Locus of Contagion Has Shifted to Private Credit Markets, Study Finds

In Brief:

A team of leading economists from Moody's Analytics, the SEC, and Harvard Kennedy School has released groundbreaking research revealing that private credit markets have evolved into a significant systemic risk to the financial system. The $2 trillion industry, which has grown rapidly since the 2008 financial crisis, now rivals high-yield bond and leveraged loan markets in size while operating with far less transparency and regulation. Using advanced network analysis and principal component modeling, the researchers found that private credit funds have become increasingly interconnected with traditional banks and other financial institutions, creating new pathways for contagion during market stress. Their analysis shows the financial system's risk network has shifted from a bank-centered "hub and spoke" model to a more distributed but denser web of connections, with private credit playing a central role that could amplify future crises.

Big Picture Drivers:

• Post-Crisis Evolution: Banking reforms after 2008 pushed credit risk into less regulated nonbank institutions, fundamentally changing how systemic risk flows through the financial system

• Rapid Growth: Private credit assets have surged to over $2 trillion globally, with three-quarters concentrated in the U.S., matching the scale of public high-yield markets

• Increased Interconnectedness: Private credit funds now share investors, funding sources, and borrowers with traditional banks, creating multiple transmission channels for financial stress

• Regulatory Gaps: The industry operates largely outside traditional oversight, with limited transparency about holdings, leverage, and true risk exposures across the system

Key Trends to Watch:

• Network Evolution: The financial system has transformed from bank-dominated networks to more distributed but densely connected webs involving multiple types of institutions

• Hidden Leverage: Multiple layers of borrowing exist across fund level, portfolio company level, and investor level, creating systemwide leverage that exceeds apparent levels

• Liquidity Innovation: Private credit funds are experimenting with semi-liquid structures offering periodic redemptions while holding illiquid assets

• Regulatory Response: Policymakers are beginning to scrutinize the sector's rapid growth and potential systemic implications

• Market Expansion: Private credit is moving beyond traditional middle-market lending into asset-backed finance, infrastructure, and real estate

• Retail Participation: The industry is increasingly targeting individual investors through new fund structures and distribution channels

• CLO Growth: Private credit CLO issuance has exceeded $100 billion, creating additional layers of complexity and interconnection

Key Insights:

• Risk Migration: While post-crisis reforms successfully reduced bank centrality in systemic risk networks, they inadvertently shifted risk to less transparent and more interconnected nonbank channels that are harder to monitor and regulate.

• Contagion Amplification: The research demonstrates that business development companies (BDCs) serving as proxies for private credit showed dramatically increased network connectivity during the COVID-19 crisis compared to the 2008 financial crisis, indicating growing systemic importance.

• Liquidity Mismatches: Some private credit funds are experimenting with semi-liquid structures that offer investors periodic redemptions while holding illiquid assets, creating structural vulnerabilities similar to those that caused problems in previous crises.

• Opacity Premium: The lack of real-time pricing and standardized disclosure in private credit markets means that problems can fester unrecognized until they reach crisis proportions, potentially delaying policy responses.

• Interconnected Vulnerabilities: Banks maintain indirect exposure to private credit through credit lines, structured risk transfers, and shared borrowers, meaning bank stress tests may underestimate true systemic risks.

• Network Density: The current financial system exhibits higher overall interconnectedness than before 2008, with the same linkages that facilitate risk-sharing in calm periods becoming conduits for contagion during stress.

Memorable Quotes:

• "Private credit, once a niche asset class, has grown in systemic importance as it takes on a larger role in corporate finance and develops linkages across the financial system while remaining less transparent, less liquid, and more reliant on structures that make its risks more difficult to evaluate than those of other types of credit intermediaries." - Research authors, establishing the central thesis of systemic risk concerns

• "Today's network of interconnections in the financial system is more distributed, with a denser web of connections than it had pre-crisis, when the system operated more like a 'hub and spoke' model with banks at the center of the network and nonbanks at the periphery." - Research authors, describing the fundamental structural change in financial system architecture

• "While a more distributed network of financial institutions may enhance efficiency and capital allocation in normal times, the increased number of connections can act as a shock amplifier during periods of market stress." - Research authors, explaining the double-edged nature of increased interconnectedness

• "The same linkages that facilitate risk-sharing in calm conditions can become conduits for contagion under strain, especially when involving more opaque segments of the network—such as private credit—where risks are harder to monitor." - Research authors, warning about the contagion potential of opaque market segments

• "Regulators and central banks should thus consider expanding the regulatory perimeter to include significant private credit funds and to monitor risk concentrations, including leverage and liquidity mismatches." - Research authors, providing their primary policy recommendation for addressing identified risks

The Wrap:

This research represents the first comprehensive academic analysis of private credit's systemic implications, providing quantitative evidence that the rapid growth of alternative lending has fundamentally altered how financial crises could unfold. The findings suggest that while post-crisis banking reforms successfully made the traditional banking system more resilient, they may have inadvertently created new systemic vulnerabilities in less regulated corners of the financial system. The authors' call for expanded oversight and transparency requirements comes at a critical time, as private credit continues expanding into new markets and asset classes while maintaining the opacity that could mask building risks. Their work provides a roadmap for policymakers seeking to address these emerging threats without stifling the legitimate benefits that private credit provides to corporate borrowers and institutional investors.