A rush of AI-related credit fears, fund outflows and the biggest known bank writedown linked to a private credit financing trade have thrust a once-obscure corner of Wall Street into the spotlight: the leverage banks provide to private credit funds.
The risk that the multi-trillion US dollar private credit industry poses to the wider financial system has also prompted dire warnings from global regulators – warnings that took on a greater urgency when HSBC disclosed on Tuesday it had written down US$400m relating to a private credit-linked financing deal.
Bankers say behind the scenes they are reviewing their private credit exposures and tightening lending standards. But they are adamant that fears are largely overblown considering the robust protections they say they’ve embedded into the structures and legal fine print underpinning financing arrangements.
Overall, the message is clear: this isn’t a re-run of the global financial crisis, despite the scary headlines.
“One of the root causes of any credit market writedown is lax underwriting standards. If the due diligence process gets short-circuited, the quality of your lending decisions starts getting degraded. That’s what happened during the global financial crisis,” said Rig Karkhanis, head of global markets at Nomura.
“While there are some liquidity challenges in certain parts of the market, these are not the issues that typically create systemic problems. We may see idiosyncratic incidents but, in general, due diligence across the market appears to be stronger.”
Financial rewiring
Private credit’s relentless advance has triggered a historic rewiring of the financial system. Private investors directly finance everything from data centres to aircraft leases to mid-sized companies. That has seen credit assets under management of the five largest private credit managers more than double between 2020 and 2025 to US$2trn, according to S&P.
But while private credit is often portrayed as a competitor to banks, in practice the two worlds are closely intertwined. That is because many funds use back leverage – where they borrow money secured against their assets – to increase the return profile of their loan books.
Banks have been happy to oblige, helping fuel a rapid growth in their fixed income financing businesses in recent years. Data from the Financial Stability Board show banks have extended US$220bn of loans to private credit funds engaging in direct corporate lending, while commercial estimates put the figure closer to US$500bn.
This is a direct result of post-crisis regulations that penalised banks for lending to riskier companies or holding large, concentrated investments. By contrast, providing senior financing against a portfolio of assets – such as private credit loans – remains an attractive business when weighing the risks against the rewards, bankers say.
Mitali Sohoni has run Citigroup’s financing business since 2004 and has seen how it works through multiple credit cycles. “It’s grown rapidly over the past five to seven years with a greater focus on private credit, but we’ve stuck to clients that have access to deep, institutional long-term capital,” said Sohoni, who also heads North America markets at the bank.
“These financings are also backed by diversified pools of credits so they can withstand stress in some industries,” she said.
Raising questions
Lately, worries about private credit have centred on the hundreds of billions of dollars of loans that private credit funds have made to software firms and other companies that look vulnerable to AI disruption. Analysts say software accounts for around a quarter of private credit corporate loans. Concerns over a potential surge in defaults has spooked retail investors into pulling money out of private credit funds this year, prompting some to limit withdrawals.
These unsettling events have raised questions over banks’ exposure to private credit. The FSB published a report on Wednesday warning these interlinkages could pose a risk to financial stability. The day before, HSBC reported a US$400m charge relating to a secondary exposure to what it called an “idiosyncratic fraud”.
However, financing specialists note important differences between HSBC’s hit from an alleged fraud involving an asset-based financing and the scrutiny over banks’ exposures to private corporate loans. Company fraud is the usual culprit for losses from asset-based financings, financing specialists say, while the main risk for corporate loan portfolios is a widespread increase in defaults.
During earnings season, bank executives were quick to downplay concerns over exposures to private corporate debt, with several noting they hadn’t suffered any losses in their financings of these portfolios.
“I don’t think it’s systemic,” said Jamie Dimon, chief executive of JP Morgan, which reported the largest bank exposure of US$50bn.
The scale of financial resources available to most private credit funds is a reassuring factor for banks. While headlines have focused on the retail flight, institutional investors account for the vast majority – around 85% – of the industry’s assets, providing a more stable capital base.
Senior bankers also say the protections they’ve wired into financing arrangements will prove resilient. They include the seniority of bank claims, the diversity of underlying portfolios held as collateral – which are typically scrutinised by dedicated bank underwriting teams – the ability to call for more margin if credit fundamentals sour and keeping a lid on leverage.
“We only provide financing on assets that we understand and that we can underwrite and risk manage very well on an ongoing basis,” said Sohoni.
Diversity matters
Wells Fargo, which disclosed the second-largest exposure to private corporate credit at US$36bn, said 98% of the underlying assets used as collateral were senior first-lien loans across more than 3,100 borrowers. That collateral showed a 17% exposure to software and 19% exposure to business services – two of the most AI-vulnerable industries. The rest comprised a range of sectors such as healthcare, financials and food and beverage.
Overall, the portfolios backing its financing facilities could on average absorb a 40% loss before Wells takes a hit. That appears in line with industry standards. Bankers say advance rates – the maximum private credit funds can borrow in these facilities – are typically 60%– 70% of the value of the underlying collateral.
“We’re comfortable with our exposures,” said Michael Santomassimo, Wells Fargo’s finance chief.
The bank highlighted another common practice: insisting on re-margining rights on nearly all the collateral it holds. JP Morgan has already used similar provisions to re-mark collateral.
“Public markets are telling us that there are certain pockets of software that you should be worried about, and we are certainly focused on that in our own exposures,” Jake Pollack, who runs global credit financing at JP Morgan, said in an April podcast. “JP Morgan has always had marking rights. We mark on the basis of the performance of the collateral, and we also adjust marks based on spreads in the market.”
Higher standard
Despite the belief in their defences, bankers admit privately that the selloff in AI-vulnerable companies has changed the financing landscape. As well as increasing the cost of new facilities, it has prompted some firms to tighten underwriting standards.
“Underwriting of credit will continue to be more challenging than ever because we have a lot more unknowns in the world of AI and how it will impact various businesses,” said the head of financing at a major investment bank.
“There is no doubt that our trade underwriting approach will be different and will be tighter than what it was pre-AI. AI has redefined how various industries are going to operate. So we will have a different standard and a higher standard,” he said.
Nevertheless, this should be a “healthy reset for the market”, Sohoni said. “Private credit origination could slow some, which means spreads will widen on the underlying collateral and for the financing deals as well. In general, that means capital structures will get better for everybody.”
