Investment Growth by Pictures of Money is licensed under CC BY 2.0

Pundits and academics are erroneously trying to prove that banks and nonbank financial institutions, such as insurance and asset management firms, pose similar or even equivalent risks to the financial sector. Conflating the riskiness of banks and nonbanks, however, is tantamount to comparing apples to oranges.  

Banks and nonbanks are funded differently. For instance, private funds, which can either provide equity or loans to private businesses, including middle market businesses that employ about 48 million people, use investments made by accredited investors, such as large institutions (e.g., endowment funds, pension funds, charitable foundations). Banks use deposits from individuals and businesses to underwrite loans or invest in securities. Congress never intended for private funds to be regulated just like banks, mutual funds, or exchange-traded funds (ETFs). The Dodd-Frank Act makes a distinction between retail (individual) investors, who need more disclosures and protection, and sophisticated institutional investors. The U.S. Court of Appeals for the Fifth Circuit reaffirmed this distinction when it struck down the Securities and Exchange Commission’s (SEC) rule to further regulate private fund advisers. Lawmakers, not unelected bureaucrats, have the power to change how private funds are scrutinized, but so far Congress has rightly declined. 

The Federal Reserve Bank of New York (FRBNY) conducted a recent analysis comparing the systemic risk exhibited between banks and nonbanks. The FRBNY acknowledges that “while there has been much interest in the systemic risk of the asset management sector, its SRISK share is relatively low.” In a crisis, the FRBNY shows that the asset management and insurance industries are better capitalized than banks. This likely reflects the differences in behavior of liquid bank deposits and less liquid investments in private funds. Even though international regulatory bodies, and some pundits, continue to cry foul when it comes to the “illiquidity” of private credit, it is in fact that specific characteristic that inevitably makes investors better off in economic downturns.  

The FRBNY analysis shows that the asset management and insurance sectors perform better in a crisis than “non-depository credit.” Interestingly, the North American Industry Classification System (NAICS), which defines “Nondepository Credit Intermediation”, and is utilized by the FRBNY analysis, explains that it includes financing offered by Fannie Mae and Freddie Mac (government-sponsored enterprises) and public debt securities, such as high-yield bonds. Using different public and private financial instruments in the FRBNY analysis for “non-depository credit” is an egregious conflation of debt instruments that differ in riskiness and performance. According to one analysis, “[p]rivate credit has historically outperformed public leveraged finance asset classes such as [broadly-syndicated loans] and high-yield bonds.” Another article discusses how private credit can perform better than publicly traded fixed income assets and “the volatility of private credit is relatively low compared to public equities.” Grouping all these debt instruments into one bucket is misleading and likely over-inflates the asset share of SRISK for the non-depository credit sector as outlined in the FRBNY analysis.  

Private credit makes up a miniscule portion of borrowing from banks compared to other nonbank financial institutions. In the first quarter of 2023, banks primarily lent money to other banks, broker-dealers, government-sponsored enterprises, and real estate.  

The FRBNY analysis also models some, but not all, nonbank activities moving in the same direction as bank riskiness during a crisis. This is likely due to bank activity shifting to non-depository funds as a result of higher capital requirements and stricter regulation. Large banks and more regional-sized banks are investing more in private credit because of an increase in government regulation that started with the Dodd-Frank Act. Stricter regulation could explain the stronger statistical evidence of interdependence between banks and nonbanks’ equity returns observed after the Global Financial Crisis.  

Imposing additional regulations on nonbanks, via the Financial Stability Oversight Council’s (FSOC) nonbank systemically important financial institution (SIFI) designation, or by other means, would not improve the financial sector or mitigate risk. Last year, the Federal Reserve acknowledged in its May 2023 Financial Stability Report that “[m]ost private credit funds use little leverage and have low redemption risks, making it unlikely that these funds would amplify market stress through asset sales.” This assessment debunks an allegation made by a June 2024 FRBNY analysis, which claims that asset sales by all nonbanks could permeate the financial sector and harm banks’ balance sheets. Private credit should not be implicated in this analysis considering the Fed’s comments from last year. The June 2024 FRBNY analysis is conflating different types of nonbank products and activities—including both public and private securities.  

Financial instruments, both public and private, differ in composition, leverage, and overall performance. Academic analysis of nonbank activities in relation to banks is not clear and fails to differentiate between the varying types of nonbank financial instruments. A result of this opaque analysis is a misleading caricature that shows nonbanks and banks posing similar risks to the financial sector. The reality is far more complex. Instead of framing analyses that lay the groundwork for more regulation of nonbanks, policymakers should take the time to understand the stark differences in asset classes. Using a blunt instrument to regulate different financial instruments will only reduce credit allocation and thus harm American businesses and consumers that rely on it.