Private credit risks are rising but not systemic, while U.S. bank capital release provides a buffer

Overview

This report summarizes views from Morgan Stanley's Global Macro Forum, covering the U.S. fiscal impulse, financial conditions, AI and labor productivity, U.S. bank capital reform, private credit risk, refinancing pressure in the software sector, and contagion risk in public credit markets. The core judgment is that, at the macro level, oil prices may offset the consumer stimulus from tax refunds; at the banking level, capital reform releases excess capital and supports loan growth; and at the credit level, private credit risk is rising meaningfully but is mainly concentrated in software and AI-adjacent industries, and has not yet become a systemic shock.

Core views

The report is relatively constructive on U.S. banks because of lower capital requirements, higher excess capital, and accelerating commercial loan growth; it remains cautious on private credit because direct lending and BDC portfolios have relatively high exposure to software, IT services, and related industries, with software companies showing median leverage of about 8.0x and cash interest coverage of about 1.4x. The report also believes spillover risk to public markets is limited, because software exposure in the IG and HY markets is below 5%, the primary market remains active, and refinancing risk in non-software sectors is more manageable.

Analysis framework

The report uses a multi-theme macro and credit framework: it analyzes the offsetting effects of tax refunds and gasoline price changes on consumer cash flow; uses a financial conditions index to measure market-driven tightening as a substitute for Fed policy tightening; groups industries by AI exposure to observe output, employment, and productivity; estimates excess capital at U.S. banks using changes in regulatory capital rules; and evaluates private credit borrower credit quality, industry concentration, and default prospects using rating agency data, valuation proxies, and BDC holdings data.

Methodology notes

• Macro cash flow offset analysisTax refund and gasoline spending sensitivity

  Neutralization of the fiscal impulse

  The report compares the year-over-year increase in tax refunds with the increase in household spending caused by higher gasoline prices, and concludes that about a 15% increase in gasoline prices or an average price of $3.60 per gallon would offset the average increase in tax refunds.

• Credit fundamentals analysisPrivate credit borrower credit profile

  Comparison of low-B to CCC credit quality

  The report uses aggregated data from Fitch, S&P, KBRA, Lincoln International, and others to assess private credit borrowers, noting average EBITDA of about $30 million to $40 million, leverage of about 5-7x, and EBITDA coverage of about 1-2x.

• Industry exposure analysisBDC holdings industry concentration

  Concentration risk in software and AI-adjacent industries

  The report uses Pitchbook and BDC collateral data to examine direct lending exposure, noting that public BDCs hold about 22% in software and about 3% in IT services; including AI-concern-related sectors such as business services, insurance, and financial services, total exposure is about 50%.

• Market analogy analysis1997/1998 and 2005 credit market analogies

  Healthy economy, solid earnings, rising capex, but lagging credit performance

  The report compares 2026 with 1997/1998 and 2005, arguing that if geopolitical concerns fade and rates move lower, credit markets may return to the pre-conflict playbook, with improved animal spirits but moderately wider spreads.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Large and mid-sized U.S. banks

  Direct beneficiaries of capital reform and loan growth

  Strengths

  Lower capital requirements should increase excess capital, commercial lending especially C&I loan growth is strong, and banks' private credit exposure is relatively small and protected.

  Weaknesses

  CET1 capital ratios have already declined quarter over quarter, and capital deployment may lead to risk-weighted asset expansion and future credit quality pressure.

  Comparison

  Compared with private credit funds and BDCs, the banking system has stronger leverage and regulatory constraints, making systemic risk more controllable.

  Risks

  Changes in the regulatory proposal, slower loan growth, rising credit costs, and weaker-than-expected capital returns.

• Private credit

  The report's key source of risk

  Strengths

  Fewer lenders and stronger covenants are expected to support higher recovery rates after default.

  Weaknesses

  Borrowers are smaller, more leveraged, and have weaker coverage, with concentrated exposure to software and AI-adjacent industries.

  Comparison

  Compared with BSL, private credit may have higher recovery rates, but lower transparency and weaker visibility into valuation and credit metrics.

  Risks

  Software refinancing pressure, rising distressed exchanges, redemption pressure in retail private credit funds, and lagged valuations.

• Broadly syndicated loans

  Facing rising defaults alongside private credit

  Strengths

  Better market liquidity and public information, with the primary market still seeing active issuance.

  Weaknesses

  The 12-month default rate is expected to rise to about 5.5%, and recovery rates may be lower than in private credit.

  Comparison

  The default rate is below the 8% expected for private credit, but covenant protection and recovery rates are relatively weaker.

  Risks

  LBO refinancing pressure, rates staying high, and wider credit spreads.

