If Kevin Warsh becomes the next Federal Reserve chair, the biggest financial-stability problem he faces may not sit inside a bank. It may be in a rapidly expanding credit market outside the Fed’s reach: private credit funds that increasingly perform bank-like functions yet answer to no single regulator.
Recent turmoil around private credit lender Blue Owl Capital offers a glimpse of the problem. When investors in one of its funds sought to redeem capital, the firm sold roughly $1.4 billion of loans to meet withdrawals. The loans reportedly cleared at about 99.7 cents on the dollar and were largely purchased by institutional buyers such as pension funds and insurers. Yet markets reacted sharply: Blue Owl’s shares fell, peers declined, and investors began offering to purchase similar funds at steep discounts.
The reaction wasn’t about one asset sale. It reflected uncertainty about what these portfolios are worth and how liquid they are. The firm soon restricted withdrawals from one retail-facing vehicle, shifting from tender-offer redemptions to periodic distributions.
In practice, much of what is presented as financial innovation amounts to regulatory arbitrage.
Where the money flows
Private credit funds now supply hundreds of billions of dollars of loans to companies traditional banks increasingly avoid. As the industry has grown into a market approaching $2 trillion, managers have increasingly sought capital from wealthy individuals and retirement vehicles through business development companies, interval funds, and similar retail structures. Credit has migrated outside the banking system far faster than supervision has adapted to follow it.
Banks once dominated middle-market lending. Post-crisis capital rules and supervisory scrutiny pushed many banks to retreat from that market. Today many of those loans are originated by private credit funds sponsored by private-equity firms.
In theory, this structure can be more stable than traditional banking. Private credit funds rely on longer-term capital and higher-equity buffers rather than runnable deposits. Investors bear losses directly. There is no deposit insurance or lender-of-last-resort guarantee.
But the risks do not disappear. They shift to different balance sheets.
Evidence of strain is emerging. New Mountain Finance recently sold roughly $477 million of loans at about 94 cents on the dollar to increase liquidity. BlackRock’s $26 billion HPS Corporate Lending Fund capped withdrawals after investors requested redemptions equal to about 9 percent of assets, exceeding the fund’s 5 percent quarterly limit.
Increasingly, those risks are also moving onto insurance balance sheets.
Over the past decade, large private-equity sponsors have acquired insurers or partnered with them, using their balance sheets as stable funding sources for private assets. Through affiliated reinsurers, captives, and other structures, liabilities can be shifted in ways that free capital and allow insurers to hold more illiquid credit originated by their sponsors.
Data from the National Association of Insurance Commissioners show insurers’ bank-loan holdings nearly doubled in the five years through 2024, reaching roughly $123 billion.
Fragmentation
None of this is illegal. But it exploits gaps between regulatory regimes.
Loans created by private credit funds can end up on the balance sheets of affiliated insurers supervised primarily by state regulators rather than the Federal Reserve. Meanwhile, banks finance the same private credit complexes through warehouse facilities and other lending relationships. The regulatory perimeter hasn’t disappeared; credit has simply stepped outside it.
The result is a credit system fragmented across federal bank supervision, state insurance regulators, and lightly regulated private funds. Each authority sees only part of the system.
That fragmentation leaves regulators with incomplete sightlines. If private credit valuations come under pressure, the effects will not remain confined to the funds themselves. Banks financing those funds may face collateral questions. Insurers holding affiliated credit may face capital strains. Retail investors in semiliquid vehicles may discover liquidity disappears when they want it most.
Some analysts warn that in a severe downturn, private-credit default rates could climb into the mid-teens. UBS, for example, has outlined a scenario in which defaults approach 15 percent if disruption hits heavily leveraged borrowers.
None of this signals an imminent crisis. Private credit remains smaller than the traditional banking system and often better capitalized.
But it does expose a structural vulnerability: a growing share of credit creation now occurs in institutions performing bank-like functions while sitting largely outside the Fed’s supervisory perimeter.
Kevin Warsh has long argued that financial markets work best when institutions can fail without public support. In earlier speeches, he warned that the “new financial architecture” must account for risks migrating beyond traditional banks. Financial stability depends less on who makes the loan than on whether regulators can see where the risks ultimately sit.
Today many of those risks sit inside credit structures spanning private funds, insurers, and banks, each overseen by different regulators. Without better visibility, policymakers may discover vulnerabilities only after they begin to spread.
Increased scrutiny
The Federal Reserve does not need to regulate private credit like a bank. But it does need far better visibility into where the risks sit.
Banks should disclose and map their exposures to private-credit sponsors and affiliated insurers. Stress tests should incorporate shocks to private-credit valuations and insurer capital relief. The Fed would also need to coordinate more closely with state insurance regulators and the National Association of Insurance Commissioners.
The goal is not to suppress innovation. Private lenders have provided valuable financing to companies that might otherwise struggle to raise capital.
The goal is to prevent regulatory boundaries from becoming conduits for hidden leverage.
Warsh has often warned that the financial system evolves faster than the institutions designed to oversee it. That warning now applies to private credit.
The Federal Reserve does not need to expand its footprint. But it cannot ignore a system performing bank-like functions beyond its field of vision.
The next financial shock may not begin inside a bank. Yet when it spreads, the Fed will still be expected to contain it.
Amit Seru is a senior fellow at the Hoover Institution, the Steven and Roberta Denning Professor of Finance at the Stanford Graduate School of Business, a senior fellow at the Stanford Institute for Economic Policy Research, and a research associate at the National Bureau of Economic Research. He co-directs Hoover’s initiatives on corporate governance, long-run prosperity, and financial regulation.
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