Jamie Dimon recently said that there will be “hell to pay” when private credit gets the comeuppance common to businesses engaged in a race to the bottom.  But, who’ll pay it?  If the $1.7 trillion sector isn’t as systemic as many fear, then hell will be paid by institutional investors and, downstream, the policy-holders and pensioners who depend on them.  But, there’s more.  Typically, Wall Street opens high-return products to retail investors only when there’s so much to go around that pricing no longer reflects risk.  As smart money stands back, retail investors are enticed in order to, as one bank CEO memorably said in 2008, keep dancing until the music stops.  As we learned yet again the hard way in 2020, hell paid by retail investors can quickly turn into hell paid by taxpayers.

Last week’s news brought an announcement that one large adviser has opened a new fund for higher net-worth clients able to put $100,000 in funds comprised largely of private-credit assets.  So far, this is just one group of funds, but so far isn’t all that long and it’s very likely that growing fears about private-credit risk among institutional investors will open the retail spigot for private-equity lenders which still have loads of high-risk they hope to move into the waiting hands of a sector less learned about opacity and manifold conflicts of interest.

Despite growing alarm about private credit from both global regulators and institutional investors, the Fed’s most recent financial stability report essentially ignores it.  Fed officials have been quizzed frequently about this, with Sens. Brown and Reed even sending a letter telling the Fed to do something about bank interconnections with private credit if it wouldn’t or couldn’t do anything about private credit itself.  Even so, the Fed has decided that a sector of this size with all the appearances of risk and regulatory arbitrage troubles it not.  Most recently, Vice Chair Barr dismissed a question about private-credit’s systemic footprint by saying he wouldn’t even think about worrying until these assets end up in open-end funds sold to retail investors.

So, will the Fed act now?  Maybe the new retail funds aren’t open-ended enough to worry the Fed, or the initial target market is affluent enough, or maybe there’s another reason to hold back or just say something that might induce a bit of market discipline even if the Fed feels it can’t do much to enforce it.

Or, maybe the Fed continues its accustomed strategy of waiting to be sure there’s really a problem and thus doing something to stem systemic risk only after there’s so much systemic risk and all the Fed seems to know what to do is bail out whoever’s played too hard for too long.  This is of course the also-accustomed boom-bust cycle of Fed policy that breeds the moral hazard that fuels the markets that create the systemic risk that leads the Fed to bail it out and thus reinforce the tails-I-win, heads-you-lose markets that have held sway since at least 1999.

However, moral hazard and systemic risk aren’t all that’s at stake.  Two recent studies also show that the longer the Fed lets private credit roam the land, the harder it will be for regional banks to remain competitive, especially if the pathway to M&A remains blocked unless or until a regional bank has failed thanks to all the risk the Fed saw but ignored.  A recent Brookings study pressing for tough bank rules also argues that more M&A approvals must come in tandem with these rules because private credit and other nonbank lenders wreak the most havoc with regional-bank viability.  The Basel literature survey analyzed elsewhere for clients today shows how quickly this risk will mount because of the acute profitability stress on regional banks resulting from the rapid growth of technology-based lenders.

As a result, wait-and-see systemic policy has two evil offspring.  The first – moral hazard – we have already learned the hard way.  The second – still more concentrated market power in a very few banks and potent private-equity lenders – is next and won’t be any more fun.