Can You Ever Actually De-Risk The Banking System?

Over the last roughly 15 years, we've seen a migration of certain types of risks outside of regulated deposit-taking banks. Private credit has boomed, shifting lending activity away from the banks. Multi-strategy hedge funds have scooped up a lot of the proprietary trading activity that was banned under the Volcker Rule. On paper, this looks good. It seems like various risks have been removed to less systemic institutions. But does the risk find its way back in? What happens when these outside entities still rely on banks for leverage? On this episode of the podcast, we speak with Steven Kelly, the Associate Director of Research at the Yale Program on Financial Stability. We talk about where risks might lie and how regulators can stay atop of them. Read More:Era of Private Credit Returns Beating Private Equity Is Nearing an EndHedge Fund Basis Trade Faces Scrutiny as Regulators Mull ProbeOnly Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox — now delivered every weekday — plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlots See omnystudio.com/listener for privacy information.

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• 0:00Speaker 00

  Finance is increasingly being built on digital rails. But as the adoption of virtual assets, tokenization and stable coins grows, can regulation not only keep pace, but help accelerate it? Find out more later in the podcast.

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• 1:04Joe Weisenthal?

  Hello and welcome to another episode of the Odd Lots Podcast. I'm Joe Weisenthal.

• 1:08Tracy Alloway?

  And I'm Tracy Alockway.

• 1:10Joe Weisenthal?

  Tracy, you know, we do all these episodes about private credit and obviously hedge funds, multi-strategy hedge funds in particular lately. And of course, it all sort of seems to be part of a bigger story of a bunch of things that used to happen inside banks, no longer happening inside banks.

• 1:25Tracy Alloway?

  Right. And this has been like a continual process ever since like the 2008 financial crisis. But even before that, we had like big periods of bank disintermediation, which we talked about recently on that episode with Hugh Van Steenest.

• 1:40Joe Weisenthal?

  Totally. There's a lot going on and not all of these trends date back to the financial crisis. But you know, this was obviously kind of an express goal, I think, of the Dodd-Frank regulations. And just from my seat, sitting here, like, yeah, it seems pretty good. A bunch of risky stuff, like multi-strategy hedge funds, et cetera. Seems kind of risky. You can lose a lot of money in theory. Lending to random middle market companies seems like you could lose a lot of money. It's like, yeah, it seems pretty good that it's not happening inside the banks. And maybe that's. It's good that it's not connected directly to deposit taking institutions.

• 2:13Tracy Alloway?

  Yeah, and I think given the increases we've seen in rates over the past couple of years, the fact that like nothing really broke or exploded in the private credit market seems like a good sign. But again, it's still relatively small and it is growing very rapidly. So I think there are more questions to be asking about this particular space.

• 2:34Joe Weisenthal?

  Well, you brought up something recently on an episode of synthetic risk transfers, where banks sort of offload some of their credit risk onto third party entities. And that's been really stuck in my head, which is, you know, okay, so these third party entities take the risk of the assets from the banks, but then that's an asset that can be levered up. And where do you get leverage? Presumably from a bank. And so I have this like sort of-

• 2:58Tracy Alloway?

  It's very circular, isn't it?

• 3:00Joe Weisenthal?

  Yeah. And I just have this nagging thing in my head somewhere. It's like, okay, yeah, great. We moved it all off the banks. There's, okay, we're not going to have another 2008. But what if in the way, what if in some way it still goes back to the banks?

• 3:13Tracy Alloway?

  Yeah.

• 3:13Joe Weisenthal?

  And the risk still is there and it just sort of takes the loop out and then comes back in.

• 3:18Tracy Alloway?

  It goes into prime brokerage instead of the balance sheet.

• 3:20Joe Weisenthal?

  That's a good way to put it. And so like, I'm still like, I'm like, yeah, things pretty good. But maybe, maybe there are still some reasons to be concerned. Like, can you ever, I guess, maybe we could title this episode, like, can you ever really de-risk the banking system?

• 3:33Tracy Alloway?

  Oh, that's a good one. Let's use that.

• 3:36Joe Weisenthal?

