Private Credit Growth Has Significantly Reduced the Financial System's Leverage

I’ve been quite critical of private investments. They’ve grown tremendously over the past decade. Drawn to their seemingly high returns and low volatilities, investors have poured billions into them, reallocating funds from traditional public stocks and bonds.

Today, private credit funds finance a variety of risks. Banks and the public markets would have traditionally underwritten some, such as loans to private equity firms buying companies; however private lenders’ ability to act quickly has gained them share. Other types of transactions are new, like synthetic risk transfers from banks which only arose from recent regulatory changes. In all respects, private credit’s market participation has grown.It’s easy to take the financial system for granted.

Less ambiguous is what fuels the system: leverage. Moving so much value across such vast distances at lightning-fast speeds requires an unimpeded flow of credit. As a matter of routine, institutions lend to and borrow from each other in a dizzying array of arrangements. Financial companies could not perform their basic operations or earn acceptable returns without them. Fundamentally, banks and financial companies are types of carry trades.

Financials play a central role in the economy. They touch nearly every company and individual. Thus, their failures can have widespread public impacts, leading to their strict political oversight throughout modern history. Minimizing their contagion amounts to constraining financial leverage.

Furthermore, private credit funds typically restrict investors’ abilities to withdraw their funds. This greatly limits the potential for liquidity problems. Private credit funds invest in illiquid assets, by design. Positions cannot be quickly sold and might require deep discounting. Limiting investor redemptions provides funds time to raise needed cash and preserve value.

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