‘Shadow banks’ quizzed over meltdown threat from hidden losses

The $2tn (£1.5tn) private credit industry is being quizzed by the City watchdog over fears its unrecognised losses could fuel a financial system meltdown, The Telegraph can reveal.Officials from the Financial Conduct Authority have in recent weeks been piling pressure on so-called shadow banks – an increasingly critical source of funding for the speculative AI boom – to more rigorously mark down the value of loans that are at risk of not being repaid in full.The FCA’s confidential discussions were revealed by City sources amid growing concern about the rapid rise of private credit funds, which compete with traditional banks to make loans to companies. Private credit assets will be worth almost $4tn by 2030, according to a recent report by Moody’s.Critics of the shadow banks have accused them of “mark-to-myth” valuations that readily account for unrealised gains but rarely take hits even as a loan is obviously turning bad. This is in contrast to “mark-to-market” accounting, which is seen as more transparent and rigorous but can mean unwanted turbulence for investors.Since the last financial crisis such lending has become a lucrative source of fee growth for some of the world’s biggest money managers including Ares Management, Blackstone, Apollo Global Management and the Carlyle Group.The industry has accelerated rapidly in the past few years. A flood of cash from Gulf sovereign wealth funds seeking higher returns than are available on public markets has met massive demand for loans from data centre builders betting the AI boom will turn profitable. Figures from private equity database Preqin suggest that about $50bn of data centre projects were funded by private markets between 2021 and May 2025.The FCA declined to comment on which of the major players in private credit it had approached about their loan valuation practices. There is no suggestion of malpractice by any individual provider.Sources said the FCA was not focused on loans issued to a particular sector, but on giving extra scrutiny to lending to critical businesses such as utilities.However, Andrew Bailey, the Governor of the Bank of England, recently warned of an “urgent need” to make the shadow banking industry safer amid growing fears it could be the cause of the next financial crisis.Funds often themselves borrow money from traditional banks, exposing the wider system to risk.Pensions riskUS domestic banks have now lent $1.2tn to shadow banks, according to ratings agency Moody’s, which estimated that $300bn of these loans were to private credit providers.Wall Street banks have emerged as among the staunchest financial supporters of the private credit industry, with the volume of their loans to private debt funds soaring 145pc from 2020 to 2025, according to a recent report by the Federal Reserve.Their hunt for cash to lend has more recently drawn in retail investors and insurers, stoking fears that ordinary pensioners could face losses in a sudden reckoning in which providers are unable to quickly return cash.This risk is understood to be driving FCA action. Officials are collaborating closely on private credit loan valuation practices with the Bank of England and its international peers such as the Securities and Exchange Commission in the US.Last week BlackRock, the world’s biggest money manager, marked down a large US private credit fund by 19pc. It is unknown whether the unusual step was taken in response to regulatory pressure and BlackRock has declined to comment on the action, which sent tremors through Wall Street.Politicians are also increasingly concerned about the dangers of shadow banking. In an echo of the financial crisis, US senators last summer raised concerns about credit ratings agencies. They were accused of providing cover for inflated loan valuations and being rewarded for playing along.The FCA is also understood to be looking at how private credit firms rely on ratings agencies to issue loans.The House of Lords’ financial services regulation committee has singled out the Treasury for its “passivity” in the face of the possible risks from shadow banking, adding that the Government had “demonstrated a limited grasp” of the potential risks from shadow banking.The Treasury said that in recent years it had worked together with regulators to significantly increase its focus on the non-banks sectors and that it has a robust, flexible framework to protect financial stability.Cracks emergeHoward Marks, the legendary distressed-debt investor, said last year that he did not believe private credit was a risk to the financial system.But he added: “The tide has never gone out on private credit, meaning we haven’t had an opportunity to see its flaws. As far as I’m concerned, the main one is the possibility that some managers have been in such a hurry to scoop up capital and put it to work – so they could come back for more – that they relaxed their credit standards and failed to demand a sufficient margin of safety.“If there’s ever another difficult period in the economy and the market, we’ll see the result.”Glimpses of overvalued private credit have begun to emerge. The bankruptcies of the car finance provider Tricolor and car-parts supplier First Brands both imposed multibillion-dollar losses on the private credit industry seemingly out of the blue, albeit amid allegations of fraud.The Telegraph last year reported concerns about borrowing by the troubled broadband provider TalkTalk from the private credit giant Ares. While TalkTalk’s listed bonds were trading at a fraction of their original value, it was not clear that Ares had marked its £500m lending to the market.It is understood that Ares evaluates loans on at least a quarterly basis and validates them with third party agencies, which are also audited annually.The FCA was contacted for comment.