🌊 Inside America’s Shadow Banks
“Private credit” is prompting warnings about the financial system. What is it?
On Tuesday, three prominent financial analysts – affiliated with Moody’s Analytics, the US Securities and Exchange Commission (SEC), and formerly of the US Treasury Department – released a paper on a rapidly growing yet poorly understood corner of the financial system: Private credit.
Their conclusion was that the industry – a product of post-2008 financial regulations – may be setting the world up for an even bigger disaster when the next financial crisis hits.
In today’s deep-dive, we look at what private credit is, how it has grown tenfold in just over a decade, and what that means for the global financial system.
Before 2008, corporate lending – especially to midsize and riskier businesses – was dominated by commercial banks. These institutions accepted deposits and then gave out loans, which they kept on their balance sheets. Banks were the industry; “private credit” was a niche corner of it.
Then came the collapse of Lehman Brothers and other banks in 2008, triggering a global credit crunch. As banks rapidly lost billions of dollars worth of assets, it emerged that they were over-leveraged – i.e., they had borrowed excessively to fund their activities and held too little capital to absorb losses, leaving them vulnerable. When the value of their assets plummeted, they didn’t have enough cash to cover the losses.
Governments passed a slew of regulations in response. The US, for example, passed Dodd-Frank, which imposed sweeping reforms on US banks, including rules that required them to keep more cash on hand and maintain tighter oversight of their assets. International regulators implemented Basel III, a set of regulations that further constrained bank activity.
A result was that many banks drastically curtailed lending, especially to smaller businesses and highly leveraged (indebted) borrowers, who were too small to raise money via bond sales but too risky to be given loans under the new regulatory environment.
As banks pulled back and this gap became visible, non-bank financial institutions saw an opportunity. These companies – including private equity firms and hedge funds – were not subject to the same regulations as banks, meaning they could fill the hole in the market and get paid a lot to do it.
So these companies went to institutional investors (pensions, endowments, insurance firms) with a simple pitch: We’ll make loans that banks no longer can, and you’ll get higher returns. They agreed, and this industry – private credit – exploded.
Within 15 years, it would go from being a $200B industry to a $2T one, per McKinsey.
But that prompted the question: What would happen if it went south?
Private credit’s explosion marked a major financial shift: More institutions were lending capital, making it easier for companies – especially riskier or smaller ones – to access funding. Many of these borrowers would not have been able to borrow from banks. Private credit, by contrast, let them borrow with more speed, flexibility, and confidentiality – and less scrutiny – than they ever could before. The lenders liked it because they could charge higher interest rates and demand significant collateral.
Private credit companies and some financial analysts claim that this industry is actually safer than typical banking. Commercial banks take short-term deposits and bundle them into long-term loans. That leaves them vulnerable to bank runs, which can trigger financial crises and threaten a bank’s viability.
Private lenders, by contrast, raise capital not from depositors, but from investors who are making long-term capital commitments and won’t be as likely to demand their money back if the markets go south.
Yet unlike banks, private credit’s role in the economy is largely unregulated. In fact, regulators often refer to it as part of the shadow banking system – a web of non-bank financial institutions that perform core lending functions without the same oversight or capital requirements.
While shadow banks helped fill a post-2008 lending gap, their opacity and interconnectedness have raised alarms: What happens if borrowers default en masse? Who holds the risk? And could these failures cascade through the rest of the financial system?
This week, Moody’s Analytics – a leading firm that assesses the financial health and credit risk of companies – released a major report that looked at these questions and others. Its conclusion was that private credit creates new “linkages” in the economy, meaning new pathways for financial contagion, and that these connections are not well understood.
Pre-2008, the report said, the financial system had a “hub and spoke” model, with banks at the center. Private credit has diffused this concentration, making the financial system more opaque and “dense.” The result, the authors wrote, was that the next financial crisis may be “amplified.” That warning came only days after another one by the Federal Reserve Bank of Boston, which warned that banks’ lending to private credit funds is leading to further risk.
It’s possible that private credit may indeed provide for better, safer lending than banks are capable of and may help small companies who would otherwise suffer from regulation. Or, it may be lighter fluid on a future financial crisis. For now, we don’t know if private credit will soften the next crash – or deepen it.