It’s worth reminding ourselves what the private credit risk is
We should, of course, worry about potential problems. But we should worry about the right problems:
‘Shadow banks’ quizzed over meltdown threat from hidden losses
Shadow banks are a specific problem.
City watchdog investigates as private credit boom triggers alarm bells
Private credit is a different problem.
As Brad Delong has pointed out over the years a bank is someone who borrows short to lend long. If you’re not borrowing short to lend long then you’re not a bank. This then comes with a specific problem. If people ask for their short term money back and you can’t get it back from those you’ve lent it to - which you can’t, you’ve lent long, recall - then you go bust. Because you cannot repay those you’ve borrowed short from on the terms you borrowed at and, well, yes, you’re bust.
This then gives us that well known problem with the very idea of fractional reserve banking, the possibility of a bank run. Thus also Bagehot’s solution, the central bank lends liberally at punitive rates of interest and so on.
Shadow banks - pretty much defined as those borrowing short, lending long, but without that backing of the central bank - have a distinct weakness, in that they can be subject to runs, financial panics and, please, let’s not go through all of that again.
Private credit is something different. Or, perhaps, a definition higher. Private credit possibly includes such shadow banks. But it also includes what we might call full reserve banking. Those who, for example, borrow long to lend long. Who do not have that mismatch in tenor over funding and lending. These are an entirely different problem. Sure, they could lose money by lending to the wrong people for the wrong reasons at the wrong price. But if they do then it is their investors who have lost money and Har Har. There is no systemic problem here, no contagion.
We can describe the problem another way. Open ended credit funds are subject to that liquidation risk where investors line up - in increasing states of panic - to get their money back. Closed end funds are not. We’ve seen this distinction play out before. Certain commercial property funds - something suited to a closed end fund structure - ran on the open ended basis. Some rather large portion of those run on that open ended basis came to grief precisely and exactly because of their open ended nature - that line of people demanding their cash back while the investments were in illiquid and thus quick to sell only at bargain basement prices buildings.
We should worry about problems. But we must be clear about the problems we worry about. Private credit not potentially subject to runs or redemption risk are only a problem to those who might have invested in them - caveat emptor. Shadow banking, as defined above, poses systemic risks and darn right we should be analysing those risks.
Which gives us the necessary structure to our worrying. If we’ve substantial shadow banking going on then worry. If it’s closed end private credit then we can just await developments.
OK, maybe keep a Har Har in reserve for the denouement but other than that we’re good to go.
Tim Worstall