  Okay. Well, I am really excited. We have the perfect guest on today's show, someone we've had on the podcast before and someone we've known and talked to for a long time. We are going to be speaking with Stephen Kelly, Associate Director of Research at the Yale Program on Financial Stability. So Stephen, thank you so much for coming back on Outlots.

• 3:53Speaker 05

  Great to be back. You know, sometimes you guys say literally the perfect guest. And so I'm 0 for 2 on that. I've only gotten perfect guest, but I'll be coming back.

• 4:01Tracy Alloway?

  We have people who complain about when we forget to say the perfect guest, but you've kicked it up to another level and are complaining about not saying, oh, literally the perfect guest. This is a new era.

• 4:11Joe Weisenthal?

  For what it's worth, I do not think that the word perfect does not actually need any adjectives, right? Because either it's perfect or it's not. It's sort of- Sort of like the word when people call something very unique. It's like either it's unique, one of a kind, or it's not. So I wouldn't take that to uh.

• 4:26Speaker 05

  I would agree with you.

• 4:27Joe Weisenthal?

  I wouldn't take that to literally.

• 4:28Speaker 05

  I would agree with you if you followed your own advice.

• 4:31Joe Weisenthal?

  Okay, that's fair enough. Stephen Kelly, literally the perfect guest who made that correction. I just should I be, I like I said, oh, everything seems fine, but are there reasons to think? And we're going to get into specifics. So this is an incredibly broad question. But just conceptually, are there reasons to think about how these risks that migrate off of bank balance sheets? Find a way to migrate back onto them.

• 4:56Speaker 05

  It's totally valid. I mean, this is part of the story of 2008, right? Is there was this whole shadow banking sector and it looked like risk had moved. And really it hadn't. The banks brought everything back first voluntarily and then involuntarily. So you're asking the exact right questions. The IMF is now asking these questions and citing odd lots. I don't know if you saw the recent global financial stability report.

• 5:19Tracy Alloway?

  I did not see that.

• 5:20Speaker 05

  Citing Tracy on exactly this issue of you talked about the synthetic risk transfers in your intro. And this idea of like, okay, but are the banks really funding it? I would say, you know, to the extent we're running risk through another balance sheet. I mean, the banks really are more protected. Even if they are lending to a firm that's taking credit risk because they do have that firm's capital and they have that firm's, you know, alleged skill at managing these risks. And so part of the issue with all the financial crisis stuff was a lot of it was unfunded. We can get into synthetic risk transfers and you had that great episode about how they're different and they're funded. But broadly, Joe, yes, you're asking the right questions.

• 5:58Tracy Alloway?

  Wait, okay, I have a very basic question, but what is actually happening in the financial system? When someone puts money into private credit? So say I'm an investor and I'm going to invest, I don't know, a million dollars in some private credit fund. What happens to that million dollars?

• 6:17Speaker 05

  Well, first, Tracy, you're probably taking the million dollars from an allocation towards junk bonds, investment-grade credit. So that's step one. I mean, the idea of like private credit is taking all these loans from banks, or it's eating the bank's lunch. We can put a pin in that for now, and we should come back to that. So usually, that's what's happening, is this is an allocation away from whether it's other alternatives or other corporate credit. But the reality is, this is deposits moving around the banking system. There's no, like, people talk about private credit like it's deposits leaving the banking system, or it's, you know, deposits are going to non-banks. But there is no shadow bank without a bank. Apollo has bank accounts, Blackstone has bank accounts. When you transfer

• 6:59Speaker 05

  money into them, they put it in their account, and then it's lent on to whomever is receiving the credit. And so you're changing the nature of the aggregate deposit franchise, to the extent deposits are moving to a different kind of actor. But deposits can't leave the banking system.

• 7:16Joe Weisenthal?

  So just take it a little step further, just to be clear. Okay, I sell some junk bonds. I decided to allocate a million dollars to an Apollo private credit fund. They lend the money. Is Apollo further leveraging that lending up to reduce returns, or how leveraged are these funds?

