Private Lending is Not a Risk to Financial Stability  

Clarion calls for private debt scrutinization are misguided and unwarranted. Regulators are making a mountain out of a molehill trying to peg private lending to financial instability. 

The components of private debt are stable. The New York Federal Reserve Bank recently published a report stating that “credit booms financed by non-banks appear to have a less pernicious effect on future real outcomes.” An article summarizing the report explains that “growth in nonbank credit actually lowers the probability of a large drop in real GDP growth.”   

The New York Fed’s discovery may have to do with the fact that, according to one University of Chicago paper, “private debt funds generate these returns using appreciably less leverage than that used by banks and CLOs.” 

Private debt funds also rely heavily on financial covenants, whereas syndicated bank loans do not. The University of Chicago paper found from other literature, that syndicated loans “are covenant-lite, i.e., tend not to have financial covenants.” The same paper talks about how sponsors of private debt funds care the most about the ratio of debt to earnings before, interest, taxes, depreciation, and amortization (EBITDA). This implies private debt funds are extremely sensitive to how much debt a borrower is taking on—preferring to see a borrower with significant free cash flow. Financial covenants allow private debt investors, such as pension funds and insurance companies, to mitigate any potential losses if a borrower is experiencing financial distress.   

The Financial Stability Oversight Council (FSOC), which has been weaponized to regulate nonbank financial firms like banks, should not be enabled to regulate private debt. In 2020, the Government Accountability Office (GAO) found that leveraged loans, which private debt funds use “as an investment strategy,” do not pose significant risk to the U.S. financial system. The FSOC, which was created by the Dodd-Frank Act and is comprised of U.S. federal financial agencies, does not possess concrete evidence to apply a designation to private debt funds, or the nonbanks that manage those funds, that would subject them to additional regulation by the Federal Reserve. Fortunately, last week the U.S. House of Representatives passed legislation that specifically requires financial regulators to notify Congress before unilaterally adopting any policies from the FSOC.  

International organizations should also not be in the business of influencing federal financial regulators without congressional oversight. Staffers at the Bank for International Settlements (BIS), of which the Federal Reserve is a member, are claiming in a new quarterly report that private market illiquidity could pose a risk to investors, such as insurance companies. However, the BIS staffers point out that an illiquidity premium reaps higher returns. The report states that “[w]hile interest rates were low, the mean returns of shares of [private equity]-linked insurers were more than twice as large as those of their peers.” Moreover, “risk-adjusted returns were also higher, with Sharpe ratios around 50% larger.” Life insurance companies that are more invested in private markets perform better than other insurers.  

Bloomberg’s Odd Lots podcast acknowledged the illiquid nature of private debt funds is better for loans because the loans they make are also longer-term. The average maturity for a private credit loan is about 5 years. The Federal Reserve points out that “redemption and fire sale risks posed by private credit seems to be low, largely due to its long lock-up periods (as high as 10 years) and low leverage or derivative exposures.” Illiquidity is not a problem because longer term investments in private funds matches up with longer-term duration of the loans they underwrite.    

The BIS staff report is an attempt to influence regulation of private markets. This is a perfect example for why Rep. Andy Barr’s (R-Ky.) bill to rein in international organizations is imperative. Rep. Barr’s bill would require U.S. federal financial regulators, such as the Federal Insurance Office (FIO), Federal Reserve, and the Securities and Exchange Commission (SEC) to continually report to Congress on their negotiations with international groups, such as the BIS, Financial Stability Board (FSB), and the International Association of Insurance Supervisors (IAIS). This is essential to ensure that the constitutional separation of powers remains intact and is not impugned by unilateral administrative actions.   

Private markets are rife with strong returns and security. The real risk to stability in U.S. financial regulation is the obsequious deference U.S. regulators, such as those that make up the FSOC, give to international organizations. Ceding legislative authority to international organizations could hamper innovation in private markets and put the U.S. at a disadvantage against foreign competitors.