How Banks and Private Credit Became the Best of Frenemies

0:00Your best bottling plant employs 3 ,300 people. How do you get 3 ,300 people working at peak efficiency? Your best store has reduced waste, water, and energy usage. How do you make every store like your best store? Your best property has every guest raving. How do you make every property like your best property? The answer is Ecolab. Better performance, better outcomes, better impact. Ecolab. Now every location is your best location. Introducing the all-new Adobe Acrobat Studio, now with AI-powered PDF spaces. Do more with PDFs than you ever thought possible. Need AI to turn 100 pages of market research into five insights with a click?

0:43Do that with Acrobat. Need templates for a sales proposal that'll close that deal? Do that with Acrobat. Need an AI specialist to tailor the tone of your market report to sound real smart in real time? Do that with the all-new Adobe Acrobat Studio. Learn more at adobe.com slash do that with Acrobat.

1:04Bloomberg Audio Studios. Podcasts, radio, news.

1:21Hello and welcome to another episode of the All Thoughts podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, I feel like I start every private credit episode with the same point. But I mean, private credit, it's everywhere right now. I think I counted like dozens and dozens of stories on private credit that came out just on the Bloomberg in the past week. There's two funny things that are going on, which is one, private credit. So these non-bank entities providing loans, et cetera, wanting to get into credit. And there's more and more about that every day. And then there's banks wanting to get more and more into private credit, which is this own thing of, okay, you're still at the bank, but you're doing it in some sort of balance sheet structure that resembles private credit.

2:04And what's up with that? What's up with that? Indeed. This is the what's up with that episode. I'm so glad you asked that question. But we're going to be talking about the relationship between banks and private credit. Because the other thing that's been happening is every time we talk to a bank or a private credit entity on this show and we ask about the relationship between regulated banks and non-banks, you get this really diplomatic kind of awkward answer. Like, well, we view our bank partners as opportunities and no one will really explain how they actually feel about each other. Totally.

2:38You know, the one other thing before we get into it that I think about a lot is I look at the rise of private credit and there is a big part of me that says this is what regulatory success looks like. This is what post Dodd-Frank success looks like, that there is more of this risk-taking activity happening outside of the deposit-taking banking institution. On the other hand, if a lot of the leverage for private credit and a lot of these relationships is being plied by banks and so forth, then it makes me wonder, did we actually extricate the risk? Or in the end, we just put a wrapper on it. We put a wrapper on it.

3:17In the end, does all financial risk read down back to the banking system? That's exactly it. And I got to say, you know, there is a lot of discourse from which we can pull from a lot of historical analogies because, of course, bank disintermediation is not a new thing. It's basically been happening for as long as we've had banks. And if I think back to like two big moments in the process of bank disintermediation, it has to be the invention of the junk bond market in the 1980s, securitization also in the 1980s and 1990s, peer-to-peer lending. That was a fun one. Remember that? Well, the other thing, too, you know, it just occurred to me and Bear Stearns was not a retail deposit taking institution.

3:57But part of why they blew up is like they had these in-house hedge funds. Right. And so even this idea of hedge funds and non-bank entities sort of existing within more larger traditional regulated financial institutions is not that new. That was a story of the great financial crisis. That's exactly right. So I'm very happy to say this is our our banks and private credit basically frenemies episode. We're going to be speaking with really the perfect guest. It's someone I've known for a long time, and we've actually had him on the podcast before, but I don't think you were there. I promise you are really going to love this.

4:30We're going to be speaking with Hugh Van Stienis. He is the vice chair at Oliver Wyman and also the former global head of banking research over at Morgan Stanley. That's where I got to know him during the depths of the Eurozone financial crisis when I was on FT Alphaville. He's also formerly an advisor to Mark Carney at the BOE. I think he won like a series of research awards at various points in his career, but really one of the smartest guys I know when it comes to banks and financials. So, Hugh, thank you so much for coming on All Thoughts. Well, Tracy, thanks so much for having me on. We are very excited.