• 7:33Speaker 05

  So what we're seeing is that they're increasingly so. It's pretty scarce so far, and that was part of the pitch, right, is like Apollo came along in 2022, when private credit was booming, and said, hey, why haven't you guys thought of this? We have like one times leverage, two times leverage. That's generally sort of the space that it's in. But as we've sort of seen the market mature and the market grow, like, there's a good reason to lever these things up. If you're doing effectively bank credit, which sometimes they are, there's a reason banks are 10 times levered. Like, that's the way the funding of the system works. I mean, that provides a whole host of other benefits to the system. But there's also a cap on how much unlevered equity is out there. If you think about what

• 8:15Speaker 05

  the financial system exists to do, it's to create as many financial goods for us, what we need, deposits, you know, other kinds of savings, on as little equity as possible. Equity is the scarce resource, and it's the input to the financial system's manufacturing process. And so you cannot recreate.

• 8:34Speaker 05

  10x, 12x, 15x leverage from the banking system on one, 2x leverage in private credit. And that's the limit, you know, to your fear, Joe, that's the limit of how big this thing can grow. And we're sort of seeing that a little bit is the bigger private credit grows relative to the economy. They're sort of nearing the kink on the funding curve as far as like what amount of funding is willing to be locked up as long-term assets. Like the fundamental idea that like on-demand par deposits can become locked up five-year equity in a private credit fund is not real.

• 9:10Tracy Alloway?

  Haven't we seen some private credit funds start to look at structures where investors can take their money out as well, like instead of having the five-year lockup periods, people can go in and out as they need?

• 9:22Speaker 05

  Definitely. I mean, the long arc of financial history bends towards banks. And we've sort of seen private credit start to look more like banks. And one of the ways is these sort of interval funds or evergreen funds they're called. And basically, these are just different types of structures that allow some amount of liquidity in the short term. And this is very, very marginal steps. It's gated, it's limited, but you know, it's gated after a certain percentage. It's limited by quarter. There's a certain time interval in which you can get it. It's not deposits yet, but that's one of the ways which funds have started to bend towards a banking model in addition to leverage.

• 9:58Joe Weisenthal?

  By the way, just speaking of the history of finance is that entities try to make illiquid things a little bit more bank-like. There was a really interesting paper that came out recently from Tim Barker and Chris Hughes about the Penn Central bailout. And in there, there was some talk about the history of CDs specifically and how there at one point, there was this really hard lockup on them, but then entities found ways to sort of, you could liquidate and sell your right to that CD. So they always find a way to create liquidity out of illiquidity.

• 10:29Speaker 05

  Yeah, you can tranche anything with cash flows. To paraphrase Robert De Niro on Meet the Parents, I mean, you can get anything out of that.

• 10:36Tracy Alloway?

  Speaking of tranching, I wanted to ask one more basic question, which is this term retranching of risk in the financial system has come up a number of times. So Hugh Van Steen has used it in a recent episode. I'm pretty sure you've used it as well in your writing. Exactly what risk is being retranched here? Like, give us an idea of what types of things end up in private credit. I imagine a lot of it is sort of middle market stuff, stuff that, to your point earlier, would have been in the junk bond market or the leveraged loan market and is now going elsewhere.

• 11:09Speaker 05

  Yeah, that's exactly right. And so, I mean, I got this term from the GFC, the Global Financial Crisis Literature. I believe it originated with Gary Gordon and Andrew Metrick, and they used it to describe increasing haircuts in 2008. So the idea that, you know, you have a AAA asset, you were haircutting at 1%, but now the market to resell that collateral is worse. You're more worried about your counterparty, and so you're going to haircut at 30%. You've sort of retranched what you've decided is AAA. And a lot of that was driven by market perception of risk as well as increased market demands for more capital. What we're seeing in the banking system is a little bit of market demands and a little bit of regulatory demand. So obviously Basel III, you know, is looming next to the maturity

• 11:54Speaker 05

  wall, and it's sort of saying banks may have to have more capital. The other thing is investors, depositors are looking for a little more liquidity in banks than they were pre-2023. And frankly, interest rate risk at a certain point becomes credit risk. And so when rates go to 5%, banks aren't really like trying to be in the business of managing all the credit risk at 5% that they were avoiding at 0%. And so getting out of that left tail and sort of retranching by selling things out of the banking system is sort of the aim. So it's all those three things at once, and it makes sense for banks to lean then on prime brokerage and lending to senior layers of these funds.

• 12:37Tracy Alloway?

