Speaker 1: Bloomberg Audio Studios, Podcasts, radio News. Hello and welcome to
Speaker 1: another episode of the All Thoughts Podcast.
Speaker 2: I'm Tracy Alloway and I'm Joe Wisenthal.
Speaker 1: Joe, I feel like I start every private credit episode
Speaker 1: with the same point, but I mean, private credit it's
Speaker 1: everywhere right now. I think I counted like dozens and
Speaker 1: dozens of stories on private credit that came out just
Speaker 1: on the Bloomberg in the past week.
Speaker 3: There's two funny things that are going on. Which is
Speaker 3: one private credit. So these non bank entities providing loans,
Speaker 3: et cetera wanting to get into credit, and there's more
Speaker 3: and more about that every day. And then there's banks
Speaker 3: wanting to get more and more into private credit, which
Speaker 3: is his own thing of Okay, you're still at the bank,
Speaker 3: but you're doing it in some sort of bald and
Speaker 3: she'd structure that resembles private credit, and what's up with that?
Speaker 1: What's up with that? Indeed, this is the what's up
Speaker 1: with that? Episode? I'm so glad you asked that question.
Speaker 1: But we're going to be talking about the relationship between
Speaker 1: banks and private credit because the other thing that's been
Speaker 1: happening is every time we talk to a bank or
Speaker 1: a private credit entity on this show and we ask
Speaker 1: about the relationship between regulated banks and non banks, you
Speaker 1: get this really diplomatic, kind of awkward answer, like while
Speaker 1: we view our bank partners as opportunities and no one
Speaker 1: will really explain how they actually feel about each other totally.
Speaker 2: You know.
Speaker 3: The one other thing before we get into it that
Speaker 3: I think about it a lot is I look at
Speaker 3: the rise of private credit and there is a big
Speaker 3: part of me that says, this is what regulatory success
Speaker 3: looks like. This is what post DoD Frank's success looks like.
Speaker 3: That there is more of this risk taking, right, this
Speaker 3: was the intent, Yeah, happening outside of the deposit taking
Speaker 3: banking institution. On the other hand, if a lot of
Speaker 3: the leverage for private credit and a lot of these
Speaker 3: relationships is being plied by banks and so forth, then
Speaker 3: it makes me wonder, did we actually extricate the risk.
Speaker 1: Or in the air we just put a wrapper on it, we.
Speaker 3: Put a rapper on it. In the end, does all
Speaker 3: financial risk readown back to the banking system?
Speaker 1: That's exactly it. And I got to say, you know,
Speaker 1: there is a lot of discourse from which we can
Speaker 1: pull from a lot of historical analogies, because of course,
Speaker 1: bank disintermediation is not a new thing. It's basically been
Speaker 1: happening for as long as we've had banks. And if
Speaker 1: I think back to like two big moments in the
Speaker 1: process of bank disintermediation, it has to be the invention
Speaker 1: of the junk bond market in the nineteen eighties, securitization.
Speaker 1: Also in the nineteen eighties and nineteen nineties, peer to
Speaker 1: peer lending. That was a fun one, remember that.
Speaker 3: Well the other thing too, you know, it just occurred
Speaker 3: to me. And bear Stearns was not a retail deposit
Speaker 3: taking institution. But part of why they blew up is
Speaker 3: like they had these in house hedge funds, right, and
Speaker 3: so even this idea of hedge funds and non bank
Speaker 3: entities sort of existing within more larger, traditional regulated financial
Speaker 3: institutions is not that new. That was a story of
Speaker 3: the Great Financial Crisis.
Speaker 1: That's exactly right. So I'm very happy to say this
Speaker 1: is our banks and private credit basically Frenemies episode. We're
Speaker 1: going to be speaking with really the perfect guest. It's
Speaker 1: someone that I've known for a long time and we've
Speaker 1: actually had him on the podcast before. But I don't
Speaker 1: think you were there. I promise you are really going
Speaker 1: to love this. We're going to be speaking with Hugh
Speaker 1: van Steinis. He is the vice chair at Oliver Wyman
Speaker 1: and also the former global head of Banking Research over
Speaker 1: at Morgan Stantley. That's where I got to know his
Speaker 1: during the depths of the euro Zone financial crisis when
Speaker 1: I was on FT Alpha bel He's also formerly an
Speaker 1: advisor to Mark Karney at the BOE. I think he
Speaker 1: won like a series of research awards at various points
Speaker 1: in his career, but really one of the smartest guys
Speaker 1: I know when it comes to banks and financial So, Hugh,
Speaker 1: thank you so much for coming on.
