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.…