  Wait, this reminds me of something else I wanted to ask, which is, I hear a lot about comparative advantages when it comes to private credit versus the banks, in the sense that private credit might be better at managing certain loans, to your point about higher interest rates. Is that true? And like, what does that comparative advantage actually look like? Does it just mean the analysts at private credit firms are like poring over the paperwork more than a bank can?

• 13:03Speaker 05

  I think that's right. And I know, I know Joe has rued the failure of the high-touch banks in 2023, you know, that banks that care about their customers are the ones that failed. But what that misses is that community banks didn't fail and those do the same thing and those don't have the attention of the market. And that's sort of kind of part of the pitch of private credit as well as like, you know, we're operating under less transparency. Again, we're seeing give on that as they've sort of bent towards banks. But in theory, this is just a product and they do have some ability. It's a smaller group, sometimes as small as one, to work with the lenders. We've seen lower default rates out of private

• 13:42Speaker 05

  credit versus their competitors in leveraged loans, but higher losses given default. So you can multiply those two things together and come up with some lesser loss. And in that case, you know, it makes sense to be allocated to private credit.

• 14:12Speaker 00

  What's next for virtual assets? I'm Jacob Grease, host of Economy Scale, a series exploring growth in key global sectors. And in this episode, we're diving into the digital forces shaping finance. Sean McHugh from Dubai-based Virtual Assets Regulatory Authority has this to say.

• 14:28Speaker 06

  We're seeing a lot of institutional players come in, digital asset dedicated hedge funds, high frequency traders and that sort of thing, and folks who service institutional clients.

• 14:37Speaker 00

  As more capital enters the market, adaptive regulation is likely to become increasingly key. Reese Merica Ripple says.

• 14:44Speaker 07

  A lot of regulators globally would like to keep the industry at arm's length. That's the opposite here. I think also what you'll find is that regulation and frameworks can come out, but some of them are maybe a slight iteration on some 80-year-old policy and not actually in line with what the technology can do and offer. And again, that's very different in Dubai.

• 15:04Speaker 00

  Listen to the full episode wherever you get your podcasts. This series is brought to you by Bloomberg Media Studios and the Dubai Department of Economy and Tourism.

• 15:13Tracy Alloway?

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• 15:57Tracy Alloway?

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• 16:12Joe Weisenthal?

  You know what I realized a little earlier in the conversation is that I actually don't know the difference in what the shadow banks, the quote "shadow banks" were doing prior to 2008 and how their relationship with real banks was different than the current relationship. I mean, it's interesting because I remember, you know, one of the things that was going on, I think, summer 2007 or summer 2008, it was like a couple Bear Stearns hedge funds, like just hedge funds that seemed like a really big deal, like seemed to be systemically important. I think Citi had something maybe too. What was the nature of those quote "shadow banks" and how they actually connected to the regulated banks?

• 16:52Speaker 05

  So the short version is that the nature of those is big banks with strong balance sheets like Bear Stearns and Citi put their name all over those shadow banks, but didn't actually have, they weren't funding them themselves, they weren't actually on the balance sheet of the banks.

• 17:08Joe Weisenthal?

  Yeah.

• 17:08Speaker 05

  So when pressure came in 2007 and nobody knew this was going to be like a repeat of the Great Depression, Citi took all that stuff back on its balance sheet to protect its reputation. Bear took one of those hedge funds on, back onto its balance These banks did not have to take on this risk, but they're going, okay, we're going to stand behind our name. We're going to stand behind our clients who thought they were buying a Bear Stearns or Citigroup product. And maybe that's a risk today. I don't know.

• 17:33Joe Weisenthal?

  Yeah, well, I was just gonna ask, because you see these headlines now, like JP Morgan is going to get into private credit and so forth. And so I get the idea that this is going to be, you know, to be a separate funding vehicle, be like off balance sheet. Kind of sounds similar.

• 17:47Speaker 05

  Yeah, I think that's totally a risk. Is there a world where, you know, Citigroup has to bail out its Apollo partnership? Because they put Citigroup's name all over it? Maybe, maybe.

• 17:58Tracy Alloway?

  Wait, that JP Morgan mention just reminded me of something, but a few years ago, well, actually more than a few years ago, maybe in like 2014 or something like that. I remember JP Morgan basically complaining that the prime brokerage business was a lot harder nowadays. And like the margins were slimmer and stuff like that. I think that's what they said. And yeah, fast forward to 2024, and it seems like prime brokerage is a moneymaker for the big banks at least. What happened there?

