Once upon a time, banking was simple: Take deposits, use depositors’ money to make loans, and transfer payments between clients and earn a commission.

All three pillars are now under assault.

Longer-term savings have migrated to wealth managers who promise much better returns over time. An array of innovative fintechs offer alternatives for payments. Home or car buyers are ever more likely to borrow from nonbank originators. Some 70% of residential mortgages in the US, the world’s largest banking market, are processed by nonbanks, according to Brian Graham, partner at the Klaros Group, which advises and invests in financial firms.

Corporate borrowers have been shifting to nonbank lending since the 2008 global financial crisis, the latest hot alternatives being collateralized loan obligations and private credit. The latter has mushroomed to $2.1 trillion globally and is still growing fast. Nonbank financial institutions, or NBFIs, hold two-thirds of financial assets in the most advanced economies, according to the Financial Stability Board (FSB).

In order for the banking sector to regain market share from nonbanks, banks will need to change how they compete for customers. Long-established banks will need to become less cautious and more agile in navigating regulations. One avenue for the banking sector is to start from scratch, as KakaoBank did in South Korea and Nubank in Brazil.

Higher interest rates have given banks some relief over the past few years, increasing their net interest income while hampering competitors—particularly fintech startups dependent on equity financing. The FSB reported that global NBFI assets shrank 5.5% in 2022, the first notable decrease since 2009, while banks’ balance sheets grew by 6.9%.

Long-term trends remain adverse, though. “Banks are losing market share to nonbanks, and the situation is much worse than what the statistics show,” says Miklós Gábor Dietz, lead of McKinsey’s Global Banking Strategy and Innovation team, the global Ecosystems Hub and is the managing partner of Vancouver Office.

Banks are competing with the equivalent of weights tied to their ankles. These, of course, are the extra regulations and capital requirements most countries have piled on since the 2008 crisis. Any new loan needs to be risk-weighted and have capital set aside to offset it, restraints that nonbank lenders can often ignore.

Even as earnings seem to be healthy, banks struggle to earn a return on all that capital, Dietz points out—particularly on corporate lending. “On paper, this is the most profitable business in the world,” he says. “But on average globally, corporate banking is adding no value.”

Banks’ long histories and diverse business lines leave them lagging behind newer, more-focused rivals, as competition increasingly revolves around technology, adds Steven Breeden, American financial services technology lead at Bain & Company. “Banks are struggling with historical complexity traps and breaking through silos,” he says. “There’s a cohort of 10 or so banks globally that really get it on tech transformation.”

Yet banks get one large advantage in exchange for the regulators’ heavy hand: state-guaranteed deposits, a cheaper and (usually) more stable source of funding than nonbank rivals can tap.

History and the capacity for a wide range of transactions also have their pluses. “Banks inject trust into the financial system,” says Sandeep Vishnu, a partner at industry consultant Capco. “They are continuing to lose market share, but any complex transaction requires banks to play a role.”

Increasingly, that role is to “run in the background,” and have deep pockets on call, while more-dynamic actors close the deal directly with borrowers or merchants. Rocket Mortgage or another US originator may find the home-buying customer; the loan will likely be packaged into a mortgage-backed security and bought by a bank. At the corporate level, a private credit or leveraged-loan syndicate will likely secure bank credit lines as an anchor.

That’s risky for the financial system, says Viral Acharya, a professor at New York University’s Stern School of Business who specializes in financial regulation. “The growth of nonbanks is really coming on the back of liquidity from the largest banks,” he explains. “The cynical view is that everyone wants to have a put from the banking system in an emergency.”

Running in the background is not a great strategic position for banks either, McKinsey’s Dietz adds. The customer-facing entity gets a free ride, so to speak, on the bank’s capital base, and reaps consumer data that may be more valuable than the transaction itself.

The classic example in developed markets is the relationship between credit card provider Visa and the numerous banks that underwrite its plastic. Equity investors value Visa at 29 times earnings and 13 times book value, according to Bloomberg. The equivalent numbers for JPMorgan Chase, the world’s most profitable bank, are 12 and 2.3. “Banks haven’t solved their fundamental problem, which is losing customer ownership,” Dietz concludes.

The outlook for traditional banks is not all so bleak, particularly in emerging markets. Nonbank competitors are less developed there, leaving banks in control of 57.9% of financial assets, the FSB reports.

The megatrend of unbanked populations joining the financial system via cellular connection may enhance, not threaten, banks’ dominance. India is the prime example. Narendra Modi’s government requires the mobile payments systems that have mushroomed over the past decade are overwhelmingly linked to banks, Vishnu says. The result: 400 million new bank accounts.

Banking systems in middle-income emerging markets tend to be younger, with less “sticky” customer loyalty than in North America or Western Europe, leading to hotter competition and more innovation that crowds out nonbank startups. “The most innovative banks in the world, aside from India, are in Turkey or Poland,” Dietz asserts. “They are leapfrogging with more digital, more automated services.”

Elsewhere, online-only “digital-attacker banks” are shaking up the landscape, Bain’s Breeden says. The biggest player in this category is probably Nubank, based in Brazil and expanding aggressively into Mexico and Colombia. Founded in 2013, it exploded from 25 million customers in 2020 to more than 100 million earlier this year, focusing on credit cards and personal loans for retail customers.

In South Korea, online-only KakaoBank has grown from a standing start in 2016 to more than 23 million customers in a nation of just under 52 million. Attacking a highly mature banking market, the bank found a niche as the go-to institution for refinancing mortgages. It’s now eyeing expansion into Thailand in partnership with brick-and-mortar incumbent Siam Commercial Bank.

Unlike many fintechs around the world, Nubank and KakaoBank are also making money. Nubank’s net profit hit $1 billion for 2023, and KakaoBank earned about $267 million.

One more innovative champion hails from the unlikely location of Kazakhstan. Kaspi, one of the biggest e-commerce platforms in the oil-rich ex-Soviet nation of nearly 20 million, used its customer reach to start Kaspi Bank, with dramatic results. “Their return on equity is 90% instead of the 10% that’s standard,” Dietz notes.

Regulation has stymied similar vertical integration in bigger markets. Chinese authorities famously curtailed Ant Financial, sister organization to e-commerce power Alibaba, a few years ago. That has left most lending in the world’s No. 2 economy to very traditional state-owned banks.

Globally, much-anticipated financial services competition from online giants like Amazon, Meta, and Google has largely failed to materialize—largely because they would have to obtain banking licenses in the process. “Big tech has been making some surgical moves, mostly in the realm of payments and digital wallets,” Breeden says. “They are reluctant to set up fully fledged banks from a risk-compliance perspective.”

In the developed world, the banking establishment also has tools to fight back against nonbank competitors, if it can shake off some rust and unleash those tools. The spread of digital payments systems actually represents an opportunity for banks, Capco’s Vishnu says. They can negotiate better fee splits with these new entrants than with incumbent credit card providers like Visa. This would bolster a key income source for banks in the US and Western Europe. “Digital is now disintermediating the credit cards,” he notes.

