Odd Lots Podcast Summary: "Can You Ever Actually De-Risk The Banking System?" Bloomberg, Released November 11, 2024

In this thought-provoking episode of Bloomberg's Odd Lots, hosts Jill Wiesenthal and Tracy Alloway delve into the complex topic of whether the banking system can truly be de-risked. Featuring insights from Stephen Kelly, Associate Director of Research at the Yale Program on Financial Stability, the discussion navigates the evolving landscape of private credit, hedge funds, and their intricate relationship with traditional banks. Here's a detailed breakdown of the episode's key points, enriched with notable quotes and timestamps for context.

1. The Shift from Banks to Private Credit

00:01 – 03:49

The episode kicks off with hosts Jill Wiesenthal and Tracy Alloway highlighting the ongoing trend where activities traditionally handled within banks, such as private credit and multistrategy hedge funds, are increasingly occurring outside of them. This shift, part of a broader narrative since the 2008 financial crisis, raises critical questions about the true extent of de-risking within the banking system.

Jill Wiesenthal (01:25): "We do all these episodes about private credit and obviously hedge funds, multistrategy hedge funds in particular lately. It all sort of seems to be part of a bigger story of a bunch of things that used to happen inside banks no longer happening inside banks."

Tracy Alloway (02:29): "Given the increases we've seen in rates over the past couple of years, the fact that nothing really broke or exploded in the private credit market seems like a good sign."

2. The Circular Nature of Risk Transfer

03:14 – 05:34

Jill raises concerns about synthetic risk transfers, where banks offload credit risks to third-party entities. She questions whether these offloaded risks might eventually circle back to the banks, potentially undermining the de-risking efforts post-2008.

Jill Wiesenthal (03:14): "It's very circular, isn't it?...what if in some way it still goes back to the banks and the risk still is there and it just sort of takes the loop out and then comes back."

Matt Levine (05:11): "Are there reasons to think about how these risks that migrate off of bank balance sheets find a way to migrate back onto them?...they really are the exact right questions."

3. Introducing Stephen Kelly: The Guest Expert

05:35 – 07:48

The hosts welcome Stephen Kelly, who brings expertise from the Yale Program on Financial Stability. Kelly emphasizes the importance of understanding the mechanisms through which private credit interacts with the banking system and the potential risks involved.

4. Understanding Private Credit Investments

07:31 – 12:52

Tracy poses a fundamental question about the mechanics of private credit investments, seeking clarity on how investor funds are utilized within private credit funds and their relationship with banks. Matt explains that private credit funds, while appearing separate, are intrinsically linked to the banking system through their banking relationships and funding mechanisms.

Tracy Alloway (06:13): "What is actually happening in the financial system when someone puts money into private credit?...what happens to that million dollars?"

Matt Levine (07:48): "Private credit is sort of the lending side... there's no shadow bank without a bank."

5. The Leverage Conundrum in Private Credit

09:25 – 13:18

The discussion delves into the leverage used by private credit funds compared to traditional banks. Matt highlights that while private credit funds typically employ lower leverage (1x to 2x), the inherent scarcity of unlevered equity and the financial system's constraints limit their growth. This section underscores the delicate balance private credit must maintain to avoid replicating the leverage risks that once plagued banks.

Matt Levine (07:48): "These are very marginal steps. It's gated, it's limited... private credit was really there to offset the bank's hung loans problem in 2022."

6. Regulatory Scrutiny and Differences Across Regions

19:34 – 22:07

Stephen Kelly discusses the increasing regulatory attention on private credit and its implications. While regulators globally are probing banks' exposures to private credit, approaches vary by region. European regulators, particularly the Bank of England, are more proactive compared to their U.S. counterparts, who are currently more focused on data collection and stress testing.

Matt Levine (20:56): "They [regulators] have just been really annoying to banks. That's a cost, right?...supervisors have just become more annoying."

7. The Role of Insurers and Long-Term Funding

22:35 – 27:33

The conversation shifts to the significance of insurers as a stable source of long-term funding for private credit. Matt explains that while insurers provide a substantial and "sticky" capital base, there are limits to their contributions, leading private credit firms to increasingly seek retail investors and explore products like ETFs to expand their funding sources.

Matt Levine (22:35): "Insurers... are a sticky source of funds... but there's a limit to that."

Jill Wiesenthal (26:55): "Why doesn't every investing firm have an insurer?... It seems like such a big advantage to have an insurer."

8. Profitability and Sustainability of Private Credit

27:33 – 30:12

Exploring the profitability dynamics, Matt reassures that private credit remains a profitable venture without undermining traditional banking profits. He attributes this to the inherent funding constraints and the distinct operational models of private credit firms compared to banks.

Matt Levine (23:57): "I think not. And it goes back to the limit of funding in private credit."

9. Macro-Economic Impacts and Stability Risks

30:12 – 35:14

The discussion highlights potential macroeconomic impacts of private credit. While private credit provided crucial support during the post-2020 pandemic period by taking on hung loans from banks, there are ongoing risks related to interest rate changes and credit risks that could affect both private credit and traditional banks.

Matt Levine (28:53): "Private credit was really there to offset the bank's hung loans problem in 2022... now we're seeing the banks come back and we're seeing private credit do payment in kind."

10. The Future of Private Credit and Potential Regulatory Changes

35:14 – 35:24

In the closing remarks, the hosts and Stephen Kelly reflect on the cyclical nature of risks and the essential constraints that limit the growth and potential dangers of the private credit sector. They emphasize the importance of ongoing regulatory vigilance to ensure financial stability.

Tracy Alloway (35:14): "It's just a really important concept to keep in mind."

Key Takeaways:

• De-risking the Banks: While significant activities have moved from banks to private credit and hedge funds, the interconnectedness of these entities means that risks might not be entirely eradicated from the banking system.
• Leverage Limits: Private credit firms operate with lower leverage compared to traditional banks, constrained by the finite availability of unlevered equity and long-term funding sources.
• Regulatory Oversight: Global regulators are increasingly scrutinizing the private credit sector, though approaches vary by region, with Europe taking a more proactive stance than the U.S.
• Sustainability Concerns: The reliance on insurers and the push towards retail investments and liquid products like ETFs highlight both the growth potential and the inherent risks of private credit.
• Economic Impact: Private credit plays a vital role in providing capital during economic downturns but faces challenges related to interest rate fluctuations and credit risks that could impact overall financial stability.

Notable Quotes:

• Jill Wiesenthal (03:14): "It's very circular, isn't it?...what if in some way it still goes back to the banks and the risk still is there and it just sort of takes the loop out and then comes back."
• Matt Levine (07:48): "Private credit is sort of the lending side... there's no shadow bank without a bank."
• Matt Levine (20:56): "They [regulators] have just been really annoying to banks. That's a cost, right?...supervisors have just become more annoying."
• Matt Levine (23:57): "I think not. And it goes back to the limit of funding in private credit."

This episode of Odd Lots serves as a crucial exploration of the delicate balance between mitigating risks within the banking system and the burgeoning influence of private credit. By unpacking the interdependencies and regulatory landscapes, the hosts provide listeners with a nuanced understanding of financial stability in the modern economy.