Speaker 2: All thoughts. Tracy, thanks so much for having me on.
Speaker 1: We are very excited. First of all, maybe let's just
Speaker 1: start with the basic question, because everyone seems to have
Speaker 1: different opinions, different numbers around this, But how big is
Speaker 1: private credit at the moment compared to the traditional banking system.
Speaker 4: Oh, I mean, honestly, it's pretty tiny. So the official
Speaker 4: stats are about one point seven trillion, and that's by Prequeen,
Speaker 4: the company that Black Croc bought recently. That number, though
Speaker 4: doesn't include insurers giving direct mandates to the private credit firms.
Speaker 4: So I think it's probably closer to two and a
Speaker 4: half to three trillion, which is a drop in the
Speaker 4: ocean to what investment grade bond markets nine trillion banking
Speaker 4: assets in Europe at thirty two trillion. These are really
Speaker 4: relatively small numbers, and so I think that's why many
Speaker 4: of these firms think they've got a long run way
Speaker 4: still to grow.
Speaker 3: So why do we care. If not because they're so big,
Speaker 3: it's just because it's growing.
Speaker 4: Fairst Well, it's also because they're eating away at bank earnings,
Speaker 4: and I think that's where, you know, if I think
Speaker 4: about our conversations with bank CEOs and CFOs, and I
Speaker 4: literally just had one before coming on your show, they're
Speaker 4: worried about how much of their juice is being gobbled up.
Speaker 4: And I think that that's you know, that's why in way,
Speaker 4: Tracy's Right has gone from sort of counterparts to frenemies.
Speaker 4: And one way to think about it is that we
Speaker 4: had a very unusual macro period. As you've spoken about
Speaker 4: many times, during twenty twenty three, private credit players wrote
Speaker 4: about ninety percent of all leverage loans, and they're also
Speaker 4: doing really well in direct lending. And so they're looking
Speaker 4: for the next avenue of growth. And one theme that
Speaker 4: we come up across a lot is about asset back lending,
Speaker 4: so in other words, financing i'd know, aviation, or auto
Speaker 4: loans or even royalties. That's a five and a half
Speaker 4: trillion dollar market in the States. Private credit probably has
Speaker 4: less than five percent share, and they're really looking to
Speaker 4: mine this seam. And so if you're a banker, thinking,
Speaker 4: these guys are now after durre investment grade assets, not
Speaker 4: just are the high old assets.
Speaker 1: So talk to us about how we got to this
Speaker 1: point because Joe correctly, I think, attributed this to a
Speaker 1: lot of the post two thousand and eight redesign of
Speaker 1: the financial system regulation. And I mean, this is what
Speaker 1: we wanted, right, We wanted the riskiest stuff, the riskiest
Speaker 1: activity to be pushed away from regulated banks and into
Speaker 1: I know they have the nefarious name of shadow banks,
Speaker 1: but you know, mostly we're talking about like a business
Speaker 1: development company or a direct lender or someone like that.
Speaker 4: No, look, I think that's right. So looks if you
Speaker 4: take it since the financial crisis, where we changed the
Speaker 4: rigs for the banking system, a lot more capital, a
Speaker 4: lot less shortened the asset liability duration, a mismatch that
Speaker 4: went beyond an elastic limit into the financial crisis. So
Speaker 4: these private credit firms have created just over a trillion
Speaker 4: dollar parallel system to lend to corporate America and parts
Speaker 4: of corporate Europe. And it's around leverage lending its areas
Speaker 4: which were either too risky or in some cases where
Speaker 4: the FED put in limits on how many leverage loans
Speaker 4: or what was the maximum you know, multiple of level
Speaker 4: that a bank loan could take on. And so these
Speaker 4: loans are being pushed outside of the banks. The other area, though,
Speaker 4: where private credit has been very active to is mid market.
Speaker 4: So let's say a loan between let's say thirty million
Speaker 4: dollars to seventy five million dollars. That's a narrow where
Speaker 4: for the top six banks, this is just too small
Speaker 4: fry for them to get excited. And therefore so there
Speaker 4: was us kind of a missing piece, which you know,
Speaker 4: the private credit firms picked up the crumbs which are
Speaker 4: left on the table by the bank. So you're right,
Speaker 4: I think the regulators push this. I think where we're
Speaker 4: going now is probably to the next level. And so
Speaker 4: what I the way I think about it is that
Speaker 4: we are now retranching the banking system where the banks
Speaker 4: are laying off the junior risk to private credit, and
Speaker 4: that's allowing them to optimize their capital, but quite frankly
Speaker 4: also lend more. And so what's really interesting for me
Speaker 4: is there's, like everything in life, people see things as
Speaker 4: an opportunity or a threat. The top banks and CEOs
Speaker 4: that I talk to are now saying, actually, private credit
Speaker 4: allows me to recycle risk more quickly, I can lend more.