Banks still retain considerable “customer ownership,” and of course trust, as the holders of deposit guarantees. The banks can possibly build on these factors to expand services instead of retreating.

One obvious area would be shifting more depositors into asset management, selling the convenience of keeping various forms of wealth under one roof. While larger banks are already doing this, they could do it more effectively. “Banks are seeing a lot of stress on net interest and fee income,” Vishnu says. “Capturing some of the wealth management that’s going outside banking could counteract that.”

Though banks in the US have access to the huge money pool, only two of the top-10 US asset managers are banks: JPMorgan Chase and BNY. And they are dwarfed by nonbank giants like BlackRock, Vanguard Group, and Fidelity Investments. European banks are more competitive in this area, accounting for three of the top-five asset managers on the Continent: Credit Agricole, UBS Group, and Deutsche Bank.

Dietz, at McKinsey, sees much broader possibilities for banks that can “organize themselves around customer needs,” creating and dominating new financial services verticals. For instance, one-stop shopping for home acquisition and ownership: combining brokerage, mortgage, and insurance in a single app. Or offering, as financial services firms do, “an adviser who knows everything about you”: wealth management, estate planning, tax and legal services bound together—a service like a private bank for the nonrich.

Breaking out these core functions into separate units would also bring universal banks some of the focus and maneuverability of “pure play” disrupters, while maintaining the strength and breadth of a larger organization, suggests Dietz.

“Unbundling the business and expanding into some nonbank areas are the two things that banks can do to escape the value trap they are in,” he says. “If they do, the opportunity is tremendous.”

One big obstacle to this transformation is psychological. Since 2008, many developed-world banks have hunkered down in a defensive crouch, focused on building buffers to avoid the near-death experiences of that time and complying with the onslaught of new regulation. Going on the offensive into new business lines has seeped out of their DNA. “Banks need to start erring on the side of maximizing their reach [and] not worry so much about losses,” Capco’s Vishnu says.

Another hurdle is technological. To leap to the kind of one-stop shopping Dietz envisions, banks will need software that works as simply and intuitively as that of digital-native pioneers like Uber or Airbnb. “Banks need to step up their game on human-centered design,” says Bain’s Breeden.

Among banks in the developed world, big US institutions look the best prepared for ongoing shifts in the financial landscape. They are ahead of the pack technologically, Breeden observes. “A handful of banks in the US Tier 1 rise above all others in being tech forward,” he affirms.

The top US players can also take advantage of weakness further down in the country’s archipelago of over 4,500 licensed banks, Klaros’ Graham says. Washington regulators contained the fallout when three second-tier banks—Silicon Valley Bank, Signature Bank, and First Republic Bank—abruptly failed last year. But many others continue to struggle with their key weakness: unrecorded losses on bonds bought when interest rates were much lower. Mounting liabilities from commercial real estate loans are compounding the problem.

A large amount of the US banking system’s reserve capital is “impaired,” Graham states. The concealed weakness is not dire enough to trigger a 2008-style wave of insolvencies, adds Graham, but it is enough to spawn an army of “zombie banks” that have reined in lending to conserve capital. Either they will yield clients or they’ll have to be acquired by stronger rivals. “This is an incredibly target-rich environment for banks that can afford to play offense,” Graham says. “They can acquire teams or grow loans.”

Like death and taxes, highly regulated banks holding state-guaranteed deposits are embedded as a fact of life in complex economies. “There is no alternative to banking as an ecosystem,” says Vishnu.

Also, like death and taxes, potential clients and customers increasingly avoid banks to the extent they can. For banks, there is no time to lose in reversing that trend.

So why is Southeast Asia’s startup engine stalling?  

Venture capital and private equity (VC/PE) flows in most regions have slowed as central banks raised interest rates to combat inflation. In Southeast Asia the flow has turned into a drought. VC/PE and infrastructure investment in the 10-nation region has plunged by two-thirds from a 2021 peak, according to the Global Private Capital Association (GPCA). That compares to investments in India dropping by half.  

The biggest reason is that Southeast Asia is in fact a notional construct made up of 10 very different actual nations at very different levels of development, says Prantik Mazumdar, head of Singapore-based entrepreneurs’ association TiE. In the irrationally exuberant 2020–2021 period, investors bought into the idea that e-commerce startups like Grab or Tokopedia could easily span a regional market of 650 million people. Not anymore.  

“It’s become clear that this is 10 countries with 10 languages.” Mazumdar says. “The only way for companies there to scale up is to venture into the US or Europe, and that will take another five to ten years.” 

Local institutional capital is scarce across the region, leaving young growth companies vulnerable to the shifting moods of far-off global deep pockets. “Most of the money coming in was from investors without a local presence,” says Carlos Ramos de la Vega, director of venture capital at GPCA. “They may have pulled back to focus on core positions in the US or elsewhere.” 

Those global moods have also shifted away from e-commerce, where Southeast Asia’s large consumer base was enticing, to artificial intelligence and green technologies, where the region is less competitive with established technology centers, De la Vega says.  

Southeast Asia lacks a vibrant stock market for startup investors to exit via a public offering, Mazumdar adds. “Singapore is pretty dead as a public stock market,” he says.  

India compares well on all these parameters. It offers a huge domestic market, which Prime Minister Narendra Modi’s reforms have made more cohesive; a rising class of native oligarchs keen to fund industries of the future; world-class, English-speaking brain trusts in Bangaluru and elsewhere; and a lively bourse with more than 5,000 public companies and a growing domestic investor base. “I’m very bullish on India,” Mazumdar says. “You have a lot of great exits coming out there.” 

Not all the Southeast Asia news is bad. As venture capitalists pull back from the region, the giants of global tech are moving in to build data centers, anticipating an AI wave. In early May, Amazon Web Services pledged to pour $9 billion into Singapore alone for this purpose.  

A few regional startups are still generating enthusiasm with ahead-of-the-curve ideas, De la Vega adds. Silicon Box, a Singapore-based microchip packaging innovator, raised $200 million in January to reach unicorn status with a $1 billion valuation. Atlan, which built India’s “national data platform” before migrating to Singapore, pulled in $105 million in May.  

Southeast Asia is not exactly swimming naked now that the tide of ultra-cheap capital has gone out. But its shortcomings as an innovation nexus and investment destination are more visible.  

In February, President Nicolas Maduro’s ravaged economy saw its first month of deflation since 2007, according to opposition think tank Finance Observatory. Annual inflation clocked in at 85%—not great, except compared to more than 400% a year ago—and the cost of food dropped more than 3%.

  “From a terribly low base, life is getting a very little better in Venezuela,” says Alejo Czerwonko, CIO for Emerging Markets Americas at UBS Global Wealth Management.

That improvement rests on two shaky pillars. The US poked a hole in its sanctions regime in late 2022, allowing oil major Chevron to resume some drilling in Venezuela and supply some desperately needed dollars. Caracas has used the greenbacks to mop up bolivars, bolstering the local currency.

Maduro, after an extended bout of hyperinflation, has also tightened domestic spending. Minimum wages have remained unchanged for the past two years, allowing price rises to eat up purchasing power, notes Ryan Berg, director of the Americas program at the Center for Strategic and International Studies.

