Japan’s giant SoftBank isn’t exactly a canary, but it’s nonetheless a reliable omen of trouble in the financial mine shaft – see as just a couple of examples its enormous, disastrous bet on WeWork and nonstop high-tech speculative flops.  It’s an archetype of yield-chasing money living on the Fed’s decade-long fumes.  Now comes news that SoftBank is going big into private credit, already a $1.4 trillion sector with big plans for super-sonic growth now that new bank capital standards are sure to suppress bank lending.  Could anything go wrong in a sector that funds its own high-risk bets, isn’t ready for high rates, takes buckets of credit risk, and has intricate interconnections across the global financial system?  Indeed it can, demonstrating yet again that asymmetric regulation has unintended, all-too-often systemic consequences.

It’s not just SoftBank’s gallop into this sector that gives me the willies.  Another early warning is Federal Reserve insouciance to looming financial system instability borne of its banking blinders.  As with its forecasts for 2019 and 2020, the Fed’s 2022 forecast was stolidly sanguine, failing this time to anticipate regional-bank systemic distress.  Its most recent financial stability report essentially ignores private credit in its nonbank financial intermediation fretting.  So too another leading indicator of policy-maker inattention:  the most recent FSOC annual report also saw no evil in Anything that hasn’t already happened to nonbanks such as money market funds.

The IMF doesn’t listen to its own analysts most of the time, but they are often prescient about looming systemic risk.  Their most recent report sees a lot to worry about when it comes to private credit.  First, there’s the intersection of acknowledged systemic sectors – life insurance and pension funds – with growing books of private-credit loans exacerbating major asset/liability mismatches and thus liquidity risk under stress.  Further, the IMF thinks the sector is vulnerable on its own due to the preponderance of highly-leveraged buyout loans, deteriorating covenant quality, and round-robin private-equity financing for competitor deals that increases concentration even as, we would add, it erodes market discipline.

There is, though, an even better early-warning flare: private capital’s unbounded confidence in its ability to grow without constraint now that banks are going into a capital box.  Apollo for one big, big player in this sector says private capital could soon replace as much as $40 trillion in the fixed-income market.  And why not?  Global bank lending has dropped 37 percent just this year.  Competitors in a capital corner combined with the sector’s exemption from regulatory capital, incentive misalignment, and boundless ambition augur shadows the size of a solar eclipse.

BlackRock says private credit can roll over anything in its way for at least five years.  But then it’s a sell-sider.  A well-respected private-credit buyer, Howard Marks,  thinks the sector is set to bump its big head.  What he sees is likely what there is:  billions of yield-chasing dollars strewn with scant due diligence that are wholly unprepared for higher rates and recessionary credit risk.

Is there a way to stop a train wreck eerily reminiscent of the S&L, commercial real estate, and Mortgage boom/busts?  Probably not, even though this doesn’t have to happen.

Fed and FSOC 2020 hindsight ensures that nothing will change until after something blows up.  This head-in-the-sand approach to systemic regulation is inexcusable and it’s especially dangerous because there are two things the banking agencies could do now to ensure that private credit’s risk is its own sad reward, not one handed off to the financial system as a whole.

First, the Fed and the other banking agencies should think not only about what they want to do to make banks safer, but also how super-safe banks generate asymmetric regulation that redefines the financial system.  I said so and I’ll say it again: there are many ways to write tough rules that keep big banks in check without neutering them.

Second, federal financial regulators should look for private credit’s interconnections to the broader financial system and throttle them.  Private creditors are and should be free of prudential regulation when they put their own funds at risk, but they cannot be allowed to take huge fees off the top, enjoy the good times when they’re a-rolling, and then step back as life insurers, bond-fund investors, pension funds, and syndicated-debt buyers take their losses.  FSOC is finally talking about interconnectivity.  Perhaps soon it will actually do something about it.