Speaker 4: And then there's a whole bunch of banks who are
Speaker 4: just sitting licking their wounds, going I'm not sure how
Speaker 4: I can do this. So I think there is a
Speaker 4: little bit symbiosis now between the banks and private credit.
Speaker 3: SORR explain that a little bit further, at least on
Speaker 3: the opportunity side, when they can recycle their capital first,
Speaker 3: just sort of walk us through.
Speaker 4: The Yeah, so Joe, let's take one of the top
Speaker 4: top us banks or your banks. So there are three
Speaker 4: ways they can lay off risk. The first would be
Speaker 4: to say I will seed the loans that I don't
Speaker 4: really want to write to give to a third party.
Speaker 4: So in a way, what you've seen with Apollo and
Speaker 4: City Group is the is the leverage lending or Brookfield
Speaker 4: with Lloyd's in Europe. Again, it was around leverage lending.
Speaker 4: So it's stuff that they didn't really want to do,
Speaker 4: but they can arrange. They can get all sorts of
Speaker 4: origination fees, and then they can also keep the relationship.
Speaker 4: The second is if they let's say, originate a loan,
Speaker 4: they then pass that up, maybe get one hundred loans
Speaker 4: on hundred twenty loans, and then do a synthetic risk
Speaker 4: transfer around this, in other words, start to basically which
Speaker 4: I think you talked about two months ago on your show.
Speaker 4: So in that case, think about a bell curve, you're
Speaker 4: going to ensure the bottom ten percent, you're going to
Speaker 4: take off the tail, and from a bank capital point
Speaker 4: of view, that dramatically optimizes your capital at risk. So
Speaker 4: the FED only permission this is about nine months ago.
Speaker 4: You've already seen Morman, Sandy, Golden Sacks a number of
Speaker 4: firms start to do these synthetic risk transfers. That space,
Speaker 4: I think is going to grow really strongly because for
Speaker 4: the largest firms it allows them to lend and then
Speaker 4: do them. And then the third is then the more
Speaker 4: you know, there's some more complexities as well around you know,
Speaker 4: how else you can sort of lay off the risk.
Speaker 1: So one thing I'm always asking on the show is
Speaker 1: how these conversations begin, because you know, I honestly have
Speaker 1: no idea. Like, clearly there's a lot of partnering that's
Speaker 1: happening between banks and private credit at the moment, but
Speaker 1: when did that start? In your mind, what was the
Speaker 1: first kind of big, notable instance of a bank teaming
Speaker 1: up with some sort of private credit entity.
Speaker 2: Oh, that's a good question.
Speaker 4: So, as you were sort of hinted earlier on Tracy,
Speaker 4: often in life a history of these things is far
Speaker 4: longer than we like to believe. So just like actually
Speaker 4: nineteen seventy three was the peak of bank lending as
Speaker 4: a percentage of lending to corporates. I mean, it's what,
Speaker 4: it's fifty years since that peak. So you're right, some
Speaker 4: of these partnerships are actually about fifteen years old. One
Speaker 4: or two of them predate the financial crisis. But if
Speaker 4: you think about today, in the twelve months to September fourteen,
Speaker 4: banks tied up deals with private credit, and in the
Speaker 4: twelve months prior it was only two So it's basically
Speaker 4: about a year ago. Suddenly it snapped. Now why is that.
Speaker 4: I think it's because the private credit firms, particularly the
Speaker 4: top ten, felt that started to max out of you know,
Speaker 4: leverage lending or direct lending. But I think the subplot
Speaker 4: is much more Shakespeare. I think there's a really interesting subplot,
Speaker 4: which which is more of the top ten private credit
Speaker 4: firms and now getting the assets from insurers. So take
Speaker 4: yesterday we had the Blackstone results. Half their assets now
Speaker 4: now come from insurance companies. Insurers can only invest investment grade.
Speaker 4: So if you think about it from the point of
Speaker 4: view the private credit player, they are structurally lowering their
Speaker 4: cost of capital, which means that they can then go
Speaker 4: after investment grade assets on the bank's balance sheets.