Both achievements are at risk, however, as Venezuela heads toward elections scheduled for July. Washington could close the Chevron loophole if Maduro strongarms his way to a fresh six-year term as president. Venezuela’s Supreme Justice Tribunal has already disqualified the opposition’s chosen candidate, Maria Machado, on charges of corruption and supporting US sanctions. 

With the opposition hobbled, Maduro will still be tempted to relax fiscal austerity to win votes. “Maintaining orthodox policy requires that he not spend any money on his base,” Berg says. Street protests are already on the rise among state and unionized employees who traditionally support the regime, he notes.

Despite the glimmer of good inflation news, to say that Venezuela faces a long road back is a massive understatement. The economy shrank by one third from 2014 to 2021, Czerwonko notes. One fourth of the population—more than seven million people—have fled the country and oil production has cratered by 70% in the past decade, even with the Chevron bounce last year. Still, a very little better is better than worse and worse.  

Two notable statistics keep private bankers awake at night: $72 trillion and 70% to 80%. The first is the estimated wealth that high-net-worth individuals in the US alone will leave to their heirs over the next two decades. The second is the percentage of those heirs who might take their business from their parents’ trusted advisor to a new wealth manager. The figures, accepted as industry standard, come from Boston-based Cerulli Associates, and include liquid assets and the value of businesses that will be passed down.

Cerulli predicts blood will prove thicker than good works for rich baby boomers when doling out that $72 trillion total worth of expected bequests. They will leave a mere $12 trillion to charity, the bulk to family.

So far, this “great wealth transfer” is a relative trickle—about $2 trillion a year, says Chayce Horton, a senior wealth management analyst at Cerulli. However, “transfers are definitely increasing beyond our expectations,” he adds.

Wealth managers who are unprepared for the gathering flood may be swept away by it.

To compete for clients—and the fees these mind-boggling sums of wealth transference will generate, private banks might have to nudge their investment focus away from meat-and-potatoes stocks and bonds toward private equity and other alternative instruments, which are more popular with the younger set. And they will have to continually raise their technology game to keep up with “digital native” and globally mobile clients.

However, the biggest challenge for banks will be expanding their traditional financial and legal planning skill sets to a broader semi-therapeutic role in holding far-flung 21st-century rich families together as they grapple with dividing money and business responsibilities.

“Our most critical task is uniting the generations and helping them find a common purpose,” says Benjamin Cavalli, head of Strategic Clients at UBS based in Zurich and Singapore. “Strategic clients” for the world’s biggest wealth manager means “the top few percent of clients” —aka, the superrich. “It is never easy,” he adds.

The great wealth transfer will bring with it a profound shift of perspective. The client base of most private banks is dominated by wealth creators who built successful businesses. Most of the next generation will be heirs. “For the first time, we are seeing more wealth that has been inherited than created,” Cavalli notes.

If banks are unprepared for this transformation, so are many of their clients. The right way to structure succession in a high-net-worth family is to start early, hammering out an acceptable greement with the key players and institutionalizing it through financial and legal structures. The wrong way is to keep everyone in suspense until the patriarch’s or matriarch’s will is cracked open.

How many rich families get it right depends on who you talk to, Cerulli’s Horton says. Three-quarters of aging parents say they have an inheritance plan in advance. Half of all children report that they only learn the details of their inheritance after the parent passes.

In any case, banks should be helping their clients do better. About half of all inheritors still wait by the deathbed to learn their inheritance, Cerulli’s Horton estimates. “The ideal way to transfer wealth is through trusts for the children or spouse,” he says. “Most of the time, it’s passed down in a less-than-ideal way.”

Dialogue between parents and successors may be particularly difficult in Asia, says Zita Verbenyi, founder of The Legacy Atelier in London. Contradicting the head of the family often is taboo. Heirs are often educated and live in the West, absorbing very different cultural values and financial reasoning than their elders. “In the Middle East or India, the younger generation may not say anything about how the business is run,” Verbenyi says. “That’s not real engagement.”

The connecting trait of next-generation inheritors across the globe is their passion for independence—personal and financial. As a first consequence, many want to leave the family enterprise that their parents or grandparents built. “We see many examples where the younger generation may not want to inherit the business,” Cavalli notes. “They have their own views, preferences and ambitions.”

In these circumstances, challenge No. 1 for families and their advisers is selling the business or arranging a passive dividend stream for the uninterested heir­—without sacrificing that precious unity and common purpose. “Families that are centered around a business or set of assets tend to stick together,” Horton observes. For families who lose that, togetherness can get more difficult.

Younger generations’ independent streak extends to investment attitudes. Simply buying and holding public securities is out. Three-quarters of wealthy investors under age 43 believe “it’s not possible to achieve above-average returns solely on traditional stocks and bonds,” a recent survey by Bank of America’s private bank found. Just a third of their elders agreed.

Next-gens gravitate instead toward private equity and other vehicles they see as more hands-on.

“They are more confident in their ability to direct their own investment,” says Lauren Sanfilippo, a senior investment strategist at BofA—at least for now. And they are demanding the technology to do it, 24/7 and globally. “They want to have everything instantly at their fingertips,” UBS’ Cavalli adds.

Those under the age of 43 were also disproportionately interested in sustainable investments, BofA found, with three-quarters of them marking that as a priority, compared to one-quarter of all survey respondents. 

A more awkward consideration is that the heirs may fall out of “strategic client” status as fortunes divide with succession, entitling them to less lavish private banking treatment than their parents. “Different wealth tiers require different services,” Cerulli’s Horton says. “You can’t service four $12 million accounts for the children the same as one $50 million account held by the parents.”

Adjusting investment portfolios or service levels falls within private banks’ established capabilities, however. The essential mission of uniting generations around a common purpose in a modern world of personal autonomy and perceived endless possibility will stretch wealth managers. They may have to dip into skills more associated with historians and curators, not to mention therapists.

Verbenyi at The Legacy Atelier brings extended families together to explore their heritage, achievements and “family culture”—a sort of Ancestry.com on steroids that also looks to determine “what each family member brings to the table.”

One example: When a Middle Eastern clan gathered to celebrate a milestone, Verbenyi used the occasion to start work on a family museum, recording memories and cataloging artifacts. A similar project with a Western Hemisphere family focused on grandparents forced to flee Europe, exploring how they rebuilt their lives and the family fortune in the New World. “Bankers only talk about governance from a financial point of view,” Verbenyi argues. “But if the family is not in harmony, the wealth will disappear.”

Private banks are aware of the wealth transfer challenge. “The proportion of wealth management relationships where the children are engaged has shifted from well below 50% to well above,” Horton says.

The global spread of family offices and their collaboration with private banks could be a big help. The family office revolution first took hold in the us, but has spread globally in recent decades. “When I first came to Asia in the 1990s and 2000s, family offices were the exception,” UBS’ Cavalli says. “Now they are more the rule.”