5:04First of all, maybe let's just start with the basic question because everyone seems to have different opinions, different numbers around this. But how big is private credit at the moment compared to the traditional banking system? them? Oh, I mean, honestly, it's pretty tiny. So the official stats are about 1.7 trillion. And that's by Prequin, the company that BlackRock bought recently. That number, though, doesn't include insurers giving direct mandates to the private credit firms. So I think it's probably closer to two and a half to three trillion, which is a drop in the ocean to what investment grade bond markets, nine trillion, banking assets in Europe are 32 trillion.

5:41These are really relatively small numbers. And so I think that's why many of these firms think they've got a long runway still to grow. So why do we care? It's not because they're so big, it's just because it's growing fast? Well, it's also because they're eating away at bank earnings. And I think that's where, you know, if I think about our conversations with bank CEOs and CFOs, and I literally just had one before coming on your show, they're worried about how much of their juice is being gobbled up. And I think that that's, you know, that's why, anyway, Tracy's right, has gone from sort of counterparts to frenemies.

6:13And one way to think about it is that we had a very unusual macro period, as you've spoken about many times. During 2023, private credit players wrote about 90 % of all leveraged loans. And they're also doing really well in direct lending. And so they're looking for the next avenue of growth. And one theme that we come across a lot is about asset-backed lending. So in other words, financing, I don't know, aviation or auto loans or even royalties, that's a$5.5 trillion market in the states. Private credit probably has less than 5 % share, and they're really looking to mine this seam. And so if you're a banker thinking, these guys are now after our investment grade assets, not just our, the high yield assets.

6:55So talk to us about how we got to this point, because Joe correctly, I think, attributed this to a lot of the post 2008 redesign of the financial system regulation. And I mean, this is what we wanted, right? We wanted the riskiest stuff, the riskiest activity to be pushed away from regulated banks and into, I know they have the nefarious name of shadow banks, but mostly we're talking about a business development company or a direct lender or someone like that. No, look, I think that's right. So look, if you take it since the financial crisis where we changed the regs for the banking system, a lot more capital, a lot less, shortened the asset liability duration, a mismatch that went beyond an elastic limit into the financial crisis.

7:40So these private credit firms have created just over a trillion dollar parallel system to lend to corporate America and parts of corporate Europe. And it's around leverage lending, it's areas which were either too risky, or in some cases, where the Fed put in limits on how many leveraged loans or what was the maximum, you know, multiple of leverage that a bank loan could take on. And so these loans are being pushed outside of the banks. The other area, though, where private credit has been very active, too, is mid-market. So let's say a loan between, let's say,$30 million to$75 million. That's an area where, for the top six banks, this is just too small fry for them to get excited.

8:20And therefore, so there was a kind of a missing piece, which, you know, the private credit firms picked up the crumbs which are left on the table by the banks. So you're right, I think the regulators push this. I think where we're going now is probably to the next level. And so the way I think about it is that we are now retranching the banking system where the banks are laying off the junior risk to private credit and that's allowing them to optimize their capital but quite frankly also lend more and so what's really interesting for me is there's like everything in life people see things as an opportunity or a threat the top banks and ceos that i talk to are now saying actually private credit allows me to recycle risk more quickly i can lend more and then there's a whole bunch of banks who are just sitting licking their wounds going i'm not sure how i can do this so I think there is a little bit of symbiosis now between the banks and private credit.

9:08Sorry, explain that a little bit further, at least on the opportunity side, when they can recycle their capital faster. Just sort of walk us through that. Yeah. So, Joe, let's take one of the top US banks or European banks. So, there are three ways they can lay off risk. The first would be to say, I will cede the loans that I don't really want to right to give to a third party. So in a way, what you've seen with Apollo and Citigroup is the leverage lending, or Brookfield with Lloyds in Europe. Again, it was around leverage lending. So it's stuff that they didn't really want to do, but they can arrange, they can get all sorts of origination fees, and then they can also keep the relationship.

9:47The second is if they, let's say, originate a loan, they then parcel it up, maybe get 100 loans, 120 loans, and then do a synthetic risk transfer around this. In other words, start to basically, which I think you talked about two months ago on your show. So in that case, think about a bell curve, you're going to ensure the bottom 10%. You're going to take off the tail. And from a bank capital point of view, that dramatically optimizes your capital at risk. So the Fed only permissioned this about nine months ago. You've already seen Morgan Stanley, Goldman Sachs, a number of firms start to do these synthetic risk transfers.