• 18:29Speaker 05

  So part of it might just be the growth of private credit. I mean, it has found a niche. I would think about it like a product. You know, like I said, it's got this middle market like you alluded to. It's sort of got a different model. And there's no reason it shouldn't exist along the spectrum of bank deposits to 30 year locked up funding to fund buried treasure expedition. Like it exists in that spectrum, which is kind of an academic answer, but it's true. I mean, Mark Rowan, CEO of Apollo recently had a comment. He said, you know, we'll get competed with like crazy. And then what's the difference between public and private? And I think that's right. It arose as a product in the years. I mean, it doubled between 2020 and 2023.

• 19:11Speaker 05

  We can talk about why, but now they have banking needs. Like I said, there's no shadow bank without a bank and they have banking needs and hedge funds too.

• 19:18Joe Weisenthal?

  So my takeaway so far from this conversation is that some of the questions we're asking is not that there's like some big looming risk out there. Or like, oh, this is a disaster waiting to happen, but mostly these are all like reasonable questions to be asking about where at some point risks could emerge, or at least we're regulators. Maybe wanna think or try to get ahead of things. What tools or specific lines of inquiry have we seen from regulators? Or things regulators could do if they're like, we want to monitor this. And I know that's already, you've written about this, but what are the specific mechanisms and questions and things they could do?

• 19:53Speaker 05

  I mean, basically so far, what we've seen is they've just been really annoying to banks. That's a cost, right? If you talk about why the economics of private credit makes sense, some of it is that, okay, the market demands a lot less capital for certain risks than banking regulators. And there's some supervision attached to those capital regulations too. And so to the extent you're making supervision, you know, just more costly, it's annoying. And banks say, whatever, you know, like JPM, yeah, they're doing 10 billion of private credit on balance sheet. That's like, they just found that in the couch cushions and they're doing it. They put out a press release so they can serve their clients. And this goes back to kind of what we were talking about earlier about what the difference is between banks and private credit,

• 20:36Speaker 05

  banks being more about managing a deposit franchise, private credit being more the lending side. But really we've seen from the Bank of England, from the ECB, from the FSA in Japan, from the Fed, they're all starting to just probe banks about their exposure, their lending to private credit funds and prime brokerage, frankly. But that's step one. I mean, you hear regulators talk either one, we need more authority to regulate the non-banking sector like banks. Or two, you know, the conservative side is let's be nicer with Basel III so you don't push all this stuff into private credit. The truth is always somewhere in the middle. Right now supervisors have just become more annoying.

• 21:15Tracy Alloway?

  That's a good way of putting it. Wait, I have a bunch of questions. Okay, one, have you noticed any like substantial differences in supervisory approaches? Like is the BOE doing something different to the Fed versus the BOJ? I know you said they're all in info collection mode at the moment, but like there must be some differences.

• 21:36Speaker 05

  So generally this stuff goes better in foreign countries than it does in the US, particularly the Bank of England. They have like a system-wide stress test now where they simulate shocks in theory through like the whole financial system. They're big on macro prudential stuff over there. In the US, like the fact that the FSOC, the Financial Stability Oversight Council, hasn't designated BlackRock or its kin as systemically important.

• 22:05Speaker 05

  Under a Biden administration, it'll never happen. And I'm not saying they should have. I mean, the idea is like, they're not doing banking. They have no short-term liabilities, blah, blah, blah. But it just doesn't get that same reception abroad. So there's more, you know, I think it'll lean harder in Europe and elsewhere. But for right now, the US is just kind of like poking at it in the stress tests and in data collection.

• 22:26Joe Weisenthal?

  By the way, you mentioned that like, one of the binding constraints in the financial system is how much money is just willing to be locked away on a permanent basis. This is really, though, where the role of insurers comes in, because this is money that people put into a pot and they theoretically expect to get all of it back, maybe at some point over the course of a lifetime, etc. But that really is a great source of cash for long-term money. Can you talk a little bit more about like, how big that is?

