Private credit markets are a $1.7 trillion ticking time bomb

In the 19th century, before the establishment of the Office of the Comptroller of the Currency by Abraham Lincoln, America had a loose, state-run banking system. This system, which essentially functioned as the entire financial system at the time, was prone to instability. The era, often referred to today as the "wildcat" banking era, ultimately came a cropper, leading to losses for depositors and hardship for countless Americans. Lincoln and his first secretary of the Treasury, Salmon Chase — one of Lincoln's most powerful and influential cabinet members, particularly on this issue — recognized the need for a regulated banking system.

Today, we have two financial systems in America: the traditional banking system and the nonbanking or "shadow banking system." While the banking system is heavily regulated for safety and soundness, the nonbanking system is not. One wonders if the nonbank financial system, with its limited regulation, could be considered a modern-day "wildcat" system ripe for instability.

Look at 2007. While the global financial crisis that began that year is often referred to as a "banking crisis," this is a misnomer. It was fundamentally triggered by nonbank entities operating with limited regulation like Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, American International Group, and various reputable and nonreputable mortgage companies — entities that thought they could build an enormous mortgage lending business relying on state licenses and essentially no prudential or compliance supervision. After the initial explosion, banks were ultimately dragged into the mess, but it was the failures of these nonbank institutions that ignited the crisis.

Today, we face the same accumulation of tinder for the next financial bonfire. The "private credit" market, a clever sobriquet for all manner of nonbank lending, is rapidly expanding — the pile of tinder with it.

At the heart of traditional bank supervision is credit risk. During my time as comptroller, a seasoned bank examiner once told me, "At the end of the day, Mr. Comptroller, it's credit, always credit." Now whether that is a bit of an overstatement, for someone in finance for decades worrying about safety and soundness, it has the ring of truth. Although compliance issues like anti-money-laundering have gained national prominence in recent years, credit risk remains a core concern.

Good banks have deep knowledge of credit issues, and their examiners share this expertise. Perfection is unattainable — it never is — but for well over a century, bank credit skills have been honed to a fine point. The scrutiny of bank supervisors has further refined these skills and improved credit quality at banks.

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Why, then, should we have confidence that the $1.7 trillion of credit held by unregulated nonbanks is as good as if it were sitting on bank balance sheets? The answer, it seems, is we shouldn't. Lawmakers' decision, in the Dodd-Frank Act, to exempt all but the systemically important nonbanks from regulation has limited our understanding of the private credit market and the portfolios of the entities in that market. It also has encouraged increasing amounts of financial business to move into the nonbanking system, and recently proposed regulatory changes like Basel III endgame will increase this tendency.

This is not to say all the entities in the private credit market are bad at credit or that all the private credit portfolios are bad. While there are undoubtedly quality players and portfolios within the market, experience suggests it's highly probable that private credit, on average, is of lower quality than traditional bank lending. The unchecked growth of this market, often referred to as the "private credit bubble," is a ticking time bomb threatening to ignite a financial conflagration.

Does this mean a systemic event is on the horizon? Quite possibly. While the exact nature of such an event remains uncertain, banks indirectly involved through various channels — such as payments, counterparty relationships and the funding of private credit purveyors — could be drawn into the fire, potentially leading to a crisis that echoes the events of 2007. Banks may not be directly impacted the same way, but as the saying goes, "History may not repeat itself, but it often rhymes."

Even if banks aren't brought into the conflagration at all or to the same extent, turmoil within a major section of the U.S. financial markets will give rise to systemic reverberations. And importantly, while some of the money fueling the private credit market comes from high-net-worth individuals, other money comes from sources like pension funds, where losses can hurt ordinary consumers.

Accordingly, it would be unfortunate if policymakers stood idle and just watched this happen. To the extent we can more closely examine the private credit market and implement appropriate guardrails, we will be much, much better off. It's a dangerous anomaly that banks are heavily regulated, while entities performing similar functions operate with little oversight. The clock is ticking. Let's hope policymakers act swiftly to address this regulatory gap before it's too late.