AI shock scenario could hit banks and insurers via private credit, warns UBS Proactive uses images sourced from Shutterstock
A rapid shock from artificial intelligence could trigger a sharp rise in defaults across the US credit market, UBS has warned, with the biggest hit landing in private credit.
Following increasing calls from investors wanting to talk about AI disruption, strategist Matthew Mish updated his views on what he called “a tail risk scenario” – ie not the bank’s base case – around the possibility of a “rapid, severe AI disruption”.
In that scenario, UBS said defaults could rise to 3-6% in US high-yield bonds (the riskier end of the bond market, where borrowers pay higher interest because they are more likely to run into trouble), 8-10% in leveraged loans (typically loans to highly indebted companies, often used in buyouts) and 14-15% in private credit (lending done outside public markets, often by specialist funds rather than banks).
“Private credit has evolved into a structurally significant segment of the US corporate debt landscape, now rivaling some traditional bank and bond markets,” Mish noted, with private credit and leveraged loans each representing 6% and 5% of GDP, respectively, up from 1% and 5% in 2008.
“This growth reflects a shift in origination from banks to private lenders, driven by regulation and a reach for yield amid low rates. However, the scale relative to GDP raises questions about systemic risk and the market’s capacity to absorb shocks.
“While default rates remain contained, stress indicators are rising. Private credit defaults are reportedly between 3% and 5%, and signs of strain – such as interest paid-in-kind – are nearing post-pandemic highs.”
Leverage has edged higher, with debt running at 7.5-8 times earnings in some sectors, while interest cover in middle-market deals is only around 1.7-1.8 times. That leaves borrowers exposed if growth slows or rates stay higher for longer.
Risk is concentrated too. In past downturns, a single sector such as telecoms in 2001 or energy in 2016 accounted for 55-80% of total defaults. Today, private credit is heavily weighted to services, technology and healthcare.
Because many borrowers and lenders overlap across private credit, leveraged loans and high-yield bonds, stress would not stay contained, Mish warned. A rise in private defaults could spill into public markets, widening spreads and draining liquidity.
He flagged knock-on risks for banks and insurers through exposure to non-bank loans.
US and European banks hold $1.3 trillion in loans and around $1.1 trillion in undrawn commitments to non-bank financial institutions, most notably loans to SPVs, collateralised loan obligations and asset-backed securities, with global systemically important banks, including HSBC Holdings PLC, JPMorgan, Citi and Deutsche Bank, accounting for 60% of the total.