• Software and IT services credit exposure

  Core vulnerability in private credit and BDC portfolios

  Strengths

  Historically, subscription-based revenue has been viewed as relatively resilient, supporting the ability to tolerate higher leverage.

  Weaknesses

  The share of tech lending has risen from below 10% before the pandemic to about 20%, while software companies have median leverage of about 8.0x and interest coverage of only about 1.4x.

  Comparison

  Compared with non-software sectors, software refinancing risk rises earlier in 2H 2026, and the impact of AI disruption on fundamental expectations is greater.

  Risks

  Concerns about AI substitution, valuation compression, refinancing difficulties, rising distressed exchanges, and higher default rates.

• Investment-grade and high-yield public credit

  Potentially affected by sentiment and spreads, but with limited contagion

  Strengths

  IG and HY have less than 5% exposure to software, issuance markets are up more than 20% year over year, and primary markets remain active.

  Weaknesses

  Credit had previously underperformed because of heavy supply, and geopolitical risk and rate volatility could cause moderately wider spreads.

  Comparison

  Compared with private credit, public credit markets offer better transparency and liquidity and lower software concentration.

  Risks

  Rates moving higher again, worsening geopolitical conflict, excessive issuance supply, and weaker risk appetite.

• Alternative asset managers

  Affected by redemption pressure in retail private credit

  Strengths

  Diversified alternative asset businesses can benefit from rotation in retail capital, while redemption thresholds can protect investors and cushion liquidity pressure.

  Weaknesses

  Retail private credit funds face redemption pressure; the challenge is viewed as cyclical but will still affect fund flows and valuations.

  Comparison

  Diversified platforms are more resilient than single-strategy private credit managers.

  Risks

  Worsening redemptions, product liquidity mismatches, and markdowns in private asset valuations.

Key data

• Excess capital at U.S. banksFrom $266 billion to $320 billion, about +20%Based on the 2026 capital rule proposal estimate for U.S. banks covered by Morgan Stanley.
• Disclosed 1Q26 bank CET1 capital ratioMedian down 40 bps quarter over quarterReflects that banks have already begun deploying part of their excess capital.
• C&I loan growthAbout 11% year over yearCommercial loan growth is accelerating and is one sign of banks deploying excess capital.
• Expected 12-month default rate for private creditAbout 8%Expected to be above average in 2H 2026 to 1H 2027, concentrated in software and skewed toward distressed exchanges.
• Expected 12-month default rate for broadly syndicated loansAbout 5.5%Also expected to be above average, but contagion risk in public markets is judged to be limited.
• Private credit recovery rate70%-80%Supported by fewer lenders and stronger covenants, and expected to be higher than BSL recovery rates.
• Median leverage of software companies8.0xHigher than the all-sector level of 6.6x, indicating greater fragility of the software sector in private credit.
• Cash interest coverage in the software sector1.4xCoverage is relatively weak in a high-rate environment, increasing refinancing and default pressure.
• Contribution of high AI exposure industries to productivity growth1.7 percentage points / 2.4 percentage pointsOver the four quarters through 4Q25, high AI exposure industries contributed most of the growth in output per worker.
• Software exposure in IG and HY marketsBelow 5%An important basis for the report's view that contagion in public credit markets is limited.

Impact & implications

For investors, the banking sector benefits from more moderate capital rules and loan growth, but capital returns, loan quality, and the pace of regulatory implementation should be monitored; private credit and direct lending portfolios need close scrutiny of exposure to software, IT services, and AI-adjacent industries, especially high-leverage, low-interest-coverage borrowers and the refinancing wall after 2H 2026; while public credit markets may see spread volatility, the report believes the probability of systemic contagion is low, with support from active primary markets and limited software exposure.

Risks

• Insufficient transparency among private credit borrowers limits visibility into the credit metrics of individual debtors.
• High leverage and low interest coverage in the software sector may trigger refinancing pressure after 2H 2026.
• AI's fundamental impact on software and adjacent industries may amplify credit pressure.
• Higher-than-expected oil prices may further erode real cash flow for U.S. consumers.
• Geopolitical conflict, rate volatility, and excessive issuance supply may cause credit spreads to widen again.
• If the final capital reform rules fall short of expectations, the scale of excess capital release at banks may decline.

What to watch

• The final form of the 2026 capital rule proposal and its actual impact on CET1 requirements.
• Growth in C&I lending, capital returns, and changes in credit costs at U.S. banks.
• Whether gasoline prices remain at levels sufficient to offset the increase in tax refunds.
• Changes in exposure to software, IT services, and AI-adjacent industries in private credit and BDC portfolios.
• Software debt maturities and the refinancing window from 2H 2026 to 1H 2027.
• Actual default rates, distressed exchange ratios, and recovery rates in private credit and BSL.
• Primary market issuance activity and spread changes in IG, HY, and BSL.