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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Private capital firms and banks are sometimes cast as opponents, with the former ascendant thanks to all the regulatory burdens heaped upon the latter since 2008. In reality, they are in a torrid co-dependent relationship.

After all, private capital is in many cases utterly dependent on leverage to juice their returns to levels that can attract investors. At the same time, banks are thirsty for all the investment banking fees that private capital firms generate.

As result, the broader blob often referred to as “non-bank financial institutions” by regulators has in practice grown increasingly entangled with the traditional banking industry. But just how enmeshed are they?

Adam Josephson of the As the Consumer Turns newsletter has alerted us to an interesting new paper by two economists at the Boston Fed that attempts to answer that question.

Using regulatory data reported by large US banks, John Levin and Antoine Malfroy-Camine have attempted to assess the industry’s linkages to private equity and private credit firms specifically. FT Alphaville’s emphasis in the paper’s conclusion below:

We estimate the banks in our sample extend around $300 billion in loan commitments to PE and PC funds and other fund-level entities sponsored by those fund managers as of 2023. In total, these loan commitments represent about 14 percent of total loan commitments to NBFIs made by the largest U.S. banks (those subject to Federal Reserve stress tests), up from about 1 percent in 2013. As such, private funds may be growing more reliant on bank loans, both by taking larger loan commitments relative to fund assets and by utilizing a higher percentage of those loan commitments.

In absolute nominal terms, the amount of lending that big US banks have done to private capital firms has risen by about 30x, from about $10bn in 2013 to $300bn in 2023.

A few words on the ugly NBFI acronym. “Non-bank financial institutions” is an almost hopelessly broad term for everything that does financial services that isn’t a traditional bank. It’s become the preferred argot over “shadow banking” — given the latter’s somewhat insidious connotations — and encompasses everything from money market funds and insurers to hedge funds and infrastructure investing.

NBFI as a whole now accounts for about half the global financial system, according to the Financial Stability Board, and pretty much every regulator and financial watchdog on the planet has in recent years been warning about the dangers this poses.

Indeed, just last week the Federal Reserve announced that it was conducting an “exploratory analysis of risks to the banking system” as a complement to its standard supervisory stress tests. Here’s the brief:

This growth poses risks to banks, as certain NBFIs operate with high leverage and are dependent on funding from the banking sector.

The proposed exploratory analysis will contain two parts:

1. Credit and liquidity shocks in the NBFI sector, during a severe global recession; and

2. A market shock featuring a sudden dislocation to financial markets resulting from expectations of reduced global economic activity and higher inflation expectations. This distress in equity markets causes the unexpected defaults of the subject bank’s five largest equity hedge fund counterparties.

This is particularly pertinent in the US, where non-banks are dominant. The Boston Fed’s Levin and Malfroy-Camine note that the NBFI’s sector’s share of overall financial assets in the US is about 79 per cent, up from 57 per cent in 1980.

Meanwhile, large US banks’ outstanding loans to the sector has grown from about $300bn in 2012 to over $1.2tn by 2023 — or from 5 per cent of overall bank loans to 9 per cent. And even this arguably undercounts the potential exposure, because a lot of banking exposures are in the form of undrawn loan commitments.

Going by FR Y-14Q regulatory filings, the two Boston Fed economists estimate that the overall loan commitments by big US banks to the NBFI sector totalled $2.2tn at the end of the third quarter of 2023. That is equivalent to nearly a third of all lending commitments.

However, Levin and Malfroy-Camine focused primarily on mapping out the direct lending linkages between banks and private credit and private equity funds. These aren’t huge compared to the size of the overall private capital industry, but it is growing quickly.

From the PE/PC funds’ perspective, the total loan commitments from banks are very small relative to total fund assets, but are growing rapidly, from below 0.2 percent in 2013 to 1.8 percent in 2023. To be sure, this still implies that the PE/PC industry is much less levered than the banking industry, for which deposits (a form of debt) finance about 75 percent of assets. However, growth of PE/PC funds’ borrowings relative to PE/PC fund assets suggests the PE/PC industry may be increasing its usage of bank credit lines to fund its asset growth — a further sign that PE/PC funds benefit from relationships with banks.

Further reading:
— The increasingly blurred lines between banks and NBFIs
— The hedge fund-bank nexus
— Is private credit a systemic risk?
— How bonds ate the entire financial system (FT)