- Key takeaway: A number of proposed changes to bank capital rules could result in a deepening of financial ties between banks and the burgeoning private credit marketplace.
- Expert quote: "One of the issues with both the opacity and the complexity of private credit lending is getting a full sense of the financing chain, which is a really complicated picture to try to actually build out." — Graham Steele, assistant professor at the University of North Carolina School of Law
- What's at stake: The proposed updates to bank capital rules come as banks' ties to private credit are already growing, while limited public disclosure makes the full extent of those relationships difficult to assess.
WASHINGTON — Proposed revisions to bank capital rules could deepen banks' ties to private credit, as questions linger about risks in the opaque market and how those risks could spread through the broader financial system.
Lower risk weights could make it more attractive for banks to finance or hold certain private credit-related assets, industry observers say. But the changes could also increase banks' exposure to a market that lacks full transparency.
Graham Steele, an assistant professor at the University of North Carolina School of Law and a former Treasury official during the Biden administration, said lending to private credit funds can result in higher returns than traditional loans, increasing banks' appetite for that kind of lending.
"The safest assets we know have the lowest return, the riskiest assets have the highest return," he said. "If you're trying to blend the mixture of risk versus return, and if you can get into some of these lending markets that offer a little bit of a higher payoff, it's obviously good for your bottom line."
One proposed change that industry experts say could increase banks' ties to private credit is a reduction in the minimum risk weight for certain senior securitization exposures from 20% to 15%.
Chen Xu, a partner at Debevoise & Plimpton, said the change would make it "more attractive" for banks to be senior securitized lenders.
"The catch is that it applies to any sort of securitization, so it ranges from private credit fund lending to auto lending to student loans and mortgages," Xu said. "It's sort of universally lowering the floor."
The securitization change is narrower than a separate proposed reduction in the risk weight for corporate loans, which would lower it from 100% to 95% for banks using the standardized approach. That change could make some lending to private credit funds slightly less capital-intensive.
"The point of the securitization changes and the regular credit risk changes is to make the rules more risk-sensitive," Xu said. "I think this will allow banks to make more nuanced decisions about how to allocate credit risk and what credit risk to take on. It'll allow banks to lend to credit funds that are more creditworthy if they do the homework."
On the other hand, Xu said, the changes could discourage banks from taking more junior positions in credit funds or lending to less creditworthy funds.
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Some industry observers also said there are other ways the proposals can encourage more bank-private credit lending. Proposed changes to the expanded risk-based approach — or ERBA, which would broadly change the capital treatment of bank exposures — could create more room for banks to offer warehouse lines and other financing facilities to private credit funds.
"I think that those rules apply … if you are doing the direct investments, but also if you're doing a fund financing facility or a credit facility as well," Steele said. "One is down to 95% and another to 65%, and because they're corporate exposures, it applies … if you're doing direct private credit investment yourself, or if you were setting up a warehouse line or some kind of other fund financing mechanism."
If banks become more involved in private credit as a result of changes to capital rules, some stakeholders warn that greater interconnectedness could exacerbate risks. The proposals, which cover Basel III, the global systemically important bank, or G-SIB, surcharge and revisions to the U.S. standardized approach for calculating capital, are expected to be
Clifford Rossi, professor emeritus at the University of Maryland, said concentration risk can emerge in part because of the opacity of the private credit market.
"There's concentration risk outside of public disclosure requirements," Rossi said. "Multiple banks may unknowingly provide warehouse lines to the same business."
Rossi said liquidity shocks are another concern, particularly when banks provide warehouse lines to private credit funds.
"When you get into financial stress, companies face margin calls, which puts pressure on liquidity," he said. "The funds will draw heavily on their committed lines — the facilities I'm talking about, these warehouse lines — all at once. That forces the bank to extend liquidity precisely when its own balance sheet is under pressure."
The extent of banks' ties to the private credit sector is difficult to measure, although lending commitments to a growing segment of the market have increased over the past decade.
The growth and limited transparency of the private credit market have drawn increasing attention from both regulators and lawmakers. In a recent hearing before lawmakers, Fed Vice Chair for Supervision Michelle Bowman said bank lending to private credit and other nonbank financial institutions, or NBFIs, has increased for years, but regulators still lack a complete view of how those funds are being used.
"That will allow us to better understand and see more transparently how bank funding is being used within the nonbank space, particularly private credit," she added.
But whether proposed changes to bank capital requirements result in a more notable acceleration in banks' involvement with private credit will be difficult to track because many of those relationships are opaque.
"You can look at some of the specific snapshots and see whether they're growing or not growing; those are not necessarily going to give you a sense of the entire chain of those financial transactions," Steele said. "One of the issues with both the opacity and the complexity of private credit lending is getting a full sense of the financing chain, which is a really complicated picture to try to actually build out."
