Bank of England hunts for ‘cockroaches’ in $11tn shadow banking market

The Bank of England has launched a stress test for the shadow banking industry amid warnings of “cockroaches” lurking in the $11tn (£8.2tn) market.

Major financial groups, including KKR, Blackstone, Apollo and Goldman Sachs Asset Management, have all signed up for the new stress test.

Officials at Threadneedle Street will subject these private equity companies’ investments to a hypothetical global economic and financial crisis to study the potential impact on the UK, its financial system and the wider economy.

The system-wide exploratory exercise (SWES) will take place next year and report its full conclusions in 2027.

The decision to subject private equity investors to the same kind of rigorous tests as banks follows enormous growth in the private credit industry, which is often referred to as shadow banking.

Private equity and private credit have expanded from $3tn of assets to $11tn in a decade, the Bank said.

In Britain, 10pc of private sector workers are employed by PE-backed companies, which also account for 15pc of corporate debt and a larger share of riskier lending.

This has helped businesses grow in the wake of the financial crisis. But officials fear that the market is far less transparent than the more heavily regulated banking, insurance and pension industries.

Earlier this year, American companies First Brands and Tricolor both collapsed, raising fears of wider dangers in the market. Both relied heavily on private credit, where funds lend to companies rather than banks.

After JP Morgan lost $170m in the collapse of Tricolor, its chief executive Jamie Dimon told analysts: “My antenna goes up when things like that happen. I probably shouldn’t say this but when you see one cockroach, there’s probably more.”

A crunch in private markets would affect banks, which lend to PE-backed companies, and investors. That could hit lending in the rest of the economy, undermining financial stability and economic growth.

Similarly if companies backed by private money rapidly contract, unemployment could surge hitting other markets such as housing, and the associated mortgage lending backing home ownership. Private equity-owned companies currently employ two million people in Britain.

Speaking at the Edelman Smithfield Investor Summit in London on Thursday, Dan Kemp, chief investment officer at Morningstar, said: “Private credit is really the risk that we should be focused on.

“We’ve seen this huge growth in an asset class which is new to most people, is somewhat opaque, is illiquid – then that’s normally a recipe for some bad behaviour and some bad outcomes.”

Announcing the stress tests, Sarah Breeden, the Bank of England’s deputy governor for financial stability, said: “Private equity and private credit play an increasingly valuable role in helping UK companies to innovate, invest and grow.

“To keep delivering those benefits, we need a robust understanding of how risks might flow through the financial system in a stress. This exercise provides a unique opportunity to work collaboratively with firms to build that system-wide understanding together.”