Private Credit Surge Raises Concerns Over Financial Stability Risks

Private credit has rapidly evolved into a significant sector within global finance, amassing a staggering $1.7 trillion in assets. Once primarily focused on middle-market borrowers, the private credit industry has expanded its footprint and is now a crucial player in financing private equity transactions, asset-based finance, and retail investor portfolios. However, this swift growth has prompted warnings from industry experts and analysts about its potential to contribute to systemic financial risk.

According to a report by Moody's Analytics released in July 2025, the increasing interconnectedness between private credit funds and other financial institutions could act as a catalyst for financial instability. The report indicates that heightened correlations and network connectivity among institutions during market stress can amplify shocks, echoing concerns about the opacity of private credit markets. 'The same linkages that facilitate risk-sharing in calm conditions can become conduits for contagion under strain,' the report states.

Shihan Abeyguna, Southeast Asia managing director at Morningstar, highlights that the private debt sector currently holds $566.8 billion in funds awaiting deployment, marking a historic level of 'dry powder.' He emphasizes the pressure on fund managers to lend quickly to generate fees, potentially leading to relaxed underwriting standards and a higher risk of default. 'If this becomes reality, then managers may find themselves lowering lending standards in a bid to lend more money, which leads to a higher default risk,' Abeyguna warned.

Serene Chen, head of credit, currency, and emerging markets sales at JPMorgan, concurs, noting that the influx of capital into private credit could result in more lenient underwriting practices. However, she also points out that these trends have not yet materialized.

Another area of concern is the rising prevalence of paid-in-kind (PIK) loans, which allow borrowers to defer cash interest payments by accruing additional debt. David Forgash, managing director and portfolio manager at PIMCO, cautions that this practice can lead to a hidden accumulation of debt. 'What’s taking shape is there’s a lot of PIK loans that go into private direct lending,' Forgash explained. 'In the event of a recession, private credit will be one of the shoes to drop, given how recessions are bad news for any companies that rely on borrowed money, especially those with a lot of debt.'

Conversely, some experts maintain a more optimistic outlook. Michael Ostro, head of private markets in Asia at Union Bancaire Privee, argues that the direct exposure of banks to private credit is limited, as most lending occurs within robust capital structures with substantial equity cushions. 'This means that even if something goes awry with the businesses that Business Development Companies lend to, the businesses will have to lose over 50% to 60% of their value before BDCs start taking losses,' Ostro noted.

Suvir Varma, an advisory partner at Bain & Company, believes fears of contagion are overstated, citing lessons learned from the global financial crisis (GFC) that have led to more disciplined underwriting practices. 'Private credit managers typically hold the risk themselves rather than slicing and distributing it across the market like CLOs used to do,' Varma stated.

Historically, systems characterized by extensive interconnections have demonstrated vulnerability during crises. Nevertheless, Ludovic Phalippou, a professor of Financial Economics at Saïd Business School, University of Oxford, suggests that the current financial ecosystem is not significantly more fragile than it was prior to the 2008 crisis. 'While there’s potential for fragility, the current financial ecosystem is not comparatively more fragile than before 2008,' Phalippou remarked.

However, he warns against complacency, suggesting that the belief that private credit is insulated from classic bank runs is overly simplistic. 'The pressure points are different: investor defaults, margin calls, and asset revaluations could create a new type of issues,' he explained. 'This isn’t a house of cards, but it smells like one, and definitely a house with a lot of mezzanine floors and a very expensive elevator.'

In conclusion, while the rapid rise of private credit presents opportunities for growth and innovation in financing, it also raises critical questions about the stability of the financial system. The interplay between increased lending, relaxed underwriting standards, and intricate financial networks warrants careful monitoring as the potential for systemic risk looms large in this burgeoning sector.