Why the Banking Industry Is Investing in Private Credit

The Magic Castle, a private club located in Hollywood, California, has been the home of the Academy of Magical Arts since 1936. A unique place where working magicians perform for small intimate audiences and share their craft with one another, membership is limited to individuals actively practicing magic who must audition to be admitted, as well as honorary and VIP members who have somehow advanced the art of magic. The club’s exclusivity makes it a huge draw for California tourists, yet the only people who can attend shows there are members or individuals given guest cards by members.Much like the appeal of private clubs to individuals, private credit is proving to be a lucrative investment for financial institutions. The Rapid Growth of Private CreditFollowing the 2023 bank failures, the banking industry has largely scaled back its lending activity to small- and mid-sized businesses. As a result, this demographic has gravitated to private credit lenders where they are able to secure the financing they need — a shift that has further boosted an already burgeoning private credit market. The value of the private credit market is soaring, with the global total of committed capital and assets exceeding $2.1T in 2023, roughly 75% of which is in the US. Private credit in the US has grown so quickly that its market share is close to the size of high-yield bonds and syndicated loans, a fact that has not been missed by the banking industry.Several major financial institutions including Citigroup, Goldman Sachs, and Wells Fargo are gearing up to invest more than $50B into private credit. Citigroup recently partnered with LuminArx Capital, an alternative investment manager, to provide private credit investing opportunities to its customers. The move follows in the footsteps of Wells Fargo, which made a similar move last year by joining forces with private equity firm Centerbridge Partners to create a private credit fund of its own. Meanwhile, JPMorgan Chase is soliciting investments from clients as part of an effort to acquire a private credit firm. In fact, JPMorgan Chase’s president recently said the firm realizes it cannot afford to ignore private credit and is acting based on that realization. Factors Driving Investment in Private CreditWhile investing in private credit may seem counterintuitive for a traditional financial institution, there are several perks driving the trend:

The Downside However, there is a downside to private credit that financial institutions need to be aware of. While there is major demand for lending among small- and mid-sized businesses, weaker lending standards within the private credit market heightens the risks associated with these loans. Many of the businesses drawn to private credit already have large amounts of debt and, according to the International Monetary Fund, more than one-third of these borrowers currently shoulder interest costs that are higher than their earnings. As such, the leaders of several major banks have become vocal about the risks associated with such lending. Jane Fraser, Citigroup’s CEO, and Bill Winters, Standard Chartered’s CEO, both recently noted the importance of financial institutions remaining acutely aware of the risks of so many people piling into such lending activities, a sentiment echoed by JPMorgan’s CEO Jamie Dimon, who warned of the risks of retail investors too actively investing in the sector. The expanding private credit market presents financial institutions with both opportunities and challenges. While investing in private credit allows traditional financial institutions to diversify income and retain customers by offering alternative lending solutions, the associated risks from weaker lending standards and less creditworthy borrowers are still of concern. Financial institutions looking to venture into this space must strike a balance between seizing new opportunities and safeguarding their financial stability.