credit cycle. Regulated institutions, in particular, have been fueling and benefiting from the growth in corporate credit — but if they are not careful of the potential buildup of systemic risk, they could be stuck holding the bag. Adapting regulation and supervision will take time — in the meantime, it is critical that executives and investors proactively enforce market discipline. They should demand transparency into funds and leverage and conduct more stress testing that allows mapping out of risks.

Policymakers should recognize that alternative asset managers play multiple roles in relation to other nonbanks, as fiduciaries, competitors, and owners. With efforts already underway to close data gaps to have greater visibility and oversight into these changes, policymakers must be forward-looking about potential interconnections, especially with the possible expansion of products into less sophisticated investor bases. Further, financial stability is not the only concern, as these changes to market structure also have implications for monetary policy, market integrity, and distributional concerns around access to investment opportunities. In the best case, nonbanks can support credit expansion with greater efficiency and safer risk distribution.

Acknowledgements

Authors

Larissa de Lima, Douglas J. Elliott, David Folsom

Contributors

Tom Buerkle, Julian Gorski, Michael Moloney, Gokce Ozcan, Dylan Plautz, Kirk Saari, Til Schuermann, Ricardo Stamatis, Michael Wagner, James Wiener, Oliver Wuensch, Joshua Zwick

Art & Design

Nicola Clarke, Ingrid De Leon, Jin Jeon, Sujin Lee, Yireli Pale, Moises Perez, Martin Sombra, Mattias Sundell, Melissa Ureksoy

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