By Sayee Srinivasan and Jeff Huther
ABA Data Bank
This essay examines a small group of beneficiaries, private credit funds (or private credit for short), that have already experienced rapid growth following previous rounds of increased capital requirements for banks and whose rapid growth raises questions about the net effects of the proposed regulations. While they represent only a small part of the unregulated financial businesses that would benefit from B3E, private credit funds are a good illustration of the shift out of banks and into opaque, expensive nonbank financial firms. Such a shift constitutes an example of the classic unintended consequences of regulations that lack holistic economic analysis.
Private credit funds are pools of actively managed capital that invest primarily in loans to private companies — a type of nonbank financial intermediation, or NBFI also called shadow banking. So, while investors could start a bank with the goal of lending to businesses, they can also choose to avoid the expansive bank regulatory framework by, instead, pooling their funds and hiring what in banking would be called loan officers. This regulation-light approach is allowed because lenders to these funds, unlike depositors, give up their right to withdraw money early and (Scout’s honor!) they will not seek government assistance if the loans go bad.
The pace of growth of private credit is starkly illustrated in figure 1. And ironically, this growth is aided by regulations that encourage banks to reduce their loan portfolios, often with hedge funds and other private credit providers stepping in to fill the void.
There is nothing new about nonbanks offering banking-type products. Also not new is that one can typically point to bank regulation as a key driver for such innovation. For example, money market mutual funds were a market response to the caps on interest payments by banks on deposits (former Regulation Q). They are now a $5.7 trillion market (as of the week ended October 4, 2023), prone to runs and requiring assistance from the Federal Reserve during stressed market conditions to stem financial contagion.
A few facts: First, while banks are still a core part of the broader financial system, the U.S. banking system now provides just 33 percent of total credit to the U.S. non-financial sector — that is, Main Street America, both businesses and households. The rest of the credit supply comes from a slew of nonbanks offering many of the classic banking services, but without the same regulatory oversight: consumer loans, lending to businesses, creation and sales of securities, management of money market assets, payment system provision and support for traditional savings vehicles such as pension funds and insurance companies.
Second, few of these alternative sources of credit are subject to any form of capital requirements — the closely scrutinized asset cushion that banks must maintain to ensure financial stability. Some face state regulations while others are completely outside the regulatory capital perimeter — and capital requirements that do exist, say, for insurance companies, do not define capital as narrowly or rigorously as banking regulators do.
Third, banking is subject to the most comprehensive set of rules and regulations, supervisory examinations, etc.; none of the other sources of credit faces anything remotely comparable. The B3E proposal, for example, is over 1,000 pages.
Fourth, the largest banks in the country have been designated as systemically important, but despite the government having the authority to designate other providers of credit following the financial crisis failure of large nonbanks, this tool has gone unused for nearly a decade. (Some insurance companies and other firms were designated for a short time, but several successfully sued to remove the systemically important designation). This designation comes with its own set of regulations and requirements.
Finally, regulatory bodies like the Financial Stability Board and the Financial Stability Oversight Council raise concerns related to NBFI, but they are thinking mainly about hedge funds and the markets-related activities of insurance companies. Other financial structures that operate outside of the regulatory framework face even less attention. Private credit funds only show up on their laundry lists of risks or as curiosities in the Fed’s Financial Stability Report (see, in particular, the box in the May 2023 FSR). A recent FSB progress report on enhancing resilience of NBFIs does not include any reference to private credit lenders. While the FSOC acknowledged the risks of regulatory arbitrage in its 2022 annual report, the lack of concrete proposals for private credit funds accompanied by additional regulations for banks clearly indicate that regulatory arbitrage risk will worsen under proposed changes.
For banks, the facts of life listed above — rigorous oversight coupled with unregulated competition — have led to a contraction of bank provision of the building blocks of a healthy economy. Business lines such as mortgage origination have been undermined by the implementation of a slew of Basel III standards and numerous customer protection rules, giving nonbanks a competitive advantage that has led them to now account for over 70 percent of the total market. Even many community banks challenged by numerous regulatory requirements shrank their mortgage business. Some bank customers have been shut out from traditional mortgage products and now rely completely on alternative sources of credit. In other markets, banks are also losing market share to less regulated competitors. For example, around 2010, banks and the nonbank, tax-advantaged Farm Credit System had equal market shares of U.S. farm business debt; the latter now has a 10 percentage point advantage over banks. And more recently, a class of nonbank players offering loan products, such as buy-now-pay-later and payday lending, have grown up on the competitive advantages of regulatory arbitrage. When policy interest rates were close to zero, some of the largest nonbank firms offering these credit products boasted equity valuations reflecting multiples bigger than many banks.