Family offices can create an institutional framework for intergenerational wealth management: boards, investment councils and other decision-making bodies with a mix of family members and outside professionals. Such structures can reduce the competitive, winner-takes-all aspect of inheritance, whereby one sibling or cousin assumes control of the family assets and the rest are cashed out, according to Verbenyi.

“These days, there can be many heirs,” she says. “You may not be engaged in the business but may want to sit on the family council. Everyone can try to find what they are good at.”

Big, global private banks may find a competitive advantage as rich families become progressively more dispersed and diversified, both geographically and philosophically. At least, that’s what the biggest of them all, UBS, is hoping. “Wealth transfer is a tremendous opportunity for a bank like ours,” Cavalli says. “Our global expertise is there to support and guide our clients.”

Horton agrees that the established banking names have a potential edge in holding onto the next generation. They can segment services as fortunes divide – that one theoretical $50 million account morphing into four $12 million accounts. “the private banks are well positioned because they can provide a range of services without giving up profitability,” he says.

The bigger houses, particularly those with a retail banking or brokerage affiliate, also have a wider pipeline of younger relationship managers, who might relate better to next-gen clients. “it’s tough to bring entry-level talent into a private bank or family office,” Horton says. “the retail branch is an excellent training ground.”

Stereotypes in the TV series “Succession” and other popular entertainment frame high-net-worth families as fractious, conniving and destructive of what their forbears have built. The best news on the Great Wealth Transfer is that not all clans are like that.

“Families do face an identity crisis after a liquidity event,” Verbenyi says. “But they still have a great opportunity, if they make it work: wealth, networks, intelligence. I’ve seen hundreds of cases where they want to make it work.”

Wu Qing earned his colorful nickname as head of the China Securities Regulatory Commission (CSRC) in the 2000’s. Back then, he shut down a quarter of the country’s securities dealers.

Xi Jinping brought the 58-year-old Wu back as top market cop on February 8. He lost no time reining in algorithmic short sellers, whom he saw as aggravating the precipitous decline of Chinese stocks.

Days before Wu’s reappointment, Beijing announced a “zero-tolerance” policy for “malicious short-selling.” Wu then widened the focus to include quantitative traders known for buying volatile small-cap stocks and hedging their bets by shorting broader market indices.

His CSRC froze the accounts of one top quant, Ningbo Lingjun, for three days, precipitating a “quant quake” that inflicted heavy losses. “Punishment will be more and more severe,” the regulator’s enforcement chief told a follow-up press conference.

Wu, however, is no anti-market zealot. A Ph.D. economist, he headed the Shanghai Stock Exchange and oversaw the commercial capital’s financial industry in between stints at the CSRC, winning praise from at least some global capitalists.

“Wu Qing’s appointment is great news,” says Jason Hsu, founder of US-based Rayliant Global Advisors. “In Shanghai he was instrumental in my own firm’s license application process.”

Closer scrutiny of quant funds should only make Chinese markets safer and bolster investor confidence; Hsu adds: “The high-frequency traders advertise themselves as scalping profits from naïve retail traders.”

Hong Kong-listed Chinese stocks gained 6% during Wu Qing’s first two weeks back at the CSRC post, momentarily reversing seven months of near freefall. The Butcher’s return was hardly the only factor; China’s “national team” of state-affiliated funds put out the word that it was buying stocks, and the People’s Bank of China cut mortgage lending rates.

Analysts question how much difference any personnel change can make given the scope of problems that have crashed Chinese equities by 60% over the past three years. Wu’s ascent is “just a case of finding a scapegoat for the market’s downturn,” says Logan Wright, who heads China markets research at consultant Rhodium Group.

Big US and European banks, whose lunch is being nibbled (if not gobbled) by private credit providers, are trying to join the private lending crowd—albeit at arm’s length—via nonregulated partners or subsidiaries. Citigroup is the latest to announce a private credit initiative, joining US rivals JPMorgan Chase and Wells Fargo, and European behemoths Deutsche Bank and Societe Generale, among others. Investment banking icon Goldman Sachs announced in December that it will double its private credit operation.

Established players, headed by large private equity (PE) funds, are eager to crow. Private credit has entered a “golden moment,” Jonathan Gray, president of Blackstone, declared on an earnings call last April. On a third-quarter earnings call, competitor Michael Arougheti, CEO of Ares Management, lauded “risk-reward characteristics that are as favorable as we’ve seen in many years.”

As the name suggests, private credit refers to corporate finance raised confidentially through nonbank lenders, typically by a few of them teaming up. Average loan size has grown to $195 million, from $135 million before the Covid-19 pandemic, according to Ramki Muthukrishnan, head of US leveraged finance at S&P Global Ratings.

Banks would have provided these loans before the 2008-2009 global financial crisis (GFC). Regulators across the globe have pushed them away since then, raising risk ratios for credit not collateralized by hard assets and discouraging the leverage levels often associated with corporate buyouts.

“Private credit was an established but sleepy part of the private markets before the GFC,” says Gregory Brown, research director at the Institute for Private Capital of the University of North Carolina (UNC). It has mushroomed as regulators push to get “some of that risky stuff off banks’ balance sheets.”

It’s easy to see why banks and other lenders want to get back into the game. Interest on private credit runs two to three percentage points above competing instruments like high-yield bonds or traded leveraged loans, says Jeffrey Griffiths, co-head of global private credit at London-based adviser Campbell Lutyens. Currently, that translates to 10%-12% annually, the kind of yield you would find in C-rated junk bonds or financially shaky foreign governments. Private credit borrowers, however, are solidly managed corporations on firm financial footing—at least, they are supposed to be.

The 10% figure also nearly matches the average return from the S&P 500 index of US stocks since it was created in 1957. So, in broad theory, private credit is a category of debt offering similar returns to equity but with a different risk profile, a sort of financial alchemy.

Most private credit deals also involve variable interest rates, which of course soared as the US Federal Reserve and European Central Bank hiked rates over the past two years. That’s fattened lenders’ profits even as conventional fixed-rate bonds and loans plunged in value.

Banks won’t be able to offer private credit directly. Instead, they have floated potential partnerships with less-regulated entities, or they’ve used their giant client bases to originate transactions that a private credit partner would fund.

That could be a big deal, bringing in a wider spectrum of borrowers and making rates a bit more competitive. “Banks have excellent networks from an origination perspective,” Griffiths says.

Although lenders celebrate fat margins in private credit, borrowers may be suffering from them. Interest rate premiums and payments are ratcheting up under tighter central bank policy. S&P provides credit ratings for some 2,000 “middle-market collateralized loan obligations,” a term largely synonymous with private credit loans, Muthukrishnan says. Of these, 175 (8.75%) were downgraded during the first nine months of 2023, a sharp increase from the previous year. “Two or three years ago, our concern was high leverage,” he says. “Now it’s interest cover.”

Companies may turn to private credit anyway, for short-term financing that no one else will offer. Two examples come from Michel Lowy, a co-founder of investor SC Lowy, based in Hong Kong. His firm helped finance a South Korean hotel, apartment and casino complex that opened during the pandemic, tiding it over until better times. The firm also sourced funds for the owner of an Indian cement factory who wanted to buy out his partner. “They wanted to use equity as collateral, which Indian banks couldn’t do, from a regulatory standpoint,” Lowy explains.

