🌊 Inside America’s Shadow Banks

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By Max Frost

On Tuesday, three prominent financial analysts – affiliated with Moody’s Analytics, the US Securities and Exchange Commission (SEC), and formerly of the US Treasury Department – released a paper on a rapidly growing yet poorly understood corner of the financial system: Private credit. 

Their conclusion was that the industry – a product of post-2008 financial regulations – may be setting the world up for an even bigger disaster when the next financial crisis hits. 

In today’s deep-dive, we look at what private credit is, how it has grown tenfold in just over a decade, and what that means for the global financial system.

Before 2008, corporate lending – especially to midsize and riskier businesses – was dominated by commercial banks. These institutions accepted deposits and then gave out loans, which they kept on their balance sheets. Banks were the industry; “private credit” was a niche corner of it. 

Then came the collapse of Lehman Brothers and other banks in 2008, triggering a global credit crunch. As banks rapidly lost billions of dollars worth of assets, it emerged that they were over-leveraged – i.e., they had borrowed excessively to fund their activities and held too little capital to absorb losses, leaving them vulnerable. When the value of their assets plummeted, they didn’t have enough cash to cover the losses. 

Governments passed a slew of regulations in response. The US, for example, passed Dodd-Frank, which imposed sweeping reforms on US banks, including rules that required them to keep more cash on hand and maintain tighter oversight of their assets. International regulators implemented Basel III, a set of regulations that further constrained bank activity. 

A result was that many banks drastically curtailed lending, especially to smaller businesses and highly leveraged (indebted) borrowers, who were too small to raise money via bond sales but too risky to be given loans under the new regulatory environment.

As banks pulled back and this gap became visible, non-bank financial institutions saw an opportunity. These companies – including private equity firms and hedge funds – were not subject to the same regulations as banks, meaning they could fill the hole in the market and get paid a lot to do it. 

So these companies went to institutional investors (pensions, endowments, insurance firms) with a simple pitch: We’ll make loans that banks no longer can, and you’ll get higher returns. They agreed, and this industry – private credit – exploded. 

Within 15 years, it would go from being a $200B industry to a $2T one, per McKinsey.  

But that prompted the question: What would happen if it went south?

Editor’s Note

What do you all think: Will private credit worsen or alleviate a future financial crisis? Do the benefits outweigh the risks? Send in your thoughts here.

Earlier this week, we ran a three-part series on the state of the war in Gaza. You can find those stories among others below.

• The Gaza War: Part Three

• The Gaza War: Part Two

• The Gaza War: Part One

• The Red Line in Iran Negotiations

• Roca Exclusive: America's Lone Pro-Tariff Economist

Thanks for reading, and see you tomorrow. Have a fantastic Friday.

–Max and Max