It’s good to be private credit
Private credit funds operate outside the regulatory perimeter, despite the fact that they raise money from investors, engage in maturity transformation, and engage in classic commercial banking activities. But they are not subject to any, once again, any bank-style rules and regulations: no capital requirements, no risk management requirements, no supervisors permanently stationed at their offices examining their books and records, no need for any regulatory reporting, no Community Reinvestment Act compliance to document. Hence their competitive advantage over banks.
In past economic cycles, corporate borrowers would have turned to banks to manage their financing, especially when rates spike and rate risk management needs grow. As described in a recent Bloomberg story, banks now face regulatory pressures to slow loan growth, causing their customers to turn to alternative funding sources like private credit. The story quotes a market participant saying that “[b]anks won’t underwrite this stuff” and that “[i]t’s going into the hands of private credit.” Presuming the market is pricing the risks appropriately, holding everything else constant, banks should be interested in making these loans — but they are not.
Private credit fund growth is driven by investors. It is not the case that the broader U.S. financial system is running short of funding. Per figure 2, investors are actively looking to invest in financial intermediaries such as private credit.
Meanwhile, the competitive playing field is tilted towards private credit. Lending is a highly competitive business, with banks competing with each other and with a spectrum of other nonbanks. If banks try to pass on the full costs from the regulatory burdens, their customers will walk across the street to a competitor.
If the pricing is attractive, a bank should be eager to provide the needed funding. Corporations have relationships with banks for a slew of credit and other products and services. So why would a bank let a customer take this business elsewhere? Simple answer: once the bank factors in the cost of figuring out the additional capital required for these credit transactions, the cost of that additional capital, the costs imposed from the back and forth with bank supervisors examining the bank’s transactions, and then any additional capital and other constraints if the bank is subject to stress tests, then the price at which the bank would be able to provide the credit will be easily undercut by the private credit funds.
Private credit also locks up investor funds. Investors in private credit funds typically cannot withdraw their money on demand. There are long lock-in periods and even more complex structures (you can read about zombie funds here) for these credit funds. Some nonbank lenders can impose withdrawal limits during stressed market conditions — if a bank were to do it, it potentially could be treated as a failed bank. In theory, this reduces the risk of a failure in a private credit fund creating contagion and wider financial instability. Unfortunately, this view misses the point that when systemic risk comes calling, lock-in periods will not matter.
It is instructive to look at the 2022 liability-driven investment episode in the UK. There was a run on the entities by counterparties in the derivatives markets as opposed to the classic depositors-running-to-the-bank-to-pull-out-their-money. This episode required very strong intervention from the Bank of England to stem broader market turmoil. More recently, concerns have been raised about private equity firms that have bought insurance companies to get access to cheap capital. If the private credit transactions (funded using insurance company assets) incur significant losses, then these will flow through to the insurance companies, creating the risk that when regular shocks hit policy holders — losses to personal property from daily events, natural disasters, and other hazards — the insurance company will not be able to fulfil its obligations. Market observers are now concerned that confidence in insurance companies could be undermined by affiliated private credit funds, potentially triggering runs by policy holders. Relatedly, the global standards bodies have been working on plans to provide liquidity support to NBFI providers during stressed market conditions. Just because we have not yet seen financial system stresses due to failing private credit/equity funds does not mean we cannot rule it out.
What’s the downside risk if Main Street America increases its reliance on private credit funds? We can start by responding to a question with another question: Do bank regulators want U.S. households and businesses turning to entities outside the regulatory perimeter for credit and hence not subject to any regulatory requirements? This is a rhetorical question, as no bank regulator will confirm that this is their intent. Unfortunately, this is not helpful as implementation of the broader Basel III standards — the original plus the endgame — is turning the proverbial dials up to 11 to take us to the state of the world where private credit funds will account for a larger fraction of credit supply to the U.S. economy.
One reason for the hundreds of thousands of pages of rules for banks is that they are dealing with other people’s money and, ultimately, financial security is fundamentally important. But as figure 3, from a recent Fed Financial Stability Report, illustrates, private credit funds too are funded by Main Street America.
