Lending money has been a profitable business for hundreds of years. Lending is often surprisingly uneventful, but when things go wrong, they can go wrong spectacularly. The industry is subject to credit cycles. This is because of the economic cycle, shifts in investor risk appetite, and changes to loan underwriting standards.
The term ‘shadow banking’ is a catch-all term for lending that takes place outside of the regulated banking system. Securitisation grew in the 1980s and 1990s, culminating in the Collateralised Debt Obligations that helped cause the Global Financial Crisis. This was once esoteric finance, but Margot Robbie changed that in the 2015 film ‘The Big Short’ when she explained how it all worked.
Private credit has its roots in the period following the Global Financial Crisis. Balance sheet constraints and tighter regulation saw banks pull back from lending to small and medium businesses. The primary role of financial markets is to intermediate between owners of capital and businesses looking to borrow. So as banks stepped back, the private credit market grew to fill this void.
The Federal Reserve estimates that banks’ share of non-financial corporate business credit has fallen from 22% in 1997 to 13% in 2025. It is important to note that there is nothing inherently wrong with shadow banking.
There are benefits and drawbacks to lending taking place outside the regulated banking system.
According to Morgan Stanley, the size of the private credit market at the start of 2025 was US$3 trillion, compared to about US$2 trillion in 2020. The IMF estimates the total global non-financial corporate debt market at around US$100 trillion; so private credit is perhaps only 3% of the total.
Struggling software exposure
Private credit has recently come under the microscope due to this rapid rise and a number of high-profile bankruptcies. One of the challenges is a lack of data and varying definitions, making private credit opaque. There are two interconnected questions to consider: What is the credit quality of the underlying loans, and what is the structure of the balance sheets of the funds and investors?
The technology and healthcare sectors are well represented in private credit. The software industry accounts for nearly 25% of private lending, and this has been under pressure as AI disrupts the industry. Morgan Stanley expects direct lending default rates to reach 8%, close to peak pandemic levels.
The global economy has held up much better than many expected since 2022. Interest rates have come down in recent years and this combination has kept credit markets relatively healthy. Software defaults are not indicative of the broader economy, although the current energy price shock poses a risk to the economic cycle.
Managing the duration of assets and liabilities is a key objective for many investors, such as pension funds and insurance companies. Many private credit funds offer quarterly redemptions but capped at perhaps 5% of the fund’s value per quarter. The private credit market is not standardised and the structure of loans varies, but direct lending tends to have a four to six-year term, or three to four-year average life. We have already seen some private credit funds limit withdrawals due to redemptions.
There is leverage in the market at different levels. Funds can use leverage, securitisation can add additional leverage, and investors can use leverage. This is all hard to measure, which helps explain why concerns have grown.
For investors with long time horizons, such as endowments, having a private credit fund gate redemption is an inconvenience rather than systemic risk. Goldman Sachs estimates that more than 90% of private credit investment is in institutional structures, which have longer lock-ups than retail funds.
Investors doing ‘dumb things’
There has been a recent focus on the interconnectedness among private credit, banks, insurance companies, and traditional asset managers. Bank lending to non-depository financial institutions has been in focus, but this is such a wide-ranging area. The Federal Reserve estimates that large US banks’ loan commitments to private credit were US$95 billion at the end of 2024, of which US$56 billion was utilised, so relatively modest.
When someone like Jamie Dimon says investors are doing “dumb things” and that there are parallels to the pre-Global Financial Crisis period, one should take notice. Housing and banks are two pillars of the modern economy; the Global Financial Crisi was so damaging because they were the epicentre of risk. However, the banking system is now far better capitalised, and household balance sheets are much healthier.
Things go badly wrong in markets when an asset that is deemed safe turns out not to be. While Collateralised Debt Obligations in 2008 were leveraged 10x, BCA Research notes that leverage in private credit funds is closer to 1.25-1.3x. Private credit typically has an expected return of high single digits or low double digits, so should not be considered a safe asset, but we do not know the motivations and aggregate balance sheet structure of investors. Insurers have been in the spotlight given their liability profiles, so this is something to watch.
It does appear a credit cycle is now unfolding, so caution is warranted, but this is far from the systemic risk we saw back in 2008.
By Nicholas Rilley, CFA, Investment Manager and Strategy Analyst
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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