The collapse of Silicon Valley Bank has created a modicum of urgency for regulators and others to search for potential sources of systemic risk in our financial markets. While most of these efforts have taken the form of increased regulatory scrutiny of bank portfolios--which appears to have been neglected with SVB--some have suggested that regulators should take a closer look at private credit, which has significantly increased in its aftermath.
Private credit is when a business borrows directly from a group of investors rather than issuing a bond or borrowing from a bank; it has been growing steadily for the last few years and will amount to $1.5 trillion in 2024.
Some have suggested that its size may be problematic, that regulators should devote more attention to it and possibly consider taking steps to constrain its further growth. Doing so would be a mistake, however. While $1.5 trillion sounds like an enormous amount of capital, it represents a small fraction of the $40 trillion of total nonfinancial debt in U.S. financial markets. What’s more, private credit is less susceptible to anything resembling a financial crisis than traditional lending markets.
Private lending entails little systemic risk because it obviates the possibility of a bank run: Unlike bank deposits, private credit lenders have no recourse to pull back their money before the term of the loan ends. Taking steps to constrain it would almost inevitably reduce financial stability while making it more difficult for companies that rely on private credit to access capital, slowing economic growth.
Private credit might best be seen as a complement and not a substitute for bank loans. Since the 2008 financial crisis bank regulators have made business lending more complicated for banks, and private credit has developed to address that lacuna.
Instead of going to a bank or issuing bonds to raise capital, many middle-market businesses (that is, firms with annual revenues between $10 million and $1 billion) prefer to borrow money from private investors because it can be more expedient: A lender can request whatever information or documentation it sees fit and not feel compelled to hew to some burdensome bureaucratic set of data requirements.
A community banker recently lamented to us that he lost a client who wanted a $10 million loan because his compliance department kept asking for more documentation on the company owner’s homeowner association fee obligations. The client obtained the money from private credit within two days, he wistfully reported.
Bank lending may further retrench whenever the U.S. adopts Basel III standards, which would require banks to increase the amount of capital they keep, constraining their ability to lend. Slowing the growth of private lending concomitantly with the adoption of Basel III would risk triggering a recession.
In some markets, private credit increases the availability of credit where it has waned. The officers of one community bank in Downstate Illinois report that the large national banks with branches in the area ceased making business loans there long ago because the short-term managers who ran those branches never stayed around long enough to learn the intricacies of the local economy. Their only competition in the lending market comes from private credit.
Mid-sized companies borrowing more money in private credit markets allow banks to maintain lower risk weights without denying mid-sized firms access to credit, which boosts lending and economic growth.
Given this reality, the notion that private credit needs more regulatory scrutiny or that credit ratings agencies should be engaged to provide credit ratings for private credit--both of which have been recently advanced--makes little sense. Government regulators can’t tamp down credit everywhere all at once without it impacting the availability of credit, obviously. With negligible benefits and tangible 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 financial 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.
Private credit is not mysterious or opaque, although some like to imply as much. It constitutes a small fraction of lending in the country and no one has identified any sort of systemic risk it brings to capital markets. Constraining it makes little sense, and considering such a step just as Basel III is to be implemented could end up degrading capital market stability at a very inopportune time.
