Finance Seminar - David Scharfstein, Harvard University

Title: Bank Capital and the Growth of Private Credit

Authors: Sergey Chernenko, Robert Ialenti, and David Scharfstein

Abstract: We show that business development companies (BDCs), a significant source of private credit, are very well capitalized according to bank capital frameworks. These types of private credit funds have median risk-based capital ratios of about 36%, which is 26 percentage points more than the Federal Reserve’s stress testing framework would require. Our evidence thus cuts against the view that private credit has grown because nonbank financial intermediaries have less capital than banks.

Instead, we argue that, for plausible parameters, banks find lending to private credit funds more attractive than direct middle-market lending. This is, in part, because over-collateralized loans to private credit funds get favorable capital treatment, enabling banks to exploit their low-cost funding.

We also present a model explaining banks’ observed preference for making middle-market loans via affiliated private credit funds rather than on the bank’s balance sheet. For plausible parameters, banks choose to forgo less expensive balance sheet funding to avoid the extra regulatory and supervisory costs of managing a risky loan portfolio on the bank’s balance sheet.

Finally, we examine the financial stability risks of private credit. While there is little risk to the solvency of private credit funds, they may deleverage during periods of stress. Our baseline estimates suggest that over eight quarters, the median BDC would reduce outstanding loan balances by 9.5%, about half by selling assets and half by using free cash flows to pay down debt rather than to make new loans.