Unconventional wisdom: A modern day bank run
Is the economy and investor portfolios at risk from a potential ‘bank run’ in private credit?
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: A modern day bank run
“A bank run never involves just one bank, however large. ... Bank runs are not about capital ratios and liquidity. They’re about confidence and psychology.”
- James Rickards
There were positive economic signs in late 1930 in the United States. The share market crash of 1929 led to a recession, but many believed it was nearing an end. But an event far from Wall Street dashed hopes of an economic recovery.
A severe drought in Tennessee led to a poor harvest and rumours spread that farmers were struggling to pay back their loans. Nervous depositors showed up at the Bank of Tennessee in Nashville to get their money back.
When the bank ran out of money and failed a banking panic spread throughout the state. Soon the crisis went national and 5.6% of all banks in the US folded in November and December 1930.
A bank run is a psychological phenomenon just as much as a financial one. Once confidence drops nervous depositors can cause even the healthiest bank to go under.
Confidence is dropping in private credit in the US. Is this unregulated portion of the credit market at risk of going down the same path?
What is happening in US private credit markets?
Investors have been pulling cash out of US private credit funds. Depending upon the size of the withdrawals this can create issues based on the same liquidity mismatch faced by banks in 1930. Investors want their cash back now but the loans that make up the portfolios of private credit are longer term.
Private credit funds are taking different approaches to deal with this liquidity mismatch.
BlackRock capped withdrawals from one of its flagship credit funds at 5% after being hit with requests amounting to over 9% of its value. It was the first time requests topped the 5% level since the fund went on the market four years ago.
The Blue Owl Capital Corporation II (OBDC II) fund also halted redemptions. The fund was changed into a drawdown fund and investors will eventually get their funds back but it could take years. By switching to a drawdown fund, cash will be returned to ivnestors whether they want it or not and at a time of the fund’s choosing.
Blackstone Private Credit, the business-development company known as BCRED, faced $1.7 billion of net withdrawals last quarter. This is the largest set of withdrawals since its early 2021 inception and gross withdrawals exceeded the 7% quarterly maximum it is required to meet.
Blackstone came up with a novel solution. Rather than prorating redemptions and returning less money to investors than they requested, Blackstone found a novel way to fund withdrawals.
Blackstone employees and the firm injected $400 million into a BCRED feeder fund for non-US investors that funnels their investments to the BDC itself. Blackstone sized that infusion to match this vehicle’s outflows so BDC’s net redemption requests were equal to te 7% quarterly minimum.
Bank runs and systemic risk: The global financial crisis
Regulators were desperate to stop the potential of a bank run during the global financial crisis (“GFC”). The regulatory environment was significantly different than the great depression. There was no deposit insurance during the great depression and going into the GFC, bank deposits in the US were insured up to $100,000 per bank, per depositor.
Regulators feared this wasn’t enough. In 2008 the limit was increased to $250,000 and the banks were bailed out by the US Federal Government. The problems in the banking system in Australia weren’t as bad as the US but guarantees were increased to $1 million in 2008 before dropping to $250,000 in 2012.
“To big to fail” entered the lexicon and it was assumed – not unjustifiably – that governments would bail out banks if needed. Bailing out well-heeled bankers didn’t sit well with the public and regulators clamped down on what banks could do. If the public was on the hook for banking problems the regulators were determined to reduce risk.
Banks could lend less money under the new regulations and private credit stepped in to fill the void. Private credit raised money from investors and lent it out to former bank customers.
Risk was transferred from taxpayers to investors in private credit. Reckless lending would result in investor losses rather than taxpayers footing the bill. This seemed like a win-win.
Private credit fills the void
Initially private credit raised funds from sophisticated institutional investors. The institutional investors understood the game they were playing. They knew they couldn’t get their money back whenever they wanted but accepted the trade-off for higher potential returns.
When private credit started courting individual investors the same liquidity mismatch and restrictions on withdrawals were largely in place – whether the individual investors understood it or not. The potential returns were much higher but there was a risk that funds could limit or halt redemptions.
Like any debt investment returns in private credit come from the interest rate on the loans. Loses would occur if the loans were not paid back and if the private credit provider couldn’t sell the collateral put up by the borrower for the equivalent of the loan amount.
In the US many of the loans are to software companies and investors were spooked at the prospect of losses from AI disruption.
This is similar to what happened in Nashville in 1930. Depositors were worried about the loans to farmers so they tried to pull their money out. Whether this fear was unfounded or rational didn’t matter. The result was the same.
Is banking an inherently unstable model?
Two economists developed the Diamond-Dybvig Model to show the inherent vulnerability of banks. Banks make money by transforming liquid liabilities in the form of deposits into illiquid assets in the form of loans.
This creates an inherently unstable equilibrium that is prone to real or perceived fears that those liabilities will not be honoured. The solution is deposit insurance.
Private credit is different. There are no legal liabilities as investors are risking their investment for a return and do not have a right to get it back. Yet that doesn’t stop investors from trying to get their money back when they anticipate future losses.
This puts the private credit providers in a difficult situation. Exercising their legal rights to limit withdrawals erodes the confidence of the current and future investors they need to run their business.
There isn’t a simple playbook to handle this situation, which is why different private credit funds have taken different approaches. The response will likely continue to evolve if first quarter withdrawal requests continue at the same volume.
Final thoughts
Adding private credit and other private investments to your portfolio requires a mindset shift. The ability to convert an investment into cash whenever you want isn’t possible. This isn’t your average fund, ETF or share investment.
There is nothing inherently wrong with the lack of liquidity if the trade-off for higher returns fits your investment goals. In evaluating any private investment understand the policies on withdrawals and consider the impact on your life if there is a delay in converting the investment into cash.
The rise of private credit also raises questions for regulators. One reason individual investors are drawn to private credit is because bank issued hybrids are being phased out. Hybrids offered compelling levels of income for yield hungry investors. Private credit does the same thing.
The de facto replacement of hybrids by private credit shows regulatory hypocrisy when it comes to systemic risk.
APRA is phasing out bank issued hybrids because of a fear that retail investors will panic if they question the health of the banking sector. APRA imagines a situation where panic drys up a key source of bank funding which leads to more instability in the banking system.
There is a reason that regulators are so wary of banking issues. It was the run on the banks and the evaporation of credit in 1930 that turned a recession into the great depression.
As private credit continues to grow as a source of funding in the economy it becomes more systemically important. Trying to protect taxpayers from bailing out regulated banks might have inadvertently increased systemic risk as unregulated funds are now a key source of credit in the economy.
Swapping hybrids for private credit also changes the risk profile of investor portfolios. As always, the key to success is understanding what is in your portfolio. Now might be a time to revisit the risk / reward trade-offs you are making.
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What I’ve been eating
We’ve been asked to incorporate AI into our day-to-day tasks. Ever obedient, I tried to settle a debate by asking AI who was smarter - pigs or goats? Copilot told me pigs are smarter because they can solve puzzles and use joysticks. Gemini told me they were both smart in different ways with pigs having superior cognitive abilities and goats better at problem solving and spatial awareness. The intelligence hierarchy of the barnyard remains inconclusive. But there is no debate that both pigs and goats taste good in ragu.
At 3:45pm the line was already forming outside Sonny’s in Hobart. Sonny’s opens at 4pm but seats are hard to get at the tiny walk-in only wine bar. I was pleased to make it in the first wave so I could get the pictured goat ragu as soon as possible. it was worth the effort.