Interest on these loans runs anywhere from 12%-20%. “It’s expensive financing, but it often works as a one-to-three-year bridge,” Lowy adds. Asia is a laggard in private credit, but he sees it as the fastest-growing region going forward.

The large majority of private credit loans, though, are sponsored deals, arranged by PE investors who partner with or control the underlying corporate borrower. These same PE players—Blackstone, Ares, Apollo Global Management, and others—are also active as lenders, though presumably on different transactions. Indeed, private credit has become the go-to solution for the PE industry, providing about 80% of its financing, says Karen Simeone, a Boston-based managing director at private market specialist HarbourVest.

“Private credit has been flavor of the month for seven or eight years,” UNC’s Brown summarizes. “It’s just entering the mainstream now.”

With those steady tailwinds, the market has grown steadily at around 20% a year, reaching an estimated $1.5 trillion in loan volume globally. The US is the center of the business, with European deal volume at about half of North American levels, Campbell Lutyens’ Griffiths estimates. A few blockbuster private credit deals, in Europe as it happens, have grabbed headlines. A cabal of US funds raised $5.3 billion to buy London-based Finastra, a self-described fintech powerhouse, in July. Blackstone and UK-based Permira Credit nearly matched that in November, raising €4.5 billion (about $4.9 billion) to buy Norwegian online classifieds platform Adevinta.

But private credit’s core borrowers remain, as S&P’s rankings suggest, midsized companies, by global capital standards. “Private credit is very relevant to firms with annual Ebitda [earnings before interest, taxes, depreciation, and amortization] of $10 million to $50 million, maybe up to $100 million,” Griffiths says. “Banks would make those loans pre-GFC. Now CFOs have to look for alternatives.”

There are reasons to turn to private credit even when alternatives exist. Issuing a bond or leveraged loan may be cheaper, but private credit can be faster and simpler. “There’s no investment bank or road show,” S&P’s Muthukrishnan says. “There’s more certainty that the deal will get done, not fall apart in syndication.”

Private credit lenders are more like business partners and less like bankers tied up with red tape. That can increase flexibility when the loan terms are drafted: an optional second tranche held in reserve, for instance. The partnership can also help if the borrower hits a rocky patch, says Daniel Roddick, founder of London-based Ely Place Partners, which raises capital for private credit funds. “These loans are not binary on performing or defaulting,” he explains. “There’s typically close cooperation between the sponsor and the company to  work through any difficult periods.”

Last, but not least, private credit is not public. “A great part of this market is opaque,” says Muthukrishnan. “Sponsors and issuers both prefer it that way.”

In theory, private credit can also match pools of stable long-term capital, held by institutional investors and family offices, with longer-term capital needs of growing corporations. Insurance companies or pension funds, the typical limited partners that funnel cash to private credit funds, are much less levered than banks and don’t face the threat of a run on deposits. “I think regulators are pleased,” Griffiths says. “It’s preferable that corporate lending be done outside of banks.”

In practice, though, most private credit is used as medium-term debt, to be paid off when the PE sponsor exits the borrower through a sale or public stock offering. The average loan is held for three years, HarbourVest’s Simeone says, though contracted maturities are more like seven years.

That’s a problem, as higher interest rates and resulting lackluster markets make exits harder to find. The value of global mergers and acquisitions, one key indicator of the exit climate, dropped by a third in 2022 to its lowest in a decade excepting the 2020 pandemic year. It declined again in the first half of 2023.

If sponsors cannot sell or float as quickly as they had hoped, they may need to roll over their private credit lines at higher interest. “Private equity companies that are finding it difficult to exit companies may need to refinance instead,” Roddick says.

PE firms may also be tapping private credit to pay back their own investors who are pressing to get some money out. “General partners need to find ways of distributing capital to their limited partners,” explains Roddick.

Stress on the system is aggravated by two more factors, an economic slowdown that is well underway in Europe and threatening in the US could squeeze borrowers’ ability to repay and a flood of would-be new lenders may be chasing increasingly risky deals. “There’s enough froth in the market that there’s got to be some folks who have been making bad underwriting decisions,” warns UNC’s Brown.

A revival of animal spirits in M&A or initial public offerings could bail lenders out. That hopeful turn of events looks more likely after 2023’s stock market rebound, with interest rates probably peaking. If not, things could get ugly. “If the exit market doesn’t thaw over the next year or two, you may see a wave in distressed private credit,” Brown says. “The music is going to stop at some point.”

S&P’s Muthukrishnan sees a similar time frame. “From a liquidity standpoint, the next year or two is OK across the market,” he says. After that, not so much.

The rush of leading commercial banks into private credit, in both North America and Europe, could alter the landscape for better or worse. Deep-pocketed newbies with money to burn might disrupt an “everybody-knows-everybody” business where trust builds up from one deal to the next. But the likes of JPMorgan Chase and Societe Generale could also extend private credit beyond PE-backed borrowers and produce hybrid deals that might be cheaper.

Regulated banks might use their own networks to recruit borrowers, then “take the most senior secure piece of the credit package,” Campbell Lutyens’ Griffiths speculates. Private credit could provide the riskier chunk. Banks can enhance packages with a range of services PE sponsors cannot provide, from corporate credit cards to foreign exchange.

Private credit certainly has its place for corporates who need short-term funding in a hurry, or the sorts of “special situations” on which Michel Lowy says he focuses. In most cases, beneath the excited headlines, private credit is the latest way of piling leverage into leveraged buyouts. That process has been controversial since Michael Milken pioneered junk bonds in the 1980s. The world’s top regulatory bodies steered licensed banks away from this lending 15 years ago, leaving a market for buyers, and even more so borrowers, to beware. So, beware.

But the bank failures of the past year illustrate that change can increase risk as well as opportunity. Bank balance sheets remain stuffed with low-interest bonds that are money losers since rates rose dramatically in the US, eurozone, and elsewhere. Such “credit mismatches” helped sink three large US regional banks—Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank—in rapid succession earlier this year.

More might have followed without adroit rescues by the Fed and other regulators, says David Aikman, director of the Qatar Centre for Global Banking and professor of finance at King’s Business School in London. “It looks like there wasn’t enough resilience to rising interest rates in big chunks of the US banking system,” he says. “We would have seen more-widespread contagion had the Fed not stepped in so aggressively.”

Banks in Europe face new regulations that will prevent them from taking certain commissions from asset managers or insurers whose investment products the banks recommend to customers. That ban could wipe out a quarter of banks’ investment fee income once it takes effect in 2026, says Jens Baumgarten, senior partner in financial services at German consultancy Simon-Kucher & Partners. “They have to find ways to generate sustainable fee income again,” he says.

