Originally published at Project-Syndicate | Jun 19th, 2024
Given the explosive growth of private credit over the past 15 years, it is understandable that regulators and central bankers are taking a greater interest in the industry. But a recent US court ruling suggests that some authorities have already overreached, and are focusing on the wrong dimension of the problem.
LONDON – It is not often that a judgment from the Fifth Circuit Court of Appeals in New Orleans provokes outrage in the pages of the Financial Times. But that is what happened earlier this month. A ruling in favor of the National Association of Private Fund Managers and co-plaintiffs against the US Securities and Exchange Commission, noted Gillian Tett, whose book Fool’s Gold was one of the more perceptive analyses of the global financial crisis, “sparked jubilation among many financiers and dismay from progressive and consumer protection groups.”
Tett’s sympathies clearly are with the latter. Yet the substance of the case was straightforward. Last year, the SEC tried to use the Investment Advisers Act of 1940 to require private-equity and other funds to implement extensive disclosure and reporting measures, including providing detailed quarterly performance and expense reports. The proposed rules also would have limited the ability of such funds, including hedge funds, to offer different terms to different investors. But the industry challenged the SEC’s rulemaking, and the appeals court concluded that the agency had overreached. The Investment Advisers Act, which is primarily aimed at protecting retail investors, could not be used that way.
The SEC now must go back to the drawing board. But given the looming presidential election, and the probability of new leadership at the commission, it is safe to assume that its efforts to expose private funds to greater scrutiny will remain in legal sands for the time being. The question, then, is whether it matters.
For some time now, regulators in the United States and elsewhere, including at the Financial Stability Board (FSB), have been taking a greater interest in private credit. Although the data are inevitably murky, given patchy disclosure rules, the market is estimated to be around $1.6 trillion, two-thirds of which is in the US, with most of the rest in Europe. The Bank of England (BOE) estimates that almost all the £425 billion ($541 billion) net increase in lending to UK business over the past 15 years has come from private credit sources. Meanwhile, bank lending to business has scarcely grown at all during this period.
Private equity has also grown very rapidly in the US, now backing some 32,000 American companies that employ more than 12 million people. The industry has grown largely because its investments have generated returns well above those available in public equity markets: 15% per year for the last two decades. But higher capital requirements for banks have also played a part.
It is understandable that regulators and central bankers, who are paid to worry on the public’s behalf, have been asking questions about the financial-stability risks associated with this remarkable growth. Since the main investors are wealthy individuals or large funds, the consumer-protection dimension is less salient, and does not offer particularly strong grounds for regulatory action, as the SEC just discovered.
When it comes to stability risks, however, central bankers have noticeably divergent views on how seriously to treat the problem. The US Federal Reserve concluded last year that the “financial stability risks from private credit funds appear limited.” Though the funds have grown rapidly, they typically use little leverage, and investor redemption risks seem to be low.
By contrast, the BOE points to worrying signs that “the significant interlinkages between private credit markets, leveraged lending, and private equity activity make them vulnerable to correlated stresses.” Investors, unable to liquidate private credit assets, may sell other assets to reduce their exposure, transmitting risks to other parts of the financial sector. The BOE well remembers the crisis in the UK pension-funds sector in 2022, when funds unloaded assets rapidly during the ill-fated, short-lived Liz Truss government.
The European Central Bank is even more concerned, pointing again to the interaction between private funds and other parts of the financial system, and to the risk of lower underwriting and credit standards. It notes that private credit funds “have started bundling their debt into collateralized loan obligation (CLO) vehicles, which are sold to investors in tranches.”
But the ECB also acknowledges countervailing financial-stability benefits: more diversified funding sources reduce the reliance on credit provided through the banking system. The European Union has long been too heavily dependent on banks, and the ECB has long sought to stimulate alternative funding sources provided through the capital markets. So, its net assessment is that the financial-stability risks “seem contained in the euro area.”
Still, both the BOE and the ECB point to the problem of data scarcity, which makes monitoring difficult. Writing before the New Orleans court judgment, the BOE explicitly looked forward to the enhanced transparency that the proposed SEC rule might provide. Thus, in exceeding its legal authority and proposing a heavy-handed approach, the SEC has, unfortunately, set back the cause of achieving greater transparency.
Since central banks do have a legitimate interest in the scale of private credit provision – for both financial-stability and monetary-policy reasons – they will need to find an alternative lens, perhaps looking through banks’ and broker-dealers’ interactions with the private markets. Investors and lenders alike also have an interest in learning more about these enormous markets. The FSB should take up the challenge, now that the SEC has failed.
Howard Davies: The first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of NatWest Group. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.
