Non-bank forms of finance have grown rapidly since the banking system collapsed in the 2008-2010 financial crisis and now account for around half of financial sector assets in the UK and globally.
Finance, somehow, always finds a way. When banks stopped lending, private credit filled the gap, partially compensating for the contraction of traditional forms of credit and the mounting restrictive regulations that followed.
This is called the “waterbed” principle of finance: pushing down in one area will simply cause it to rise somewhere else. Regulators are always one step behind; while they're busy strengthening the system from the last crash, the markets are inevitably sowing the seeds of the next one in new, less transparent and less monitored areas.
In a recent speech, Lee Foulger, the Bank of England's director for financial stability, strategy and risk, estimated that these forms of non-bank lending account for almost all of the £425 billion net increase in lending to UK businesses since the financial crisis.
Of course, this may be seen as a good thing in that private creditors are at least expanding credit. On the whole, mainstream banks have welcomed the competition, keeping many struggling companies afloat and protecting them from further costly impairments.
Private lending also offers an alternative source of capital for today's tech startups, most of which survive on whim and prayer for only a few years at best, making banks reluctant to lend to them.
Prudential regulators have been similarly ambivalent, well aware of the risks but reluctant to crack down on banks that are key drivers of growth and an easy source of capital for companies that might otherwise struggle to raise funds.
Thus, private credit came to be seen quite widely as a useful shock absorber and, in an era of stifling banking regulation, as an important alternative to banks as a catalyst for economic growth.
But the danger is all too clear: What really drove the growth of private credit was another enduring feature of finance: the search for yield.
Ultra-low interest rates are driving investors to seek higher rates of return and are increasingly forgiving of risk.
If it sounds too good to be true, it usually isn't, and that's certainly the case with private credit yields that can reach the mid-teens.
With the banking sector once again on the mend, most creditworthy companies can now borrow all the money they need at much lower interest rates, so one must ask: what kind of companies would be so desperate as to agree to such dizzying debt-servicing costs?
Arrangement fees also tend to be quite high, providing a further incentive for lenders to promote this form of lending.
Providers claim that the higher cost of credit reflects increased risk, but it still seems like a form of fraud.
One practice that is becoming increasingly common is “amendment and extension” (A&E), where a lender agrees to postpone a loan's maturity in exchange for a higher-than-normal yield. Also gaining popularity is the “payment in kind” (Piks) practice, where cash-flow-poor borrowers issue new debt to cover interest payments on old debt.
This is Ponzi lending, and our old friends the credit rating agencies, the architects of the deterioration of risk assessment standards that led to the financial crisis, are once again frequent accomplices by granting investment grade ratings.
As one veteran credit analyst told me, “You can write whatever you want about private credit, but I strongly recommend not investing in it.”