The role of private credit in the economic cycle

Sockeye salmon jumping up brooks falls during the annual migration at katmai national park, Alaska Sekar Balasubramanian © /123RF Stock PhotosWith banks pulling back as suppliers of credit in times of economic downturn, investment funds entering the private credit space can help promote economic resilience and more could be done to facilitate the flow of private money into this space, according to a new paper.

The background and motivation for this paper  has to do with how, since the financial crisis, there’s been a growing focus on risks outside the regulatory perimeter, says the paper’s author Christina Parajon Skinner, assistant professor of legal studies and business ethics at the Wharton School of the University of Pennsylvania. “So it’s specifically risks in non-bank financial institutions and some concern about certain forms of non-bank credit intermediation, precisely because it’s taking place outside of the classic banking regulatory perimeter.”

However, Parajon Skinner’s paper highlights the important benefits of certain non-bank financial institutions coming in to fill the lending gap.

“Certain of these private debt funds or private credit funds which are structured appropriately can really benefit financial stability,” she says, noting certain types of private debt funds are structured and incentivized to deploy capital in countercyclical ways.

“This is good because what we see is that during economic downturns or economic crises, banks have precisely the opposite set of incentives and structures. Banks are really set up to pull bank from lending or deleverage during these times. Meanwhile, these private debt funds are . . . turning on their credit spigots precisely when banks are pulling back.”

Private credit has become increasingly popular over the last decade. According to the paper, the private credit industry has quadrupled in the past 10 years and is expected to hold $1 trillion of assets under management by 2020.

“In a nutshell, what we’ve learned from decades of experience is that what the economy really needs after a crisis and during a downturn is credit,” says Parajon Skinner. “That’s what it needs to heal itself. So by acting as a foil to banks, turning on their credit spigots, these private debt funds, I’m arguing, tend to really have the potential to smooth out the financial cycle, to make the downturns and the troughs less severe.”

Although only a preliminary suggestion, the paper noted that, because of the positive role private credit can play in economic recovery, it’s worthwhile to consider whether this can be an option for retail investors. Parajon Skinner says she intends to pursue this idea in further research, acknowledging there are a host of issues that would need to be addressed for it to take place. One example is studying how liquidity would work in a retail setting because a 10-year lock in, for example, may not be feasible for these investors.

To understand the benefits for the economy, it’s also key to look at the structure of private credit, adds Parajon Skinner. “When something — a disruption in the economy or the markets — happens, what we are sometimes concerned about is the runability of funds, both in banks and in non-banks. So that’s been something that post-crisis reforms have tried to address in open-ended funds. And so I think it’s important that when I’m saying we should encourage the growth of private funds, we want to look and see that they’re structured stably.”

Parajon Skinner says she hopes macro-financial regulators, after reading the paper, will take away that private debt and private credit deserve to have a separate analysis in the shadow banking conversation. “I would urge them to consider the financial stability benefits of these funds in their analysis, in particular, the potential for them to smooth out the financial cycle.”