Longer term, banks are losing out to other intermediaries in the competition for new capital. The threat from online startup “neobanks” has somewhat faded. Many of the upstarts have failed or slowed down as both debt and equity capital dried up. The threat from other nonbank financial institutions—insurance companies, pension funds, sovereign wealth funds, and private credit—is only growing. These alternatives siphoned off “more than 70% of the net increase of financial funds” in the US from 2015 to 2022, McKinsey reports. “The traditional core of the banking sector—the balance sheet—now finds itself at a tipping point,” the consultancy concludes.

The acceleration of artificial intelligence (AI) through ChatGPT-style generative AI is a wild card. McKinsey emphasizes the new technology’s potential for cutting back-office expenses. “Generative AI could be a game changer, lifting productivity by 3% to 5% ,” McKinsey estimates. Baumgarten focuses more on individualizing customer relationships to drive engagement. One example: “When I board the plane for a ski trip, my banks can send me an email offering additional accident insurance.”

McKinsey coins a new phrase in its 2023 banking survey: “Indo-Crescent Region,” an arc of financial health that  stretches from Singapore across the Indian Ocean to the Gulf Arab states and down the eastern coast of Africa to Mozambique. This region is raking in capital fleeing wartime Russia and Ukraine. Fully half of the world’s best-performing banks are Indo-Crescent domiciled, McKinsey finds. Expected annual revenue growth this decade ranges from 6% in Singapore and others, to 9% in the United Arab Emirates.

The Indo Crescent accounts for just 8% of global banking assets, however. Much of the other 92% looks to be sailing into heavier weather. “We’re not heading for a ‘big bang’ like the 2008 global crisis,” Simon-Kucher’s Baumgarten asserts. “We are going into a cautious economic phase that could last a few years.”

Banks in North America and Europe are acting accordingly. Almost two-thirds of US banks with assets of $10 billion or more increased provisions in the second quarter of 2023, an S&P Global survey found. Bank CFOs are also piling up cash, more than $3 trillion at US institutions alone, CRISIL’s Vora reports. “Lifting liquidity is a focus for many of them now,” he says. Cash cushions can hide those holdings of low-yielding, pre-inflation bonds, whose diminished value helped sink SVB and others, he adds.

Savers are demanding higher returns on their deposits, which means less interest-rate windfall for banks going forward. The average rate in the euro area for “new deposits with agreed maturity” has jumped from near zero to 3% this year, the European Central Bank reports. US banks are still paying less than 2% for one-year certificates of deposit on average, but a host of online upstarts offer more than 5%. “Everyone knows that the tailwinds from interest rate hikes can end pretty quickly, especially when customers grow more sensitive on the rate differences and start shifting their funds more actively, ” Baumgarten says.

Then there’s China. Banks have long been presumed insulated from the No. 2 economy’s ups and downs, thanks to state ownership and enormous balance sheets. But that’s a safe bet only for the Big Four—Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, and Bank of China—which control about 40% of the system’s assets, says Logan Wright, head of China Markets research at the Rhodium Group consultancy.

Trouble is brewing at the municipal banks that account for another third. These institutions, linked formally or informally to local politicians, are heavily exposed to local-government funding vehicles—nonfinancial state-owned enterprises that focus on infrastructure development to sponsor local economic growth but tend to have very weak credit profiles—largely supported by land sales. The land sales have crashed as overleveraged property developers stopped buying, transmitting financial shocks backward along the train.

Forecasting how numerous and severe these shocks may be could involve a lot of guesswork, given Beijing’s preference for secrecy and accentuating the positive in economic news. Five rural banks collapsed last year in Henan and Anhui provinces, and that’s unlikely to be the end of it. “It’s a slow-motion financial crisis,” Wright says.

The central government guarantees retail deposits up to 500,000 renminbi (about $68,000). Otherwise, its rescue plans are fuzzy. Xi Jinping’s team is wary of writing a blank bailout check for the municipal banks, given suspicions of dodgy transactions related to their local governments, Wright says. “Do you want to bail out all these localities?” he asks rhetorically. “Probably not. We’re not seeing a coherent strategy at this point.” The good thing about China’s slow-motion financial crisis is that it’s staying in China, with little if any international contagion.

Banks in India, the emerging megastate, are on an opposite, positive trajectory. India looked to be lurching into its own slow-motion crisis five years ago. Nonperforming loans in the banking system, which is two-thirds state-controlled, peaked at over 11% in 2018, stressed assets at 14%. Yes Bank, one of the biggest private institutions, collapsed in early 2020, packed with dud credits to a few favored conglomerates.

Tighter regulation and economic growth—annual GDP expansion has topped 6% since the pandemic dip—have cut those NPL ratios in half. Private Indian banks like HDFC and ICICI have become global investor favorites, feasting off an expanding middle class with minimal exposure to state enterprises.

It doesn’t hurt that the government has not granted a new banking license in 30 years, says Amit Anand, co-founder of NextFins, which runs an exchange-traded fund for Indian bank stocks. Limited competition makes for hefty, well-protected interest margins. “The cool thing about Indian banks is they are really profitable, with net interest income around 4%,” he says.

Commercial real estate loans are a global concern, as high office-vacancy rates combined with spiking interest costs put pressure on borrowers. The risk is particularly concentrated on smaller US banks. Institutions with less than $100 billion in assets average 14.4% exposure to commercial real estate, compared to 2.9% for the “systemically important” giants, according to Fitch Ratings. Nearly 600 US institutions exceed regulatory guidance on the proportion of their balance sheet tied up with the sector.

The banking disturbances of 2023 are a far cry from the years following 2008, when leading institutions around the world ran for government bailouts and more than 400 banks disappeared within five years in the US alone. Bankers and regulators have learned at least some of the lessons from that disaster, which the financial sector inflicted on itself and everyone else.

But there’s only so much protection the industry can build against the fallout from the fastest interest rate increases in 40 years. Higher for a little while was a boon for bankers, higher for longer probably not so much. “It’s all really contingent on the path of rates,” King’s College professor Aikman says. “If we get back to a world of lower rates soon, then debt stocks are manageable.”

If not, watch out.

Russia’s top economic officials, known as cosmopolitan liberals in better days, have kept a low profile since their boss, President Vladimir Putin, invaded Ukraine 18 months ago. Central Bank Governor Elvira Nabiullina lost that luxury due to a plunging ruble.

As the national currency dipped below 100 to the dollar in mid-August, Putin’s economic adviser, Maxim Oreshkin, pointed the finger at the soft-spoken 59-year-old central banker. “The main source of a weakening ruble and rising inflation is lax monetary policy,” he wrote on the state news service, TASS.

Popular jingoist TV commentator Vladimir Solovyov also piled on. “Every other country is laughing at us because of our central bank’s brilliant policies,” he said. Moscow pundits started to wonder how long Nabiullina could keep her job.

The criticism was unjust. Nabiullina has been a consistent hawk during 10 years at the bank’s helm. Russia’s prime interest rate was 8.5%, with inflation around 3%—hardly lax. The ruble’s slide is driven by falling oil and gas export revenue and rising imports as the country navigates sanctions.   

Nabiullina responded to her critics within a few days. “Different conspiracy theories arise when the ruble weakens,” she told a financial conference. “You have to look first at the dynamics of foreign trade.”