10:20That space, I think, is going to grow really strongly, because for the largest firms, it allows them to lend and then do that. And then the third is then the more, There's some more complexities as well around how else you can lay off the risk.

10:48Your best restaurant location gets five-star reviews. How do you make every location like your best location? Your best paper mill has been operating at peak productivity. How do you make every mill like your best mill? Your best data center has optimized every drop of water. How do you make every data center like your best data center? The answer is Ecolab. Better performance, better outcomes, better impact. Ecolab. Now every location is your best location. For enterprise organizations, managing all your food needs is a tall order. But with Easy Cater, you get a single workplace food vendor with the tools and resources to make it easy, giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform, all while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting.

11:43Easy Cater, your business tool for food. To learn more, visit easycater.com slash podcast. So one thing I'm always asking on the show is how these conversations begin, because, you know, I honestly have no idea. Like, clearly, there's a lot of partnering that's happening between banks and private credit at the moment. But when did that start in your mind? What was the first kind of big, notable instance of a bank teaming up with some sort of private credit entity? Oh, that's a good question. So as you sort of hinted earlier on, Tracy, often in life, the history of these things is far longer than we like to believe.

12:22So just like actually 1973 was the peak of bank lending as a percentage of lending to corporates. I mean, it's 50 years since that peak. So you're right. Some of these partnerships are actually about 15 years old. One or two of them predate the financial crisis. But if you think about today, in the 12 months to September, 14 banks tied up deals with private credit. And in the 12 months prior, it was only two. So it's basically about a year ago, suddenly it snapped. Now, why is that? I think it's because the private credit firms, particularly the top 10, felt they'd started to max out of, you know, leverage lending or direct lending.

12:59But I think the subplot is much more Shakespearean. I think there's a really interesting subplot, which is more of the top 10 private credit firms are now getting their assets from insurers. So take yesterday, we had the Blackstone results. Half their assets now come from insurance companies. insurers can only invest investment grade. So if you think about it from the point of view of the private credit player, they are structurally lowering their cost of capital, which means that they can then go after investment grade assets on the bank's balance sheets. And so that subplot, I mean, I think now of the top 10 firms, on my numbers, about 40 % of the assets come from insurers.

13:36They become much more relevant to compete for the investment grade pieces on the banks. And I think that's what, you know, whether it's the Barclays deal with Blackstone, whether it's Oaktree with Sokjen, whether it's Citi with Apollo, in a way, the private credit is able to nibble away at more assets than they could in the past. I'm going to back up and ask the dumb question. I'm like, oh, I think maybe listeners will want a clarification, but it's actually just me. What's the difference between leveraged lending and direct lending again? Oh, look, this is one of these where nomenclature is pretty poor.

14:09Okay. I mean, it's really poor and it's pretty blurry. I think the way they think, most of them would think about it, direct lending is I'm lending to a mid-market company, you know,$30 million to$100 million, the kind of area, mid-market finance, whereas lending is going to be acquisition-related finance. Oh, okay, I got it. Yeah, yeah, I got it. But Joe, it's a blurry Venn diagram. No, the acquisition-related finance, that makes a lot of sense to me. So I'm going to go back to that conversation point and ask, Okay, so, you know, a bank approaches a private credit lender or a private credit lender approaches a bank and says, hey, we need to do something in this environment.

14:46You know, there's a lot of demand. I've got a bunch of insurance companies that are interested, whatever. How do they go about identifying what exactly they're going to do and which particular assets or loans might be realistic for this kind of partnership? Oh, that's a great question, Tracy. Look, some of these relations, these firms have been counterparts of the banks for many years. So there's a degree of relationship, even if maybe historically being a little bit antagonistic. And certainly one of the leaving private credit firms has a swear box for every time they talk about a counterpart rather than a partner these days.

