The Private Credit Infection

We are constantly being worned by politicians about the threat of private credit. Even some business leaders have warned the world about how private credit has the potential to destroy the banking system. This exposure to private credit could actually end up being quite similar to the 2008 financial crisis for the same reasons that caused that debacle. The argument against private credit states that banks have enough exposure to private credit that they will bear large and asymmetric risks if the private credit market ever takes a turn for the worse. Because the market is not as regulated as traditional lending, there is no regulatory stamp of approval on the various forms of private credit. Some banks have taken the approach of breaking their private credit exposure into tiers based on the quality of the debt. Grouping all private credit into one category is unable to account for the very real differences and risks of various types of private credit. However, in the years leading up to 2008, banks assumed that they would get bailed out if the mortgage back securities market ever crashed. While banks do their best to reassure us that they are being responsible, it seems much more likely that they are being responsible in our current system, which means basing action on the assumption that they will get bailed out, even if the private credit market fails. While not all banks will do this, the government protection that seems almost inevitable incentivizes most banks to have a higher exposure to private credit than they would otherwise because it poses no real risk to their long-term success. A lack of real risk bearing allows low quality private credit exposure to infect our most important financial institutions.

Private credit allows lending outside the structure of traditional banking, and thus allows more innovative and free credit offers. Bank lending is heavily regulated because governments have made a commitment to protect the banking industry, and as such, they put restrictions on it to ham-handedly reduce risk exposure in an industry that the government and people should not bear the risks of in the first place. Private credit allows non-bank entities to lend to businesses who otherwise not qualify for loans or not qualify for the sort of credit product that they would want. The 2008 regulations led to a subset of the market with demand for loans effectively unable to be served by banks. This gap was filled by private credit and it allows good risk adjusted returns for banks or other groups willing to invest in it. Private credit often serves as a lender of last resort for distressed businesses or businesses that are of a size and risk profile that make it not worth it for banks to attempt to jump through the regulatory hoops necessary to lend to them. While the firms that borrow in the private credit market are not necessarily more risky, the market as a whole does present more high risk, high reward situations than the businesses that banks lend to under the new regulatory structure.

As banks are extremely aware of the regulatory scrutiny that they are put under for being involved in private credit, many have a limited and high-quality exposure to private credit. However, the government’s consistent pattern of bailing banks out and treating them like they could not have known better will inevitably lead a subset of banks to take on extremely risky private credit exposure justified by higher returns. Given the recent handling of First Republic and Silicon Valley Bank, it would be very easy for a bank to assume that any shocks to the private credit industry that damaged a large bank would merely end up with additional government support. Additionally, if a bank looks at all their peers and sees that they are invested in private credit, it is easy to assume that they will not be penalized for doing what everyone else does. If the private credit market drastically restructures at one time, many banks make the assumption that they will be equally positioned. However, this is not true, as the underlying quality of private credit will play a much larger factor than private credit exposure itself. To look at private credit as a monster that will indiscriminately hurt banks is an oversimplification that can be quite damaging as it does not allow people to make discerning decisions within private credit that balance high returns with risk.

If we were to truly reduce the potential damage of risk exposure to low quality private credit, the Fed must credibly convince banks that it will not step in to bail them out in case of a private credit emergency. As long as firms think that the Federal government will be there to nurse their wounds and pick them back up from a destruction of their own making, the easier it will be for them to chase returns without an understanding of the danger of their exposure. Firms must be responsible for their actions, and in seeking to protect the people in the banking system, the Fed is giving an excuse for poor behavior, and only banks that can resist this incentive will survive without government assistance. The process of the next several years must be a weaning of banks from government support, or otherwise the American financial system will continue to face unneeded volatility and risk, exposing the people to ill-advised industrial risks.

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