Not so Fragile: Private Credit Getting Some Credit for Reducing Systemic Risk

The size of the private credit market seems to know no bounds. Recent calculations estimate that non-bank financial institutions have lent more than $2.1 trillion to corporate borrowers just last year alone in assets and committed capital.

For borrowers, these loans provide an alternative to traditional financing with less stringent requirements. The benefit for investors is more attractive returns than they would get from other fixed-income products.

A vast majority of the volume is in the US, where a company’s financing needs may have been either too large or too small for commercial banks, so that in a Goldilocks turn of credit events, private debt became “just right.”

And as no surprise, this phenomenon is not always just right for everyone. In an April blog post, this year the IMF charged that the private credit market “warrants closer watch” and the rapid growth could “heighten financial vulnerabilities given its limited oversight.”

The arguments from the IMF identify a number of other “fragilities” in a larger essay called “Global Financial Stability Report.”  These include claims that private credit borrowers “tend to be smaller and carry more debt” and thus may be more vulnerable to rising rates, and that competition puts pressure on “private credit providers to deploy capital and thereby leads to weaker underwriting standards and looser loan covenants.”

All fair points to some extent and many of those so-called fragilities are echoed by other European counterparts, who call on stricter reporting requirements.

However, in recent weeks, and certainly in light of the US election results, it seems as if a slight shift is taking place among regulators and academics that leans to a softer stance on regulation.

U.S. Securities and Exchange Commission Chair Gary Gensler, at the Bloomberg Global Regulatory Forum in Washington, DC, last month in a speech called, “A Feature, Not a Bug: The Important Role of Capital Markets in the US,” called out the resiliency of these markets and the importance of private credit.

“The non-bank sector provides important alternatives and competition to the banking sector,” he said in prepared remarks. “This competition benefits investors, savers, borrowers and issuers, as well as the banks themselves.”

Gensler warned that when looking at risk and fragility in finance, “it’s important not to paint with a broad brush. Not every risk is the same. In fact, the financial sectois about allocating and pricing risk, not eliminating it.”

A more moderated stance it appears from a regulator than some may think. But Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, also noted that private credit may in fact reduce systemic risk in the US financial system.

“It’s scary at some level, because it’s exploded to a trillion-dollar-plus market fairly quickly,” he was quoted at a Bloomberg story last month out of Buenos Aires. “But as I’ve examined it, a bank in the US today – a big bank – is levered 10 to one times as much assets for their equity. These private credit vehicles are typically levered one to one, so it’s much less leverage.”

In fact, Kashkari believes that private credit vehicles may be lower risk than banks because they typically lock in capital for longer periods of time.

It’s probably a safe market bet that it won’t be a longer period of time to see the rhetoric around regulation and reporting for private credit to become even more accommodating to evolve from fragility to bug to resilient feature in financing.

Mark Kollar
Partner, Prosek Partners

Mark Kollar’s monthly Letter from America can be read at The Alternative Investor.