15:19How much do you have to put in? Is it like$5 ,000 or$5? Well, it probably should be$5 ,000, but I think it's actually, it's the charity pot. And so if we think about those deals, half have been around asset-backed lending and half around the overflow, the leverage financial, the more levered stuff. So I think what the private credit companies are doing is very shrewdly going through. They're almost doing like my old job being a bank analyst. They're looking at a bank and saying, where is capital constrained? At the end of the day, particularly in Europe, but even in the state, I mean, even particularly think about US regional banks or some of the European banks, they've become optimizers.

15:56They're optimizing for cost efficiency, capital efficiency and revenues. And in that mindset of optimization, they're always looking to try and lay off risk. And so the private credit company often says, well, look, I see you're capital constrained. You need to grow. An example would be, let's say, Blackstone with Barclays. They want to grow their credit card business, but equally want to keep lots of money in their investment bank. By partnering up, they can now fuel the growth of the credit card business in a way they couldn't do before or at least didn't believe they could before. So I think this is, you know, in a very constrained world.

16:32In fact, I was at an event last week with a bunch of investors and private credit firms. And one of the investors said, well, look, there is not enough capital for any bank to put capital behind an acronym. You know, that's just space is gone. You need to find partners. And so I think they're forensic. They're hiring people to do banks analysts for them. And then they're looking to try and create a solution. Because I said the top 10 firms feel their origination constraint. And so they need the access to more assets. So in a situation like a credit card deal, what the bank wants and the bank still has and the bank will probably still have is that brand, that relationship, that retail distribution network and so forth.

17:15And then the private credit entity just allows them to keep growing these lines and they're presumably other lines without impairing their balance sheet. Exactly. It's about optimizing for capital as well because, you know, it's at the end of the day, if you take off the riskiest piece or take off the entire slice, then you can just grow much faster. That is very helpful. Can you go further in talking about the role of insurance and all this? Because one of the things that I still find actually completely strange is that we have these gigantic financial entities called insurance companies. They're mammoth and they're important in all kinds of areas and no one ever talks about insurance companies.

17:53There's like, you don't really see them in the media the same way you see banks. It's very strange. That and accounting. Yeah, that and accounting. Like the two missing, like major ingredients of financial journalism. Of the financial ecosystem that seemed to like punch, and maybe they like it, and punch it like, you know, 10 % of their weight in terms of our understanding of their role. But talk a little bit more about the role of insurance capital and all this. Oh, this is a great plot. And actually, it's very different in Europe versus the US. But let's say if you go back to Tracy's point, the railways were funded mostly by insurance companies.

18:26I mean, large capital projects were mostly funded by the insurers because they had long dated funding. And you still had wildcat runs in the States, as you may not remember, but it was there. So everyone's looked at Apollo and their arrangement with Athene and seeing that they've created a very – they've got a very stable source of funding through their annuity business. much like you might have seen through the last, actually even before the financial crisis, hedge funds wanted permanent capital vehicles. Everyone wants to be aligned to long data capital. And so I think most of the top 10 now have an insurance business.

19:02So I mean, I listened to the Blackstone call yesterday, 221 billion other assets are now from insurers out of 432. So over half of their credit assets come from insurers. Now, obviously that's great because these are investors with long-duration liabilities who need long-dated assets. So they're the right kind of people to fund data centers, infrastructure assets, you know, the long-dated stuff we need to fund our growth. But the interesting thing for private credit is, rather than having to go for, I don't know, 10 % to 13 % return, if they can just simply get 100 to 200 basis points more than the insurer could have got through the public markets, they're actually quids in.

19:44And so certainly the expectation for the CIOs of insurers I speak to is if they can get 150, 175 basis points pickup on a single A bond by buying a private bond rather than a public bond, if you compound that over 10 years, that's huge for the insurance sector. And so, as I said, I think about 40 % of the assets now of the majors come from insurance. I think for the industry as a whole, it's probably near a 30. And so that's fueling the growth. And it's changing the nature of where private credit can invest. By the way, Tracy, I didn't know that insurance companies funded the railways. But I will say early on in my career, I do remember, and I sort of pat myself on the back for this.

