AI and private credit are goading banks back into the risk game

One thing the post-2008 financial reforms did was to force banks to be less risky. They have to hold more capital on their balance sheets, they have to regularly stress test their balance sheets, they have to submit to more oversight. The primary mechanism for this was the so-called Volcker Rule, part of the Dodd-Frank bill's overhauls. So far, for the most part, they seem to have worked. We haven't had another financial crisis, and the banking industry is wonderfully profitable. But that doesn't mean that everybody was forced to take fewer risks. 

The demand for risk-taking gets met by the supply of credit, and the supply of credit is kind of on fire right now. Morgan Stanley estimated that investment-grade corporate bond issuance in 2026 could be a record $2 trillion, much of it earmarked for the AI industry. JPMorganChase thinks about $1 trillion of corporate debt will be refinanced this year. I noted last week that the AI industry alone is likely to spend $3 trillion in the next few years, much of it financed. That's a tremendous amount of credit, and a lot of demand for credit. Part of it will be met by the banks, and part by the nonbanks, i.e., private credit. 

Private credit is basically creditors who aren't banks filling the gap left by banks that couldn't get too risky. These private creditors don't operate under the same regime as the banks. The problem with this is that what you've ended up with is an opaque market that by its nature courts risk. Its very opacity poses risks to the financial markets, our Maria Volkova wrote last week, citing a report from the Financial Stability Board. 

Increasingly, banks are doing business with and in private credit, the FSB said, which creates connection to the very activities that were deemed too risky after the financial crisis. How well do the banks understand the risk they are taking in this market? That was a question I asked M&T Bank's CEO Rene Jones when I interviewed him back in March. "One of the concerns is that we don't have that full transparency, as much as we would like," he said. "And so we have to be cautious as we move in that direction."

How cautious can banks be if they don't have enough transparency? The FSB report highlighted the increasing connections between banks and private credit. "This web of interlinkages may create challenges for banks in effectively managing their direct and indirect risks," the report said. "Fragmented oversight increases the difficulty of identifying and addressing risks that may arise from these interlinkages."

And, of course, there's an AI angle here, since much of this new demand for credit is coming from the tech industry. Even the so-called hyperscalers, who practically mint money, are increasingly turning the debt markets to finance their capital expenditures, analysts at Pimco wrote last month. But the AI picture is not as clean as Sam Altman, Elon Musk and the others make it out to be. How much demand will there be for AI really? How great will the ongoing costs of these data centers be? How much revenue can any of these companies possibly generate, and will it be enough to pay back the trillions in loans? "Whether these liabilities will ultimately be justified by future earnings growth remains the central question," Pimco wrote.

The whole rise of private credit, really, is the story of a market built to take on risks we as a society didn't want banks to take on. But the post-crisis rules have been watered down over the years and there is now so much demand for credit that the banks and private credit are inevitably intermingling. And I get that the profit potential here is almost off the charts. But can the banks both operate under a risk-minimized model and take on a load of risk? When will we get the answer to that question? "The creation of a systemic-risk oversight body is a welcome concept whose ultimate success or failure will be difficult to gauge until the next crisis," we wrote back in 2010 about the Volcker Rule and the Dodd-Frank Bill.

A historic frenzy of credit lending, mostly to an industry that has myriad questions about its future, sounds like a pretty good seedbed for a crisis. So maybe we'll get the answer to our question soon enough after all.