This essay is based on the paper “Bank Capital and the Growth of Private Credit” by Sergey Chernenko, Robert Ialenti, and David Scharfstein.
Over the last decade there has been very significant growth in private credit. At a broad level, private credit can be defined as loans that are originated and held by nonbank financial intermediaries (NBFIs). Examples include consumer loans originated by fintechs, commercial real estate loans originated by alternative asset managers, and loans to fund buyouts of middle market firms originated by private credit funds, often referred to as “direct lending.” Our paper seeks to understand why nonbank lenders have grown to be such a prominent source of these types of loans and explores the financial stability implications of NBFI lending. We focus on direct lending, the most significant form of private credit.
Despite the lighter regulation of direct lenders, we find that they are much better capitalized than banks would be if they held middle market loans on their balance sheets. To perform an apples-to-apples comparison of the capitalization of banks and direct lenders, we apply bank capital regulatory frameworks to business development companies (BDCs), a type of private credit fund that makes loans to middle market private equity-sponsored firms. We are able to perform this exercise because the Securities and Exchange Commission (SEC) requires BDCs to publicly report their portfolio holdings and financial statements, including information on how they are funded. We find that BDCs have median risk-based capital ratios of about 36 percent, which is twenty-six percentage points greater than what the Federal Reserve’s stress testing framework would require.
Our evidence thus cuts against the view that private credit has grown because NBFIs hold less capital than banks. Instead, we argue that, for plausible parameters, banks find lending to private credit funds more attractive than direct middle-market lending. Importantly, bank loans to private credit funds are highly over-collateralized and effectively treated as AAA-rated tranches of securitizations. As a result, banks hold relatively little capital to back loans to private credit funds. This favorable capital treatment, combined with low expected default rates and relatively high interest rates given the default risks, drives a high return on equity (ROE) for these loans. By contrast, loans to risky middle market firms require a lot more capital. They are also more costly to originate as they require a platform to identify and underwrite potential borrowers among a pool of many thousands. The high ROE of lending to private credit funds—and NBFIs more broadly—may help explain why loans to NBFIs have grown so dramatically in recent years.
Interestingly, there are a number of banks that engage in lending to private equity-sponsored firms, but when they do so, they make these loans via affiliated private credit funds rather than on the bank’s balance sheet. The affiliated private credit funds borrow at much higher rates than sponsoring banks and hold much more equity capital. We argue that for plausible parameters, banks choose to forgo their significant funding cost advantage to avoid the extra regulatory and supervisory costs of managing a risky loan portfolio on the bank’s balance sheet. These regulatory and supervisory costs could include the costs of complying with guidance around making loans to highly leveraged or unprofitable firms. In particular, we show that as long as these extra regulatory and supervisory costs exceed one hundred basis points per year it makes sense for banks to fund middle market buyout loans off balance sheet.
Finally, we examine the financial stability risks of private credit. While there is little risk to the solvency of private credit funds, they may deleverage during periods of stress. Because private credit funds use fair value accounting of their assets, during periods of stress as defaults rise and credit spreads widen, they will have to mark down the fair value of their assets. This increases their leverage, which could violate leverage restrictions in bank credit agreements or SEC regulations. To avoid violating these restrictions, funds will likely use loan repayments to pay down their credit facilities as opposed to reinvesting these proceeds into new loans. They may also be forced to sell some of their portfolio loans. Our baseline estimates suggest that over eight quarters in the Fed’s severely adverse stress scenario, the median BDC would reduce outstanding loan balances by 9.5 percent, about half by selling assets and half by using free cash flows to pay down debt rather than to make new loans. Thus, even if private credit funds remain solvent, their ability to originate credit may be impaired, which could have spillover effects to the rest of the economy. Our ongoing research examines additional scenarios, including a stagflation scenario that many economists think could ensue in the coming months in response to the current policy regime.
As private credit continues to grow and evolve, it will become increasingly important to understand the financial stability implications of private credit. While this migration doesn’t necessarily increase systemic risk, we will likely need new tools to be able to identify and mitigate potential financial stability issues without stifling healthy credit creation.
Read the full paper here.
Sergey Chernenko is associate professor of management at Purdue University.
David Scharfstein is the Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School.
This essay is part of the Financial Regulation Research Brief Series. Research briefs highlight the policy-relevant research on financial systems, including the impact of financial regulations on economic growth and stability.