• 22:53Speaker 05

  Yeah, it's huge and growing. I think you're exactly right. That is sort of a sticky source of funds. And if you hear Apollo talk about their Athene Insurance Unit, it sounds like it's basically unlimited. I mean, they'll say like, our limit of new private credit is finding good things to invest in, not the source of funds. And so we may see a bifurcation across the system of like, do you have an insurer attached to yourself? I mean, this again goes back to sticky funny. Can you get bank leverage? Do you have an insurer attached to yourself? I mean, the other thing about insurance is that it still is a savings vehicle. And so there still is a limit, you know, annuities aren't on demand.

• 23:32Joe Weisenthal?

  But they always, and they try to like, layer and stuff so that it looks more and more like an investment, right? Over time, it looks more and more like a mutual fund or something like that. And so even there. The other question, so we're talking about the distribution of risk across various entities. What about, and I kind of think this might be a core question from an investor perspective, I guess, the distribution of profitability. And when you look at the profits that come out of prime brokerage units and banks, how do those stack up compared to the profits of traditional banking? And is there a risk that making risky loans, setting aside the risk part, is a profitable business? And does that ultimately impair over time how much money what we call banks can make?

• 24:14Tracy Alloway?

  Good question.

• 24:15Speaker 05

  I think not. And it goes back to the limit of funding and private credit. Like, take COVID, for example. In the two weeks after the pandemic really hit in March 2020, banks increased their business loans by 25%, half a trillion dollars, two weeks. They didn't go to market and issue equity. They didn't go find investors. They are able to create deposits at a keystroke. And that's always going to be the advantage of banks. And so, like I said, private credit, we're seeing them sort of get closer and closer to this kink on their funding curve where all of a sudden the long-term wealth lockup sources are scarce. And frankly, we're seeing this a little bit. Fundraising is falling in private credit.

• 24:58Speaker 05

  And we're seeing more institutional investors say like, we're at our alternatives allocation. And now it's all the big push is retail. And again, talk about looking more like a bank. Like, that was one of private credit's original promises to us as well. It's like, oh, this is different. This is just safe, like institutional investors. Now everyone's after the retail money. How can we make a retail vehicle? How can we tap on An ETF from private credit. ETFs.

• 25:22Tracy Alloway?

  They are moving into ETFs, which again is another good example of like putting a liquid wrapper on a bunch of illiquid assets.

• 25:29Speaker 05

  Right. That was the other thing is, oh, private credit doesn't mark to market. Once you have an ETF and we've seen a bunch of banks and non-banks start to build out their secondary trading desks for private credit. I mean, it goes back to what Mark Ron said. Eventually, what's the difference between public and private?

• 25:44Tracy Alloway?

  Just to go back to something you touched on earlier. Do you get the sense that regulatory attitudes towards private credit and banks and the relationship there are starting to change in the sense that, you know, Joe and I have talked a lot about how in the aftermath of the 2008 financial crisis, there were deliberate efforts to shift risk into the shadow banking system. Does it feel like maybe there's some like change in the vibes, the regulatory vibes now?

• 26:15Speaker 05

  Not yet. I think regulators are looking for sure. It's a matter of do they find something? I mean, you talked about this on the episode with Hugh Tracy, how when you ask a private credit investor, you say like, oh, are you guys eating the bank's lunch now? And they sort of wax and wane and they say, well, it's an ecosystem and we're partners. And then they go in the bathroom and scream in the mirror at how embarrassing that is. Like, it goes back to them needing the banks, for one. And two, I think everyone's sort of happy with the status quo. The question is the direction of travel, and that's where the risks are.

• 26:51Joe Weisenthal?

  I'm just really fascinated by this idea of like, the kink in the funding curve for private credit, because I'm trying to reconcile that with this idea that at least from Apollo, via all the money that they have for their Athene insurance vehicle, it sounds like there's still plenty of money and that they don't need to go out to retail, that they don't need to make ETFs, that they just have to find more good deals to employ all of the premiums they're collecting from insurance.

• 27:14Speaker 05

  Yeah, I think, like I said, we may see some kind of bifurcation. I mean, there's a question about how popular annuities remain and if rates go lower and all that stuff. And I don't have a view on that. What we see from other private credit lenders is they're chasing retail money now, because institutional investors are full on private equity, which isn't giving them their money back. You know, they have hedge fund allocations, they have venture capital allocations, and they say, hey, we're full on alternatives now. Insurance is definitely a space where more money can come and more diversification, because it is so sticky in long term. But there's a limit to that, and it may be that two of the partners go to spoils for insurers.

