Opinion: Non-bank lending is growing – and it comes without the systemic risks of banks

Nick Chamie is the chief strategist and senior managing director of total portfolio & capital markets; and Jennifer Hartviksen is the managing director and head of global credit at the Investment Management Corporation of Ontario (IMCO).

Just over a year ago, we witnessed the largest U.S. banking failure since the 2008-09 financial crisis, the collapse of Silicon Valley Bank (SVB). That appeared to accelerate the pace of institutional players stepping in to fill the void left by traditional U.S. banking institutions.

In reality, though, SVB’s failure was just another withdrawal in the lending retrenchment of commercial banks, deepening a void filled by private credit providers since 2008. The postcrisis era ushered in more stringent regulations and increased capital requirements for systemically important banks, weighing on the ability of large U.S. commercial banks to extend credit. Credit penetration by large U.S. commercial banks never fully recovered. Data from the International Monetary Fund bear this out – after peaking at nearly 60 per cent of gross domestic product in 2007, bank credit as a share of U.S. economic activity has stagnated for almost a decade.

Armed with stable long-term funding sources, institutional investors such as asset managers, insurance companies, pension funds and sovereign wealth funds are capitalizing on this opportunity, propelling the private credit market to nearly triple in size, with projections reaching US$2.8-trillion by 2028, according to investment data company Preqin. No wonder, according to a recent report, banks are now trying to claw back this business. At the same time, fears are being stoked of private credit’s risk profile, complete with accusations of “shadow banking” that is not subject to regulatory oversight and outright dismissal of its staying power through a potential recession.

But private credit is here to stay. Here’s why it’s a good thing for both investors and borrowers as well as the economy, and what’s at stake.

Banks are funded by deposits that can be withdrawn at any time, without notice. At the same time, banks primarily use these funds to loan to borrowers, for terms ranging from months to years. Banks (such as SVB) are ever vulnerable to too many depositors withdrawing their funds at once and operate on high leverage to operate their businesses, relying on volume to make up the small return gained from lending at slightly higher rates than what they pay depositors. The potent combination of the asset and liability mismatch coupled with high leverage inherently poses a systemic risk.

In contrast, institutional investors, with their appetite for long-term assets, provide a stable funding base that aligns more closely with the needs of borrowers seeking long-term financing.

Institutional funds represent some of the most sophisticated investors in the world. Their scale and long investing horizons enable them to participate throughout the ups and downs of the credit cycle. They have proven well suited to innovate in the credit space, leveraging their expert underwriting, risk management and rigorous oversight to lend across credit segments while mitigating risks.

In turn, borrowers gain access to well-capitalized investors, who are not only filling the private credit void, but are also providing more bespoke financing solutions than what’s available in traditional public market segments.

Simply put, private lending leads to less systemic risk. Meanwhile, a recent analysis by the Canadian Association of Insolvency and Restructuring Professionals of data from the Office of the Superintendent of Bankruptcy shows that in 2023, Canada had the largest increase in business insolvency filings in 36 years.

When public markets close, private credit can serve as a lifeline to borrowers, conferring all the associated benefits that credit brings to the table in those transactions and an undeniable economic benefit. Take distressed debt as an example. If commercial banks are withdrawing, companies under financial stress would be left with no alternatives, leading to bankruptcies.

After more than a decade of global zero (or in some cases negative) policy interest rates, we are returning to a more normalized rate environment, enhancing the appeal of credit as an asset class.

Looking ahead, higher and more volatile inflation and interest rates are expected to persist, introducing uncertainties that could further constrain traditional banks’ willingness to extend credit. This environment could further benefit institutional investors, as they capitalize on market dislocations and the increased demand for alternative financing solutions.

It reflects a market working just as it should, where capital providers move closer to end borrowers, and with it, a new set of investment opportunities becomes possible for both investors and borrowers.