Private credit exposure is weighing on bank stocks, even where the loans look well protected

Bank share prices have lagged this month on concerns about exposure to private credit, a discount that sits awkwardly alongside what the underlying loans actually look like.

The exposure in question is lending to non-depository financial institutions, or NDFIs — the credit funds, business development companies and specialty finance vehicles that have absorbed much of the leveraged lending that once sat on bank balance sheets. Analysts covering the sector generally characterize direct loss risk on these facilities as low to moderate, because banks tend to hold senior secured positions with meaningful overcollateralization.

Investor unease has focused instead on three other things. The first is credit quality at the underlying borrowers, where non-accrual rates have risen and the use of payment-in-kind financing — allowing a borrower to defer cash interest by adding it to principal — has increased. Both are conventional signs of distress being deferred rather than resolved.

The second is liquidity mismatch. Funds that offer investors periodic redemption while holding illiquid private loans depend on orderly conditions to meet withdrawals. The third, and the hardest to quantify, is valuation opacity: private credit marks are model-derived rather than observed, which means a repricing can arrive suddenly rather than gradually.

Supervisory reporting has so far described bank exposure as manageable and unlikely to threaten solvency. That assessment addresses a different question than the one equity investors are asking. Banks can be well secured and still see multiples compress if the market cannot verify the quality of what sits behind the collateral.

The practical test will come in the next reporting season, in the granularity of NDFI disclosure rather than in the headline exposure figures.