Nonetheless, she hiked interest rates to 12%. Putin signaled his support by having Nabiullina in for a public meeting at the Kremlin. His minions let it be known they were “advising” importers to convert more of their take into rubles and mulling more formal capital controls.

That flurry of activity pulled the ruble back up to 95 to the dollar. It’s still down more than 20% this year.

Nabiullina looks steady in her chair for now. “Putin seems generally unwilling to change his team while the Ukraine conflict is ongoing,” says Tom Adshead, director of research at Macro-Advisory.

She may be wondering if she still wants it, however.

Receiving a bow from the US Treasury Secretary Janet Yellen is an auspicious way to debut in the world of global diplomacy. Such was the coming out that Chinese vice-premier He Lifeng enjoyed during Yellen’s July olive-branch visit. 

Chinese chains of command can be less than transparent. He’s star turn with Yellen marked him as Xi Jinping’s new economic emissary, heir to Lui He, who hammered out trade deals with Donald Trump’s administration, among other achievements.

Whether He, 68, can fill Lui’s shoes is another question. He lacks his predecessor’s fluent English and Harvard graduate degree, instead attaining his current position by riding Xi’s coattails beginning in the 1980s, while they were Chinese Community Party officials in the booming Fujian province.

His predilection for massive development projects earned the future vice-premier the nickname “He, The Big Demolisher.” But not all of his schemes worked out. “He is well known for financing one of the biggest ghost cities in China, the Yujiapu Financial District,” notes Victor Shih, director of the 21st Century China Center at the University of California San Diego.

He also has been a vocal proponent of the Greater Bay Area initiative that seeks to bind Hong Kong and Macau closer to the mainland with four new airports, artificial islands, undersea rail tunnels and other expensive showpieces.

Working with entrepreneurs who could make all this expenditure payoff apparently is not He’s department. However, Premier Li Qiang is mending fences with Alibaba, Tencent and other new-economy giants after two years of government crackdowns.

“There’s a generational shift, with Western-friendly officials retiring,” notes Michael Hirson, head of China research at 22V Research.

Pan Gongsheng, recently named deputy governor of the People’s Bank of China in July, rose through the technocratic ranks. He is slated to formally take over as governor from Yi Gang soon but is not expected to alter the central bank’s role of stimulating a flagging economy and managing China’s debt.

A dissolute British aristocrat in Ernest Hemingway’s novel The Sun Also Rises, when asked how he became bankrupt, famously answers, “Two ways. Gradually, then suddenly.” That could also describe the financial inflection point the world may be reaching today. Governments and corporations borrowed on a wartime scale to meet the challenge of the Covid-19 pandemic. A large slice of that debt will need refinancing at the much higher interest rates in the wake of central bank actions to stem post-pandemic inflation. Governments from Tokyo to Washington face rising expenditures for pension and health benefits, and voters are not inclined to approve either benefit cuts or tax increases as a solution.

Developed-economy debt plus inflation is constricting credit for developing countries, some of which are already enveloped in a wave of post-pandemic defaults. All this as the whole world needs to mobilize a new mountain of capital to slow climate change or adapt to its most dire impacts.

“There is no historical precedent for the current global debt situation,” says Emre Tiftik, director of Sustainability Research at the Institute of International Finance (IIF). “We are in uncharted territory.”

A few sobering statistics to underline the point: Global debt has increased by $45 trillion, or 17%, since the pandemic hit in early 2020, the IIF calculates. Even after a slight decline in 2022, that makes global debt now three times the size of the world economy. Emerging markets, led by China, accounted for almost $25 trillion of that bulge since 2019. Sovereign states’ interest payments jumped by 20% last year to $1.4 trillion, says James Cielinski, global head of Fixed Income at Janus Henderson Investors in London. That figure could double by 2025 under the current interest rate outlook.

Soaring rates have pushed one in seven US corporations into “zombie” territory—meaning their debt service exceeds profit—according to the IIF. Chinese corporate debt relative to GDP is nearly double the US level, and rising again as the world’s second-largest economy emerges from its “zero-Covid” lockdown. More than half the world’s low-income countries are “in debt distress or at high risk of debt distress,” according to the International Monetary Fund. Nine developing nations have already defaulted over the past three years.

When, how and where we lurch from “gradually” toward “suddenly” is anything but clear, however. “The idea that we’re at an inflection point has a great deal of credibility,” Cielinski says, “but that point could go on a lot longer than you would expect.”

The biggest sovereign debt gorgers over the past few years have been the governments of the three biggest global economies: the US, China and Japan. That’s a big departure from past cycles. Emerging markets fighting to peg weak currencies to the dollar drove debt crises in the 1980s and 1990s. The proximate cause in 2008 was consumer overleveraging, particularly by US homeowners, whose bad credit spread worldwide thanks to the magic of mortgage-backed securities.

It’s a good thing that supersovereigns are in the lead this time, because they have the deepest resources to pay it back. It’s a bad thing because if one of them fails, no one else on the planet can step in to mop up the mess. US government debt—including federal, state and local jurisdictions—grew from 108% to 128% of GDP during the peak pandemic year of 2020, Federal Reserve data show, before subsiding to 119% as a post-Covid growth spurt and inflation lifted nominal GDP and tax collections. But that shot in the arm is wearing off.

The US federal government alone ran a $1.4 trillion deficit last year, about 5.5% of GDP—Argentina, a byword for leaky fiscal policy, did much better at 3.8%. The US political landscape offers no easy path forward. Republicans refuse to consider tax increases or cuts in military spending, and Democrats vow no cuts to pensions or health care. Recent theatrical haggling over the national debt ceiling had negligible longer-term impact.

All the same, the prospect of the US Treasury going broke seems remote now. “We are at the beginning of a very classic late bigcycle debt crisis, when you’re producing too much debt and you also have a shortage of buyers,” Ray Dalio, chief investment officer of Bridgewater Associates, said at a conference in June. “There’s a supply/demand issue for that debt,” he continued.

“If we continue down this path, in terms of what’s likely over the next 5-10 years, you reach the point that the balancing act becomes very difficult.”

Private Sector Resilience

Corporate debtors in the US and most other places ex-China look reasonably resilient, zombies notwithstanding, because they locked in abundant financing during the long stretch when rates were near zero. “The corporate side is very similar to homeowners,” says Jack McIntyre, portfolio manager for Global Fixed Income at fund manager Brandywine Global. “They fixed in a lot of debt and don’t have to worry about refinancing in the short term.”

Yes, debt burdens are getting heavier: Interest costs at US companies jumped 22% year-on-year during the first quarter of 2023, Bloomberg reports. But corporates came into the current crunch with debt “coverage” at 20-year highs, notes Richard Familetti, chief investment officer for US fixed income at SLC Management, which is linked to Canadian insurer Sun Life. Defaults and downgrades are in line with historic averages.

“Corporate credit risk in the USA is kind of OK,” he concludes. Another bright spot is household debt, which sparked the global financial crisis 15 years ago. That metric dropped from 98% to 75% of GDP in the US since then, and remains subdued around the world—with a few exceptions like Australia and Canada.

