Regulators Need to Play Catch-Up on Private-Credit Risk, Canada Central Banker Says -- 2nd Update

By Paul Vieira

OTTAWA--Global authorities must step up their surveillance of lending by nonbank players such as hedge funds and institutional investors to minimize risks to financial stability, Bank of Canada Gov. Tiff Macklem said.

Stronger banking regulations introduced following the 2008-09 financial crisis have shifted riskier activities to nonbank participants such as hedge funds, pension funds and asset managers, diversifying risk and improving access to financing, he said.

"But risks have not disappeared--they've migrated," Macklem said, adding that "our global surveillance and regulatory frameworks haven't kept pace with the change."

"Risks may be growing faster than our ability to understand and mitigate them," the central-bank chief said. "Economic uncertainty is already high--we cannot afford to add financial instability to the mix," he said.

Recently, the share prices of some of the biggest private-market lenders in both the U.S. and Europe have been dragged down by concerns that private-credit investments could go sour en masse, and that improved artificial intelligence will kill some of the software companies that these managers back.

Macklem cited two areas that required increased oversight. First, hedge funds have emerged as notable buyers of government debt. In Canada, the Bank of Canada estimates that hedge funds buy up to 50% of government of Canada bonds sold at auction, and that they account for a significant portion of trading activity in the secondary market.

The purchases are mostly financed with debt, largely through short-term repurchase, or repo, agreements, Macklem said. A shock to markets that leads to increased interest-rate volatility could force hedge funds to sell some of their bond holdings to raise cash, he said.

"Short-term funding strains could cause severe dislocations in sovereign debt markets--the backbone of our financial system. And the cross-border nature of markets means that stress that begins in one jurisdiction or sector can quickly move to another," he said.

Macklem also cited the growth of private credit, which has a global footprint in the trillions. Private credit incorporates lending by institutional investors and investment funds, and Macklem said this is expected to be a key source of funding to expand AI deployment.

"Private credit hasn't been through a full economic downturn," the Bank of Canada head said, adding that it falls outside the purview of global banking regulators. And private credit is opaque, he added, so investors may not have sufficient information about the quality of the loans.

"Weakness in private credit could spill back to the regulated sector," he said. "And because private credit is increasingly global, those spillovers could travel quickly across borders," he added.

Private-credit funds use client money to make loans, earning hefty interest payments that are handed out to investors through dividends. Stocks of these fund managers soared in recent years, in part on optimism that they could raise trillions of dollars from individual investors.

But the pullback in the shares of private-fund managers reflect concerns such as their exposure to software companies at risk of AI disruption. Bankruptcy filings by auto-parts supplier First Brands and auto lender Tricolor also triggered fear among investors about firms' private-credit portfolios.

Write to Paul Vieira at [e-mail]

(END) Dow Jones Newswires

03-04-26 1321ET