Intermediation matters, and to many people, it matters a lot. Consider a residential neighborhood: the residents’ quality of life may be very different depending on whether people live in houses purchased with bank loans or rent houses from large-scale investment funds. The type of intermediation creates different incentives to invest in the character of the community. Same people, different financing, different outcomes.
Another reason, one that doesn’t get mentioned at all, is a strong policy interest in ensuring that banks remain resilient to continue supporting their customers — Main Street businesses and American households — through the ups and downs of economic cycles. Unfortunately, as burdensome regulations drive U.S. banks out of the business of providing credit to these communities, the vacuum will be filled by poorly capitalized private credit funds (and other nonbank lenders) that will provide credit when times are good but disappear when times are tough.
Lacking any equivalent requirements for capital and conduct, there is a risk that these nonbank lenders will not survive the regular boom-and-bust cycle without support from the Federal Reserve — that is, their current success is partially based on an implicit subsidy from the Fed. We have seen nonbank residential mortgage originators shrink their operations very quickly in response to the sharp drop of transactions in the residential real estate market — they are here today, but might be gone tomorrow. Recent experience in the UK when some gas suppliers went bust during an energy crisis, leaving UK households and businesses without power, is instructive. Reports on “zombie” private equity funds make for interesting reading on the longer-term reliability of these nonbank financial institutions.
Over time, lacking the restrictions on counterparty credit risk imposed by regulators on banks, private credit funds have progressively increased the size and types of firms they lend to. And as they are typically more expensive, the cost of banks being pushed out of credit supply will ultimately be borne by Main Street America. In fact, U.S. firms are already in this situation. As banks are being forced to shrink their footprint in the credit provisioning business, nonbank sources such as private credit have become the only option for many firms.
In short, the recent B3E proposals are a stark illustration of how bank regulators in the U.S. (and their collaboration with bank regulators in other jurisdictions as part of the Basel Committee on Bank Supervision) are continuing to enact regulations that push banks out of the business of banking. We witnessed a similar shift after the adoption of the post-financial crisis Basel III capital standards in the context of the residential mortgage origination business and in the business of liquidity provision in U.S. Treasury securities markets. Today, nonbank players operating outside the regulatory perimeter of these new capital rules account for over 70 percent of the mortgage origination business, up from 20 percent prior to implementation of the Basel III rules. These mortgage companies are thinly capitalized and frequently specialize in riskier types of mortgage lending that are prone to outsized losses during periods of financial stress.
In the U.S. Treasury markets, the supplemental leverage ratio is seen by many as hindering banks’ ability to step up to smooth disruptions. Strains in the Treasury market have been exacerbated by capital regulations that discourage banks from acting as shock absorbers during bouts of volatility, forcing the Fed to step in, most recently at the beginning of the pandemic. It is reasonable to expect something similar to occur in the business of credit provision to U.S. households and businesses.
It is likely that the proposed B3E will continue to push additional activities out of banks to the other, less regulated entities. Private credit players are reportedly sitting on $2 trillion of cash, or “dry powder,” waiting to be deployed, largely unconstrained by even modest rules governing leverage and potential risk to financial stability. The banking industry, in contrast, is very liquid, but is also dealing with high capital requirements, comprehensive supervision of all aspects of business and funding pressure as a consequence of the Fed’s monetary policy decisions. In addition to available cash, private credit already has approximately $1.5 trillion dollars in assets under management, as shown in figure 4.
From a free market perspective, the effects of the B3E proposals may suggest robust capitalism that will be boosted by the B3E proposals. From a historical perspective, they should raise concerns that the next financial crisis, when it inevitably occurs, will require bailouts of unregulated, leveraged firms with systemically large economic footprints.
The recent B3E proposals extend an already restrictive approach to capital management by regulators. While the 2008 financial crisis was largely the result of imprudent lending (and, of course, borrowing) by a wide range of financial intermediaries, the legislation and regulation that followed largely focused on banks and, specifically, the amount of capital they hold. The bank-capital focus has been pushing financial assets out of the safe banking sector into opaque nonbank financial institutions. While this push may lead most of us to shrug our shoulders and say, who cares, many more are exposed than we may realize. Pension funds are increasingly using hedge funds to boost their yields, insurance companies are increasingly owned by private equity looking for additional sources of funds. All of us pay the price when large, heavily leveraged firms go belly up — which is why we should think twice about creating a regulatory framework that drives business away from the brightly lit world of highly regulated banks and into the shadows of private credit.
Sayee Srinivasan is chief economist at ABA, where Jeff Huther is VP for banking and economic policy research.