Weigh up policy proposals that might reduce the risks that private credit brings.
The idea
Policy proposals aim at specific weak points. For opacity and data gaps, the answer is standardised reporting to authorities of holdings, leverage, valuation methods and borrower-level data. For valuation, it is independent or third-party valuation and consistent standards. For leverage and bank linkages, it is caps on fund leverage, limits or higher capital charges on bank lending to non-bank financial institutions, and look-through reporting of exposures. For liquidity mismatch, it is aligning redemption terms with asset liquidity through notice periods, gates and swing pricing. For insurers, it is stronger capital rules and scrutiny of asset ratings. System-wide stress tests complement these. Judge each proposal by the vulnerability it addresses and its cost. Tight rules may push activity to less regulated corners or reduce credit to mid-sized firms. A leverage cap with fixed equity is met by selling assets and repaying debt until debt does not exceed the limit times equity.
Formulas
Asset sale to meet a debt-to-equity cap with fixed equity
sale = D − k × E
- D
- the fund's current debt
- k
- the maximum debt-to-equity ratio
- E
- the fund's equity, unchanged
Assets are sold at book value and the proceeds repay debt. Repaying all the debt, or working from assets, gives the wrong amount.
A practice question
Which policy proposal most directly addresses the data gaps in private credit?
- Raising deposit insurance limits for retail savers of banks and credit unionsWhy not: Deposit insurance does not address information gaps in non-bank lending.
- Banning floating-rate lending by non-bank institutions altogetherWhy not: Does not address transparency and removes a normal feature of loans.
- Setting a legal maximum interest rate that lenders may charge on loansWhy not: A rate cap does not improve data and could reduce credit supply.
- Standardised regular reporting of holdings, leverage and valuation methods - correct
Authorities cannot assess risk without data. Standardised reporting of holdings, leverage and valuation methods tackles opacity.
A harder one
A bank has Tier 1 capital of USD 20 billion and USD 4.5 billion of exposure to private credit funds. A proposed rule caps such exposure at 15% of Tier 1 capital. By how much must exposure be reduced, closest to?
- USD 3.0 billionWhy not: Reports the cap level instead of the excess over it.
- USD 0.68 billionWhy not: Applies 15% to the exposure rather than to capital.
- USD 1.5 billion - correct
- USD 4.35 billionWhy not: Treats 15% as USD 0.15 billion and subtracts it from the exposure.
Cap = 15% x 20 = USD 3.0 billion. Excess = 4.5 - 3.0 = USD 1.5 billion. The limit constrains the transmission channel from non-banks to banks.
The hardest tier
A fund has assets of 1,000 financed by equity of 400 and debt of 600. A rule limits debt to 1.0 times equity. Equity is unchanged, and the fund sells assets at book value and repays debt. How much must it sell, closest to?
- 100Why not: Computes the excess of debt over half of assets, forgetting that selling reduces the asset base.
- 200 - correct
- 400Why not: Uses the amount of equity as the sale size.
- 600Why not: Repays all of the debt rather than only the amount above the limit.
With E = 400, debt must be at most 400. Debt falls by the amount sold: 600 - S = 400, so S = 200. The fund is then at 800 assets and a debt-to-equity ratio of 1.0.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in The Rise and Risks of Private Credit
- Describe private credit, including the usual lenders and borrowers, and contrast it with other forms of lending and with fixed-income securities.
- Explain how private credit has grown and what it returns, and compare its track record of returns against that of other asset classes.
- Characterise and judge the risks and weak points of private credit, and show how it can threaten financial stability.