“Consumers and consumer lenders have been relatively conservative since 2008,” says Terence Chan, a Melbourne-based senior researcher for S&P Global. China’s debt landscape presents a reverse mirror image to that of the US. Official central government debt is low while leverage piles up among corporations (many state owned), and local and regional governments.

Worries about the latter are rising at the moment. Local and regional borrowers now owe $23 trillion, by Goldman Sachs’ estimate. Most of this is held by so-called local government financing vehicles (LGFVs), whose finances are entirely opaque.

Local authorities’ revenue engine, land sales to property developers, meanwhile has sputtered. China’s builders sustained a body blow as the pandemic’s impact coincided with a Beijing-orchestrated leverage crackdown, and recovery looks halting. “Demand won’t come back nearly as it was over the past 20 years,” predicts Michael Hirson, head of China research at New York–based 22V Research. “Property has permanently shifted down to a lower gear.”

China’s central government, which racked up a $402 billion current account surplus in 2022, likely has the means to bail out any cash-strapped regions this year, but not to put the problem off indefinitely. President Xi Jinping and his team are wary of signing blank checks that could subsidize provincial government “shenanigans” that allow hidden debt to grow, Hirson cautions. He expects Beijing to start letting some of the LGFVs default late this year or early next, running the risk of financial contagion. Regional borrowers account for some 40% of China’s domestic bond market.

China theoretically has room to raise taxes. Government at all levels takes in about 20% of GDP, compared to an average 34.1% in 2021 for advanced member countries of the Organization for Economic Co-operation and Development. Only 10% of Chinese pay income tax, and none pay property tax. Beijing seems reluctant to move on this front too, despite the absence of organized political opposition.

That leaves Xi & Co. no easy way to reverse a worrying debt trajectory, but also some time—probably—to figure it out. “The sky isn’t falling this year, but the next few years will be important,” Hirson warns.

Japan played its part in the great pandemic-era splurge, maintaining the distinction of government debt champion with more than 260% of GDP. But the third-largest economy inhabits a fiscal and monetary world of its own, with interest rates still near zero and a captive domestic universe of bond buyers.

Investors in Japan Inc. are more worried about idle corporate cash balances than excessive leverage. Don’t expect a global debt meltdown to start there.

The eurozone, after its brush with death during the Greek debt crisis a decade ago, remains the most sober of the major economies. Government debt is lower now than in 2014. Banks, kept on a tight regulatory leash, have so far avoided the spasms affecting regional institutions in the US.

The European Union in 2020 proposed to issue a series of joint bonds—€806.9 billion worth for a pandemic recovery fund—with talk of a second round aimed at energy transition. That show of unity decreases chances of a national meltdown in Italy or another high-debt Southern European member of the EU, Cielinski says.

“Politically, people feel like the union is very strong,” he adds. “Any future problem will be more a eurozone problem.”

Big Challenges for Economies

Poorer countries don’t have the luxury of dawdling while gradually going bankrupt. “Debt vulnerabilities are primarily concentrated in low-income countries, many of which no longer have access to international debt markets,” notes the IIF’s Tiftik.

Most emerging markets, China excepted, lacked the means for big new expenditures to offset Covid-19. But the pandemic walloped their revenue, as exports plunged and tourism evaporated. Rocketing post-pandemic interest rates hiked their borrowing costs, if they could borrow at all. A US dollar that rose over 30% in value over the past decade hasn’t helped either.

Defaults have so far been confined to the global economy’s fringes: countries like Sri Lanka, Ecuador, Zambia and Ghana. (Russia, Ukraine and Belarus are special cases, stemming from the war and related sanctions.) But other large and strategic nations—Nigeria, Egypt and Pakistan— have been entering the debt spotlight this year. Nuclear-armed Pakistan’s fiscal outlook appears the most volatile, given a concurrent political struggle between deposed Prime Minister Imran Khan and the influential military, plus recurring natural disasters.

Floods and fires driven by climate change will compound financial pain across the developing world, predicts Ulrich Volz, director of the Centre for Sustainable Finance at the University of London. Back in 2009, developed nations pledged to funnel $100 billion a year by 2020 to developing states to offset climate change. The rich countries have fallen far short—collateral damage in part from rising debts at home.

While corporate debt remains largely manageable, a few pockets of the private economy could wreak systemic havoc. One is commercial real estate, which remains in a funk as shoppers and office workers cling to pandemic stay-at-home routines. “Office occupancy rates in New York were around 50% of their pre-pandemic level in May; and as of March, office occupancy in London still stood at around 26.5%, down from pre-pandemic levels of 60% to 80%.”

That spells a lot of at-risk credit, which in the US is concentrated in already-troubled regional banks. About one quarter of all US banks with assets below $50 billion exceed regulatory thresholds for commercial real estate and/or construction loans, according to a recent study by industry data provider Trepp. That’s unwelcome news after three notable collapses this year: Silicon Valley Bank, Signature Bank and First Republic Bank.

“Commercial real estate portfolios, particularly loans backed by office properties, face challenges should demand for office space remain weak,” Federal Deposit Insurance Corporation (FDIC) Chair Martin Gruenberg warned following release of the FDIC’s quarterly report in May.

Any pullback by regulated banks, however, could boost more market share for private credit, an industry that has grown from zero before 2008 to more than $2 trillion globally, according to the IIF. “We expect ongoing pressures on US regional banks will facilitate the continued expansion of private debt markets,” Tiftik and colleagues write in May’s Global Debt Monitor.

Upward of $2 trillion in opaque, illiquid financial commitments is enough to raise at least a yellow flag under current volatile conditions, S&P’s Chan argues: “Private credit is one of those areas that could be exposed if everyone rushes for the door.”

At the very least, the prospect of the world’s leading governments borrowing ever-more trillions at elevated—or, if you prefer, normalized—interest rates is likely to mean tighter money for everyone else, despite any magic that global finance can bring to bear.

CFOs in the private sector will have to focus more on avoiding zombie status and probably a little less on funding expansion or productivity improvements.

“My advice to CFOs is to carry a higher cash balance than usual and accept the 5% the US Treasury is offering,” SLC Management’s Familetti says.

A dose of capital discipline might not be a bad thing in some respects: trimming outlays for ghost cities in China, say, or virtual-reality headsets from Silicon Valley.

But writ large, the world will still need to invest more to save itself from increasingly severe climate dislocations: an average of $3.5 trillion a year more through 2050 (“worth about 2.8% of global GDP between 2020 and 2050”), according to a January 2022 McKinsey report on netzero carbon emissions. China also needs resources to keep the promises it’s already made, pensions and health care for aging populations, education, and infrastructure upgrades to meet the needs of a changing economy.

Across the globe, a “Great Reset” of attitudes is needed from policymakers and citizens alike, Chan and colleagues argue in a January report. “Avoiding the hell of a debt crisis may require ensuring only productive new debt is deployed, writing down unproductive debt, curbing overconsumption and restructuring loss-making enterprises,” the researchers note. “These actions may not be popular.” Indeed, there will be no easy ways out.