• 27:51Joe Weisenthal?

  Tracy, I don't understand, why doesn't every investing firm have an insurer? I mean, this is like Berkshire Hathaway, right? They just collect all this premiums and they have all this money that they can invest. It seems like such a big advantage to have an insurer. And I know various hedge funds, they have their reinsurance thing, it's kind of similar. Seems like such a huge advantage.

• 28:07Tracy Alloway?

  You should suggest it, Joe.

• 28:09Joe Weisenthal?

  We should have an insurance company.

• 28:10Tracy Alloway?

  A sales pitch, a deck.

• 28:12Joe Weisenthal?

  Like, why would you be an investor without an insurance company? I don't really get it.

• 28:15Tracy Alloway?

  The one thing I was thinking about, though, is just going back to this lack of deals point. It kind of feels like if you can't put your money in good deals, like if you can't get a big enough volume of those deals, then the temptation is presumably to try to eke out more returns from the ones you do get and apply leverage. And that's, again, like where some of the risk could come from. That's not a question, that's just a point. I will continue on.

• 28:42Tracy Alloway?

  One thing I wanted to ask is, you're obviously focused on the financial stability aspect of all of this, but I feel like there's been some macro impact from private credit as well. And if you think about, you know, financial stability is tied very much to fundamental economics. And if the economy is good, then probably you're not going to see a bunch of banks blowing up and that sort of thing. But what are you watching in terms of like, the real world impact of private credit?

• 29:11Speaker 05

  So there's absolutely a risk. It's almost a trope now to say like, this stuff has not seen a downturn, private credit has not seen a downturn. And I don't know what's going to happen to it in a downturn either. So sorry, that's a terrible answer. But there obviously is like, a credit crisis type of risk to this in the same way there is for leveraged lending, which, you know, has held up well in the past. That's maybe, you know, a good analogy. I think part of this, you talk about stability, private credit was really there to offset the banks hung loans problem in 2022. So rates go from zero to five. Banks are sitting on billions of dollars of hung loans, most famously Twitter. And they're in the news, again, talk about the benefits of being private, like, everybody knew Morgan

• 29:54Speaker 05

  Stanley had that Twitter loan, like, so private credit was really there to take a lot of deals. And they did a lot of refinancings in 2023. That problem is sort of worked through on the bank side. And now we're seeing the banks come back and we're seeing private credit do payment in kind modifications, do extend in pretend type things. So the sort of longer part of higher for longer, you know, it's like, it goes back to what I said about interest rate risk becoming credit risk. We're sort of seeing that in private credit. So in that sense, like, it's nice that we have these two side by side systems that can sort of cushion each other. But as we've seen, they're increasingly becoming one.

• 30:31Joe Weisenthal?

  I have one last question. It has nothing to do, actually, with private credit. But I figure you're here, and I think you might have some thoughts on this topic. We did an episode probably about two months or so ago about stable coins. And we saw recently Stripe made a $1.1 billion acquisition of a stablecoin companies. There are some, I think, issues related to financial stability related to stablecoins, because anytime you have an asset or a product that's pegged one to one against the dollar, we all, you know, we can talk about money markets all the time. But I actually have like a separate question than financial stability related to stablecoin. Do you, as a researcher in how the financial system works,

• 31:14Joe Weisenthal?

  take them seriously as something that will be important for payments in the financial system going forward?

• 31:20Speaker 05

  I'm going to hit you with another trope, which is that I think the tech is good. The product is not. I think this is another area where the big banks will win. I mean, it'll be, it'll be a stablecoin technology, but like now, we don't actually experience ACH versus like, you know, Fedwire versus whatever else. It'll be that. It's the right technology, but the ultimate question is payment in what? And you don't want the answer of that question to be USDC. Like you want it to be a deposit that-

• 31:50Joe Weisenthal?