20:26I do remember having the realization that sort of like clicked how similar banks and insurance companies are because with the bank, you know, you make a deposit of a thousand dollars and over the lifetime, the bank will probably give you back your a thousand dollars in the form of you take it out. Insurance company is basically the same. You buy a - Collect premiums, pay it out. And you get the, you know, on average - No, but like on average, right, for the industry, they pay out roughly what they get in and they hope to like make it on the float kind of and so in the end like the models in the ideal sense it's just a matter of timing of when the cash comes back out but in aggregate certainly in aggregate but it's not my individual experience some people get screwed and some people get way more than they put in and then on average anyway yeah that sort of clicked to me one time in my no i there's there's a lot of overlap here for sure okay so i want to go back to the financial risk slash regulation points so we've established a number of times that to some extent this is exactly what regulators wanted to see happen.

21:25But I think there's always a concern that maybe this will come back to bite them and the overall financial system in some unexpected way. And that maybe there are avenues that some of this risk is still entangled with the banking system, especially as we see these new partnerships develop. What are the avenues for private credit risk to, I guess, re-enter the banking system and potentially cause problems? Look, I think it's a great question. I think I've had almost every regulator pose this question. This is one of the very hot buttons for them. So look, my take is that for a sector which is very low on leverage, doesn't have the big asset liability mismatches, is not systemically interconnected, and to be honest, is still relatively small, less than three trillion, it's on the whole not a source of systemic risk.

22:13But the question you gather, therefore, are there pockets of leverage that we can't see? So, for instance, the Bank of England's got an investigation to think about where is the hidden leverage? Because obviously, having had the LDI problems under trust, they're worried about hidden leverage. So, NAV finance is an area which the regulators are pouring over and are trying to get the data from firms just to see is there leverage on leverage in the system that may trip them up. I think second would be, on the whole, if you've got 10 plus 2, if the funds are 10-year in duration, or even if they're six years, and you're lending to five-year loans, there isn't a big asset liability mismatch.

22:55But to the extent that private credit may potentially be put into retail vehicles or even to ETFs, is there going to be an asset liability mismatch? and certainly the more the private credit looks to raise money from retail the more there's going to be questions around the structure and we can come back to that because there's a cambrian explosion of interest of traditional asset managers and private credit players teaming up to create commingle vehicles and then the third though but tracy to your point is how do the tentacles overlap so there was a good piece by liberty street so like the fed in new york that 27 of bank loans are now two non-bank financial institutions so hedge funds private credit you know private equity and the like and it's been growing like a weed and so they're wondering you know you know at one level they're very happy that uh firms are laying off risk to private credit but they but the question in fact one of the big central banks is all is asking the banks to try and toss up every loan to private credit firm a every loan to private credit firm b in reality they're not making the loan to the firm they're doing it to the underlying asset but they want to have a consolidated tape because, you know, what you don't know scares you.

24:02And so they're trying to get a much better transparency on this space. This kind of reminds me of the conversation we had with Mickey Shemi about synthetic risk transfers where, you know, it's sort of the same idea. The bank is like selling off part of the risk of a loan portfolio to another entity. And that sounds fine, except sometimes those other entities who tend to be hedge funds or someone like that are borrowing from banks in order to apply leverage to boost the yield. Yeah, say more about that 27%. I have to go read that Liberty Street economics report. But what is, from the bank's perspective, that specific type of lending, what are the risk characteristics?

24:40What are the capital cost characteristics of this kind of activity? Well, look, Sue, by the way, I'll send you the notes. I think it's about where do banks end and private markets begin as oil and banks begin is the title. So I think, look, it's very heterogeneous at the moment. So it's hedge funds. And I know that my good friend Torsten Slok said that's to a new high. It's to private equity firms. So it's all over the place. But so I'm just thinking, sorry, Jay, go back again. I know my question wasn't particularly cogent here. My answer was it was worse. No, no, no, it's fine. It's fine. I'm just trying to understand, like, right.

25:17Okay. So banks are optimization vehicles. They're capital optimization vehicles and so forth. And they want to do the lending that creates the fewest constraints on the size for regulators and all that stuff. So where does lending to financial institutions fit into this sort of like matrix of costs and benefits? Okay. So the way bank regs work these days is to encourage the banks to do senior or high quality lending and to try and limit the amount of riskier lending, either to try and originate and distribute it very quickly or to lay it off through derivatives of some sort. And so let's say it's lending to hedge funds.