Private debt ‘helps smooth out credit cycles’

Private debt could help to stabilise markets in times of financial stress and smooth out the extremes of the credit cycle, according to research.

An academic paper, titled Nonbank Credit, suggests that rather than increasing systemic risk, alternative lenders may be acting in a countercyclical way that provides defence against market extremes.

In her draft paper, Christina Parajon Skinner, assistant professor of legal studies and business ethics at the Wharton School at the University of Pennsylvania, said: “Private nonbank credit can promote economic resilience — by smoothing the credit cycle with a steady supply of countercyclical capital.”

Private debt funds are structured and incentivised to provide the economy with a countercyclical source of credit, according to Skinner, and turn on credit at a time when banks are pulling back, which helps to smooth the credit cycle and make economic downturns both less prolonged and less severe.

She argued that banks are prone to being procylical and said: “Procyclical lending appears to be an unavoidable consequence of a big bank’s balance sheet and its regulatory constraints. When banks’ existing credit assets (such as loans) suffer losses, their balance sheets become impaired and equity liabilities must be written down. At such point, lending becomes difficult, given that prudential regulation requires banks to sustain a certain level of equity capital against the sum of their risk-weighted assets.”

Banks also suffer from their main funding source, consumer deposits, also becoming more likely to decline during an economic recession, according to the paper.

Private debt investors adopt a different approach to risk and tend to me more aggressive, she adds, saying: “The private fund’s strategy will be opportunistic— meaning that it is contrarian in many cases, buying debt in directions that are opposite the market’s momentum — that is, in countercyclical directions. In a similar vein, where the strategy is long-term in nature, the fund will tend to invest in assets that are distressed but quite likely have fundamental value to recover.”

The paper argues that regulators should consider the countercyclical effects of alternative credit when considering how to regulate the industry in the future and ensure it does not stifle the ability of funds to lend across the credit cycle. Skinner also argued the Securities and Exchange Commission should consider revising its definition of accredited investor to enable retail investors to participate in private debt funds and expand the pool of capital available to the economy.