For much of the past year, a cohort of financial regulators have signaled their desire to clamp down on private credit--whereby businesses get capital from investors instead of issuing bonds or borrowing money from a bank. Their concern is that such loans could constitute a systemic risk to financial markets. Credit rating behemoth Moody’s has also chimed in by calling private credit “opaque” and arguing that the potential risks it poses are increasing. Even Bloomberg’s Odd Lots podcast, which has a strong following on Wall Street, weighed in last month with an ominous sounding episode entitled “The Black Hole of Private Credit That’s Swallowing the Economy.”
These critiques wrongly insinuate that private capital poses a threat to financial stability – something that couldn’t be further from the truth. It constitutes a small portion of the U.S. financial markets and there is no evidence that it is particularly risky. Limiting its growth or the types of investments it supports would make it harder for companies that rely on private credit to access capital, thereby slowing economic growth.
Private credit is a relatively new phenomenon: While most individuals who need a loan go to a bank, middle-market businesses (firms with annual revenues between $10 million and $1 billion) are increasingly turning to financial firms that raise money from sophisticated investors. One advantage to borrowing from private credit is that it is often easier to procure.
There are also broader benefits: For starters, private credit is highly unlikely to blow up the economy. While some proportion of these loans will certainly go bad, the market constitutes a small proportion of all financial transactions. Private credit has nearly $1.7 trillion in assets under management, while total non-financial sector debt is $73 trillion.
It is also the case that the investors providing the capital are financially savvy, have deep pockets, and understand the risks involved. Unlike bank depositors, they have committed to lend their money for an extended period of time. There is no possibility that the money being lent will be called back because of some incipient financial crisis. If losses do take place, investors would simply absorb them and the asset manager can conduct an orderly liquidation -- unlike the rapid demise of Silicon Valley Bank, Signature Bank and the other banks that failed in 2023 because of bad investments and panicky depositors.
Following the 2008 financial crisis, banks pulled back from business lending, mainly due to more stringent regulations, and private credit took up the slack. In recent years, banks have further retrenched amid a variety of liquidity constraints and regulatory scrutiny, and private credit again stepped up to provide loans -- especially to mid-sized companies. This shift from bank credit to private credit is far from over: Federal Reserve Board Governor Christopher Waller has observed that a plan from U.S. regulators to toughen capital requirements would further reduce banks’ willingness to make business loans, which would drive even more lending into the private credit arena. Thankfully, the latest proposal issued last month is not as onerous as previously suggested, but it still increases capital requirements by nine percent for big banks.
The unsurprising result of this series of bank regulatory actions has been that mid-sized companies now borrow more in the private credit markets. This new equilibrium allows banks to maintain lower risk weights, which is what regulators want, and mid-sized firms can maintain access to credit, which benefits the broader economy.
Given the benefits and the limited risks, there is little reason for regulators such as the Federal Reserve, U.S. Treasury and the Office of the Comptroller of the Currency to be given greater regulatory authority over private credit.
There is also no reason for credit rating agencies to have a greater role in private credit. The various post-mortems of the 2008 crisis all concluded that credit rating agencies failed in their responsibility to provide an objective and unbiased perspective on the safety of various financial assets, and Dodd-Frank effectively directed regulators to reduce reliance on rating agencies.
To that end, it is fair to question the motives behind recent Moody’s reports suggesting that private credit poses an outsized risk to the economy: If the government were to step up its oversight or regulation, it would be easier for Moody’s and its competitors to engender demand from investors to rate private credit.
What makes Moody’s critiques especially troubling is that they are based on unsubstantiated claims – not anything happening in the markets. For example, in a July report the firm said “opacity” can make it challenging for investors to know what risks may be lurking in private credit portfolios. Moody’s added that private credit lenders may not mark down their loans in an economic downturn, causing them to “overstate” fund performance. There is zero evidence that either concern is legitimate.
Private credit is a natural—and salutary—outgrowth of bank regulators’ efforts to reduce the risk exposure of banks. Unless regulators would prefer to starve middle-market companies of credit and deter their ability to grow, or introduce more risk into capital markets, they should resist imposing new regulatory strictures on private credit.
