The European Central Bank has issued a warning that the investment surge fueled by artificial intelligence and increasingly reliant on private credit financing poses a new threat to the eurozone's financial system, with insurance companies and pension funds being particularly vulnerable.
In a report released on Tuesday, the ECB stated that if private credit continues to expand rapidly, providing funding for AI companies and data centers, eurozone investors could face losses if market expectations for AI development fail to materialize.
The ECB noted in excerpts from its Financial Stability Review: "Should exposures grow rapidly and actual cash flows in the AI sector fall short of expectations, private credit could evolve into a more significant source of credit risk and potentially amplify market pressures on eurozone financial institutions."
The ECB conducted a severe stress test on the global private credit market. The results showed that while direct losses for eurozone financial institutions would be limited, the impact of widespread risk contagion would be significantly more severe, with insurance companies and pension funds bearing the brunt.
The report stated: "In an adverse scenario, with widespread stress across leveraged loans, high-yield bonds, and equity markets, insurance companies and pension funds would face more severe secondary valuation losses."
This stress test scenario considered the combined effects of losses in private credit funds and leveraged loans, along with the ripple effects from sell-offs in public equity and high-yield bond markets.
Calculations indicate that under this scenario, losses for eurozone pension funds could reach 5% to 6% of their total assets, while losses for insurance companies would be around 4%.
The ECB stated that losses for eurozone banks would be manageable due to the seniority of their loans and the relatively small size of their exposures: equity losses would not exceed 1.3%, and asset losses would be minimal.
Concerns are already mounting in the US private credit market. The market perceives that many highly indebted software companies borrowing in this sector are vulnerable to shifts in the AI industry. Coupled with rising interest rates, some borrowing firms are now struggling to service their debts.
Recent collapses of US firms First Brand Company and Tricolor, along with UK-based Market Financial Solutions, all heavily involved in asset-backed lending, have led to significant losses for several major banks. In response, regulators have intensified their scrutiny of the private credit industry.
The ECB emphasized: "Risks such as insufficient transparency and maturity mismatches must be addressed to ensure private credit remains a stable and reliable source of financing."
It called for enhanced data collection and sharing within the EU, along with harmonized industry definitions, to fill data gaps on a global scale.
The report also suggested that further clarity is needed on whether liquidity and leverage rules for open-ended funds, proposed by the global Financial Stability Board, should also apply to global credit funds.
Data shows that eurozone private credit funds have grown at an average annual rate of 14% since 2010, but their total assets remain around €100 billion, significantly lower than their US counterparts.
The ECB noted that by the end of 2024, the US private credit market had rapidly expanded to approximately $1.4 trillion, approaching the size of the $1.5 trillion US subprime mortgage market which triggered the 2008 banking crisis.
However, the report pointed out that subprime mortgages constituted a much larger share of the US economy two decades ago compared to private credit's current share. It added: "Unlike subprime mortgages, the private credit sector generally has lower leverage and is funded by longer-term capital, eliminating the risk of a run."
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