The Bank of Canada’s worried about the rise of private credit. Here’s why

The Bank of Canada is closely observing the expansion of private credit, an alternative lending landscape where businesses secure loans from non-bank entities such as asset managers, insurers, and pension funds. This sector, which lacks a universal definition, represents a significant exposure for Canadian investors and banks, totaling an estimated $500 billion in loans that are largely not publicly disclosed.

Private credit typically serves mid-sized businesses seeking capital for growth but who may not yet qualify for traditional bank loans or cannot issue debt on the bond market. While its use in Canada remains relatively limited, its rapid proliferation globally, particularly in the United States where it has been linked to major bankruptcies, has prompted concern.

The Bank of Canada highlighted private credit as a risk in its May financial stability report. A recent paper from the central bank's economists detailed the model's growth in Canada and explained the reasons for heightened vigilance. Globally, firms are increasingly turning to private credit for swift and flexible access to capital. However, the share of loans from non-banks to domestic Canadian businesses has remained stable at about 15% over the past decade, suggesting it hasn't displaced traditional funding sources.

Canadian firms are not broadly taking out these loans, but many are involved in underwriting them. The $500 billion in private lending by Canadian investors and to private credit funds by Canadian banks is predominantly directed towards the U.S. market. While insurers and pension funds are seen as stable investors, domestic asset managers represent a smaller but growing segment, and banks' direct exposure is considered low-risk. Despite deeming these risks 'manageable,' the Bank of Canada emphasizes that private credit has not been tested in a prolonged market downturn, leaving its potential ripple effects on the financial system uncertain.

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These exposures may help diversify portfolios and support returns, but they also create potential channels of contagion.