  I mean, I guess my thinking is like, you know, I actually buy kind of the argument from the stablecoin advocates that like it solves a lot of problems with tech interoperability, that it could never, you will never get a sort of blockchain type solution from all the big banks working together because of, you know, lack of trust or whatever else. Like, I buy that, but I guess like, I guess to your point specifically, I don't know how big ultimately that demand will be, especially since as you put it away, for most payments in most of the world, these things are pretty abstracted away. I would say, I don't know, I don't want to like jump to conclusions because I know there are underdeveloped banking systems, but for much of the world, for much of the wealthy world,

• 32:34Joe Weisenthal?

  a lot of these problems are completely seem abstracted away.

• 32:38Speaker 05

  The other challenge is to go find a bunch of safe assets to invest in. You know, if you're replacing trillions of dollars of payments, you have to go find a bunch of safe assets. And that's why we run this through banks because they don't have to find safe assets. They can back deposit mortgages.

• 32:51Joe Weisenthal?

  Stephen Kelly, thank you so much for coming on Avast. That was great. You answered a bunch of questions, I think, that at least in my head had been lingering for a long time.

• 32:58Speaker 05

  Thanks, guys.

• 33:12Joe Weisenthal?

  Steven is so good. He's so clear.

• 33:14Tracy Alloway?

  Yes, he is. It's always good to catch up with him. I mean, I do think like the circular nature of the leverage is obviously a concern. Again, like we're talking about relatively small volumes right now, but it feels like it could become problematic at some point.

• 33:32Joe Weisenthal?

  It's interesting. I kind of forget when I think about 2008 and 2009, how much of those first like tremors, I guess of the crisis were literally, you know, non-banks. And I think, you know, people never talk about those Bear Stearns hedge funds that blew up.

• 33:49Tracy Alloway?

  Yeah, that was the start.

• 33:50Joe Weisenthal?

  But that was like really kind of, I mean, there was the quant quake. What was that? Late 2006? And that was sort of freaked the market out a little bit. But then it was really like those Bear Stearns hedge funds. And then, you know, you mentioned the Citi one. And just this idea that they had these banks, they had these off balance sheet vehicles, probably for many of the reasons that, you know, the same reasons that shadow banks or private credit or multi-strategy hedge funds exist today, less capital intensive vehicles. And then they felt the need to bring them on, maybe for reputational reasons. I think that's like a really interesting history that gets forgotten about.

• 34:23Tracy Alloway?

  No, you're absolutely right. And money market funds as well, when they broke the buck. You know, the other thing I was thinking about was just this idea of, again, liquid wrappers on illiquid assets. And I kind of think like the ultimate expression of shadow banking has to be someone putting an ETF wrapper on like private credit.

• 34:42Joe Weisenthal?

  It's so perfect. They always find a way to do that. They always find a way to like, we're going to get the liquidity premium and then we're going to still give you the liquidity. I think one of the most important points that Steven makes, and I've heard him make it before, is just this idea that like the key scarcity in the financial system is cash that's willing to be locked up, right? Cash that's willing to not be sold in an instant or in a demand deposit. And so there is therefore then this natural constraint on how much, say, a private credit firm could take away. From the banking system because in the end, banks, as we know, as you mentioned, are very levered. How do you recreate that leverage? How do you satisfy the financing

• 35:25Joe Weisenthal?

  demands of the real economy, given this constraint and locked up capital? I think it's just a really important concept to keep in mind.

• 35:32Tracy Alloway?

  Yeah. All right. Well, shall we leave it there?

• 35:35Joe Weisenthal?

  Let's leave it there.

• 35:35Tracy Alloway?

  This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

• 35:41Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at the Stalwart. Follow Stephen Kelly at Stephen Kelly 49. Follow our producers, Carmen Rodriguez at Carmen Armin, Dashal Bennett at Dashbot, and Kel Brooks at Kel Brooks. Thank you to our producer, Moses Andam. For more Odd Lots content, go to Bloomberg.com/oddlots, where we have transcripts, a blog, and a new daily newsletter. And you can chat about all of these topics 24/7 in our Discord, discord.gg/oddlots.

• 36:09Tracy Alloway?

  And if you enjoy Odd Lots, if you like it when we ask questions about private credit, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. You'll also get access to our new daily newsletter. All you need to do is go to Apple Podcasts and find the Bloomberg channel there and follow the instructions. Thanks for listening.

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