Fed Scrutiny Increases on Private Credit’s Risk and Reward

Generally speaking, the more capital in the markets, the better — as that money finds its way into new growth opportunities (including innovative firms) and provides the backing for lending and other financial services activities.

Through the past few years, private credit has proven to be a hyper-growth source of funding, estimated at $2 trillion by the International Monetary Fund and on track to nearly double by the end of the decade, according to some estimates.

Increasingly Interconnected

However, the web between nonbanks — hedge funds, private equity firms and investment management behemoths — and banks is increasingly interconnected. Traditional financial institutions supply capital to nonbanking financial firms, and nonbanks give rise to the private credit market, which then deploys capital into all manner of ventures, including some of the FinTech platforms that, in turn, lend to individuals and enterprises. Wall Street firms, such as Goldman Sachs, and some of the biggest traditional banks, such as J.P. Morgan, are growing their own private credit ambitions to the tune of tens of billions of dollars.

Earlier this month, in tandem with details on stress testing on larger banks, the Federal Reserve said in an announcement that it would conduct an “exploratory analysis” focused on “certain risks” posed to banks by nonbank financial institutions (NBFIs) as the latter organizations “operate with high leverage and are dependent on funding from the banking sector.” The findings of the analysis are slated to be published in June and will take stock of the impact of credit and liquidity shocks in the NBFI sector during severe global recessions and “market shocks” that would come alongside reduced global economic activity and higher inflation expectations.

What the Fed Will Examine

In an example of the scenarios, the Fed offered up a market shock that would conceivably cause the unexpected default of a bank’s five largest equity hedge fund counterparties. The Financial Times reported earlier this month that banks in the United States have lent $300 billion to private capital firms. In all, private credit accounted for 12% of bank loans to nonfinancial corporations, with particular concentration in the U.S., the OECD estimated.

The ripple effect might be pronounced in a higher rate environment, as the debt extended to private capital firms (and to their own enterprise investments) becomes more expensive, or they unwind positions — pulling out of equity and other holdings or marking down portfolios acquired from FinTechs — in the event of market shocks.

There are examples of the interconnectedness of FinTechs — particularly platforms — with investment firms (and private credit).

Late last year, SoFi expanded its loan platform with a $2 billion agreement with affiliates of Fortress Investment Group.

Elsewhere last year, Upstart Holdings sold up to $2 billion of consumer installment loans to private credit lender Blue Owl Capital. The deal included $290 million of personal loans that were completed, as well as debt that Blue Owl agreed to buy over several months in a forward-flow agreement, buying the loans before they were originated.

Separately, LendingClub said in investment materials that its structured certificates, which are backed by pooled loans, are a “preferred structure for private credit.” In the most recent quarter, LendingClub detailed that $500 million of its $1.8 billion in loan originations came from that program.