Regulators are laying the groundwork to rein in private credit

Bloomberg News

WASHINGTON — The rapid expansion of private credit — and banks' relationship with firms that offer it — has begun to draw significant attention from bank regulators, and could signal a new regulatory priority if President Biden wins a second term. 

Private credit — also known as private debt — refers to instances where nonbanks lend directly to companies, bypassing more traditional and regulated paths like bank lending, capital markets or bond issues to obtain capital.   

The alternative investment class has seen substantial growth since its inception in the 1980s, reaching an estimated total lending volume of nearly $2 trillion in 2024. The Congressional Research Service estimates that the market could grow to $3 trillion by 2028, driven primarily by institutional investors seeking diversification and higher returns. That growth has positioned private credit as a significant alternative to traditional bank loans for businesses seeking financing.

The Financial Stability Oversight Council — a regulatory body created by the Dodd-Frank Act composed of the heads of nine federal financial regulators — pointed to the sector's lending to high-risk borrowers and its links to banks as potential sources of financial instability in a May 2023 report. The council stopped short of demanding regulatory action, suggesting instead that the group enhance its data collection on nonbank lending to nonfinancial businesses.

Industry experts say the likelihood of FSOC taking action is low in an election year, but that another Biden term could give the group time to pursue such risks.

"If Biden remains in office, I think you will see continued statements of concern from Democratic regulators," said Ian Katz of Capital Alpha Partners. "In a second term the FSOC would have four years to do something, so I think there's a good chance of some kind of measure by FSOC, perhaps a designation of some private credit-related activity as potentially systemic."

Regulatory agencies — many of which also have leaders who sit on FSOC — have raised concerns on their own. A February 2024 report by a researcher at the Federal Reserve identified five major risks associated with private credit, including the absence of a secondary market for private credit loans, rendering the debt less liquid; higher default risk from highly leveraged corporate borrowers; private credit's potentially lower underwriting standards; and the hidden risks of the sector's interconnectedness with other financial firms like pension funds, insurance companies and banks. The 2024 findings offer a more concerned perspective than the current official agency line. The Fed called risks stemming from private credit "limited" in a financial stability report the year prior. 

Acting Comptroller of the Currency Michael Hsu recently highlighted his concern with nonbanks like private equity firms performing functions traditionally done by banks. He said the increasing prevalence of evergreen funds that forgo investor fund "lockups" — proscribed periods when withdrawals are forbidden — is concerning, likening the vehicles to open-end bond funds, which have themselves been cited as risky by FSOC. He suggested that FSOC develop a regulatory "tripwire" to impose restrictions when funds' get too risky.

"[Under this approach,] closed-end funds with long lockup periods would have a lower scalar than innovative, non-closed-end fund structures, such as evergreen funds," Hsu noted. "Private credit funds with no links or affiliations with PE-influenced insurers or reinsurers would have a lower scalar than those with links and affiliations."

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Katz said regulatory interest adds pressure on both fellow regulators on FSOC to do something about the alternative investment class. 

"The FSOC probably has the most direct tools. It could designate non-bank firms systemically important, subjecting them to Federal Reserve oversight. And the FSOC could designate an activity as systemic," Katz said. "Nonbank private credit firms don't have a natural overseer, so it's not easy."

He notes that the Securities and Exchange commission, which regulates many of the firms which provide private credit, can impose indirect oversight through increased disclosure. No single agency, however, can take more direct action like growth caps or restricting private credit firms from certain activities, rendering FSOC the most likely venue for such restrictions.

Lawmakers have ramped up calls to address the rise of private credit as well. Sens. Sherrod Brown, D-Ohio, and Jack Reed, D-R.I., urged the main three bank regulators to scrutinize private credit in a letter last fall. They argued that private credit poses systemic risks, highlighting the lack of transparency in key aspects such as loan terms, funding structures, and borrowers' financial health. The senators warned that private credit could harbor hidden dangers for the banking system.

"Linkages [between banks and private credit] may pose hidden dangers to the banking system, especially as most of the private credit market has not endured a full economic cycle with elevated default rates," the letter noted. "Given the sector's expectations of rapid growth, these risks are already increasing as private credit fund managers continue to collect cash and deploy it on riskier deals."

Amongst regulators however, there is a diversity of opinion about how urgent the risks posed by private credit are. Federal Reserve Chair Jerome Powell acknowledged the rapid growth of private credit in a speech to the Foreign Bankers Association this May, but said the practice doesn't yet pose an obvious threat to financial stability. Fed Gov. Lisa Cook and Vice Chair for Supervision Michael Barr have made similar points, arguing that while the sector warrants monitoring, the closed-end nature of these funds means they are less prone to run risk. 

Investment sector advocates like the Managed Fund Association's President and CEO Bryan Corbett argued private credit is already well regulated. 

"Private credit does not have a government backstop and presents no taxpayer risk, unlike banks," he said. "Private credit managers have investors with long time horizons and are already well regulated by the SEC."

Banks, meanwhile, see the sector as a source of growth. JPMorgan Chase & Co. is reportedly seeking to buy Monroe Capital — an $18.8 billion private credit firm — to augment the giant bank's asset management arm. As private debt's profile grows, the upcoming elections will shape its regulatory environment. Katz notes that a loss for Biden would all but guarantee more industry-friendly regulators.

"I think a Trump administration would have a more hands-off approach to private credit and would be less interested than the Biden administration in trying to restrict it," Katz said.