Even the Federal Reserve has trouble seeing into the nonbank black box

Should we worry about private credit? Part of what makes the question so vexing is that we don’t have the information to answer it. Sometimes I think to myself, nah, you’ve just got shellshock from 2008. Those of us of a certain age, who were working during the financial collapse in 2008, were so scarred by that experience that everything now is the next great crash waiting to happen. 

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On the other hand, maybe not. Lawmakers and bank regulators met yesterday, as our Kyle Campbell reported (and as we live-blogged as well), and this topic came up. 

What we do know is that the so-called nonbank market has grown quite a lot over the last two decades. This was a result of the post-crisis reforms that forced banks to pull back on lending, especially risky lending. That curtailed what the banks could do, but it did not curtail the demand for credit itself, and that demand was met by other creditors, creditors that were not banks, were not part of the financial system. The thinking was, of course, that if those nonbanks got themselves in trouble, that would be okay, acceptable, because it wouldn’t threaten the banks, it wouldn’t threaten the foundations of the financial system. What we think of as “the banks” would be walled off.

There are at least three complications to that theory, though. The first is that the nonbank credit market has grown, a lot. It’s not just some weird little side market. The second is that the share of traditional bank loans going to that market has also grown. In other words, the wall isn’t all that high. The third is that we can’t see well enough into that market to know how risky it is. “It’s been very difficult for us to have a clear understanding of where those funds have been flowing,” Michelle Bowman, the Federal Reserve’s vice chair for supervision, told Congress yesterday. 

Now, it’s one thing for me to not know where those funds are flowing. It’s one thing for outside analysts and pundits and flamethrowers on Twitter to not know. It is quite another when one of the top officials at the top banking institution in the country says that she does not know.

That worries me.

We do know a couple of things. Assets at private equity, private credit and real-estate funds had grown from $500 billion in 2007 to more than $7 trillion in 2023, according to the FDIC. These lenders typically use bank loans as a source of funds, the FDIC said.

We do know that an increasingly large share of bank loans are loans to the nonbank market. Bank loans to nonbanks comprised more than 11% of large bank assets and almost 18% of loans, according to the Philadelphia Fed. 

Now, the occasional auto lender going down is one thing. That’s not good for anybody, of course. But that is not where the real risk lies. The real risk lies in the absolute gluttony of lending going on in the AI arena. The industry is spending and will be spending about $1 trillion a year to build out its AI dreams, according to Morgan Stanley. At least half of it will be financed. Much of it will come from private credit. Private credit uses banks as a source of funds. As Bowman pointed out, we don’t have a lot of transparency into where those funds are going. And it is not at all clear that an AI business will generate enough revenue to make those investments profitable. That’s the connection, and that’s the risk.

And, look, I get it. There is a big opportunity there. It’s like that distracted boyfriend meme. The boyfriend is the banks, the girlfriend is regular deposits. The girl walking by is nonbank lending. Banks are interested in that girl. But what do you really know about that stranger?