The views expressed here are those of the author, executive vice president and chief investment officer of Global Liquidity Markets at Federated Hermes.

By Deborah Cunningham

NEW YORK, May 26 (Reuters) - Mounting concerns about private credit have made investors ask whether stresses in this opaque asset class could spill over into the broader U.S. financial system. While the threat of a liquidity crisis driven by private lending looks minimal, several potential secondary risk channels warrant close attention.

U.S. private credit’s rapid expansion and growing interconnectedness with the broader financial system mean that any stress is unlikely to stay fully self‑contained.

As funds in the U.S. have scaled up, private lenders have relied more heavily on short‑term funding, leverage, and operational links to traditional financial institutions.

When looking for signs of stress, therefore, it makes sense to first examine money market funds (MMFs), which play a central role in short-term cash management.

During the COVID-19 pandemic, MMFs served as a liquidity buffer amid the heightened demand for cash – and that buffer still appears intact. As of March, MMF net assets stood at around $8.3 trillion, a level close to historical highs and more than double their pre-pandemic size.

In other words, there is no indication of any trouble brewing here.

That’s unlikely to change even if U.S. private credit weakness intensifies, at least via direct channels. MMFs consist of highly liquid, high-quality instruments, so private credit - an illiquid asset class - is not typically a core component of these portfolios.

PASSING THE STRESS TEST

The next – and arguably more important – lens to use to assess any potential vulnerabilities is the fundamental health of major U.S. banks. Here too, the picture is broadly reassuring.

Top-tier U.S. banks continue to demonstrate solid fundamentals, supported by robust capital positions, sound liquidity buffers, and stable funding profiles. This is reflected in Common Equity Tier 1 (CET1) Ratios and Liquidity Coverage Ratios that remain comfortably above regulatory minimums.

This contrasts sharply with the period leading into the 2007 to 2008 global financial crisis (GFC), when banks were far less well capitalised, liquidity positions were weaker and asset quality problems were emerging.

Recent stress testing appears to support that view. The Federal Reserve’s 2025 stress test suggested that large U.S. banks would remain well capitalised even under a severely adverse economic scenario, with projected capital declines notably lower than in previous stress tests.

Based on the Fed’s aggregate measure, the banking sector’s CET1 ratio would decline by 180 basis points, materially less than the 280 bps and 250 bps declines projected in 2024 and 2023 respectively.

Recent credit spread patterns have also not pointed to systemic stress or a broad repricing of bank credit risk – even during the weeks when private credit fears were spiking earlier this year.

INDIRECT CHANNELS

High-quality banks’ vulnerability to private credit weakness thus appears very limited, but there are several secondary channels that could expose banks – and by extension the broader financial system – to greater risk.

Balance-sheet linkages between private-lending institutions and banks are one space to watch. Bank loans to non-depository financial institutions (NDFI) - a broad category including private credit funds and other nonbank lenders - have risen sharply to nearly $2 trillion, up from around $1.23 trillion a year ago, according to the Fed.

That growth means the boundary between banks and private markets is more porous than it appears, raising the issue of whether stress in private credit could feed back into bank balance sheets through receivables or certain funding structures.

Structured finance is another potential transmission channel. Some asset-backed securities – tranched instruments created by pooling loans or receivables, such as mortgages, credit card debt or auto loans – may carry indirect exposures to private-lending activity. The risk is that credit stress could be dispersed throughout these instruments’ layered structures, making exposures harder to trace and potentially amplifying pressure if the value of the underlying collateral falls.

Moreover, risk in global liquidity markets does not always surface immediately. History offers several reminders that institutions once regarded as "high quality" can come under pressure when risks become concentrated in specific asset types associated with lower credit profiles. Just look at Icelandic, Irish and Italian banks during the GFC.

This is why greater disclosure would be beneficial. Risks transmitted through secondary channels often emerge gradually, so to properly analyze market liquidity threats, one must be able to closely monitor the underlying credit risk.

That analysis typically starts with fundamental credit research, combining quantitative indicators such as financial ratios and profitability metrics with qualitative factors including management quality and strategic positioning.

Greater disclosure of banks’ private credit exposure would help sharpen this assessment, particularly because the diverse links that banks and asset-backed securities groups have to private credit are typically housed under broad "nonbank financial" categories in their financial statements.

In an environment where risks can migrate rather than disappear, clarity itself becomes a source of stability.

(The opinions expressed here are those of Deborah Cunningham, chief investment officer of Global Liquidity Markets at Federated Hermes. This column is for educational purposes only and should not be construed as investment advice.)

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