Bank Capital and the Growth of Private Credit

We show that business development companies (BDCs)—closed-end funds that provide a significant share of nonbank loans to middle market firms—are very well capitalized according to bank capital frameworks. They have median risk-based capital ratios of about 36% and, under the Federal Reserve's stress testing framework, median excess capital in the severely adverse scenario of about 26%. Our evidence thus cuts against the view that private credit has grown because nonbank financial intermediaries have to hold less capital than banks. Instead, we argue that, for plausible parameters, banks find lending to middle-market lenders such as BDCs and private credit funds more attractive than middle-market lending itself. This is, in part, because over-collateralized loans to BDCs and other nonbank financial intermediaries get relatively favorable capital treatment, enabling banks to exploit their low-cost funding. We also present a model to explain banks' observed preference for making middle-market sponsored loans via affiliated BDCs or private credit funds rather on balance sheet. For plausible parameters, banks would be willing to forgo less expensive balance sheet funding to avoid the extra regulatory and supervisory costs of managing a risky loan portfolio on the bank's balance sheet. Finally, we examine the financial stability risks of private credit. While there is little risk to the solvency of BDCs, they may deleverage during periods of stress to remain in compliance with the SEC regulatory leverage limits and bank loan covenants. Our baseline estimates suggest that over eight quarters the medianx BDC would reduce outstanding loan balances by 9.5%, about half by using free cash flows to pay down debt rather than reinvest in new loans and half by selling assets.