Speaker 2: And so that's subplot.
Speaker 4: I mean, I think now of the top ten firms
Speaker 4: on my numbers, about forty percent of the assets come
Speaker 4: from insurers. They become much more relevant to compete for
Speaker 4: the investment grade pieces on the banks. And I think
Speaker 4: that's what you know, whether it's the Barclays deal with Blackstone,
Speaker 4: whether it's oak Tree with the SoC Gen, whether it's
Speaker 4: City with Apollo. In a way, the private credit is
Speaker 4: able to nibble away at more assets than they could
Speaker 4: in the past.
Speaker 3: I'm going to back up and ask the dumb question.
Speaker 3: I'm like, oh, I think maybe listeners are a lot
Speaker 3: of clarification, but it's actually just me. What's the difference
Speaker 3: between leverage lending and direct lending?
Speaker 1: Again?
Speaker 4: Oh, look, the this is one of these where the
Speaker 4: MAENDC clature is pretty poor. Okay, I mean it's really poor,
Speaker 4: and it's pretty blurry. I think the way they think
Speaker 4: most of them would think about its direct lending is
Speaker 4: I'm lending to a mid market company, you know, thirty
Speaker 4: million dollars to one hundred million dollars, the kind of
Speaker 4: a mid market finance, whereas lever lending is going to
Speaker 4: be acquisition related finance.
Speaker 2: But okay, got it? Yeah, yeah, Joe, it's a it's
Speaker 2: a it's a blurry fandomic.
Speaker 3: No, the acquisition related finance. That makes a lot of
Speaker 3: sense to me.
Speaker 1: So I'm going to go back to that conversation point
Speaker 1: and ask, Okay, so you know, a bank approaches a
Speaker 1: private credit lender, or a private credit lender approaches a
Speaker 1: bank and says, hey, we need to do something in
Speaker 1: this environment. You know, there's a lot of demand. I've
Speaker 1: got a bunch of insurance companies that are interested whatever,
Speaker 1: how do they go about identifying what exactly they're going
Speaker 1: to do and which particular assets are loans might be
Speaker 1: realistic for this kind of partnership.
Speaker 4: Oh, it's a that's a great question, Tracy. So and
Speaker 4: it cuts look some of these relations These firms are
Speaker 4: being counterparts of the banks for many years, so there's
Speaker 4: a degree of relationship, even if maybe historically being a
Speaker 4: little bit antagonistic, and certainly one of the leaving product
Speaker 4: credit firms you know, has a swear box for every
Speaker 4: time they talk about a counterpart rather than a partner
Speaker 4: these days, how.
Speaker 1: Much do you have to put in? Is it like
Speaker 1: five thousand bucks or five dollars?
Speaker 4: Well, it probably should be five thousand, but I think
Speaker 4: it's actually got it's the charity. It's a charity pot.
Speaker 4: And so if we think about those deals, half have
Speaker 4: been around asset back lending and half around the you know,
Speaker 4: the overflow, the leverage finance or the more levered stuff.
Speaker 4: So I think that what the private credit companies are
Speaker 4: doing is very shrewdly going through that. They're almost doing
Speaker 4: like my old job being a banks on list. They're
Speaker 4: looking at a bank and saying where is capital constrained
Speaker 4: at the end of the day, particularly in Europe, but
Speaker 4: even in the state and even particularly think about US
Speaker 4: regional banks or some of the European banks. They've become optimizers.
Speaker 4: They're optimizing for a cost efficiency, capital efficiency and revenues.
Speaker 4: And in that mindset of optimization, they're always looking to
Speaker 4: try and lay off risk. And so the private credit
Speaker 4: company often says, well, look, I see your capital constrained.
Speaker 2: You need to grow.
Speaker 4: An example would be let's say Blackstone with Barclays, they
Speaker 4: want to grow their credit card business, but you know,
Speaker 4: but equally want to keep lots of money in there
Speaker 4: in their vestment bank. By partnering up, they can now
Speaker 4: fuel the growth of the credit card business in a
Speaker 4: way they couldn't do before, or did at least didn't
Speaker 4: believe they could before. So I think this is, you know,
Speaker 4: in a very constrained world. In fact, I was an
Speaker 4: event last week with a bunch of investors and private
Speaker 4: credit firms, and one of the investors said, well, look,
Speaker 4: there is not enough capital for any bank to put
Speaker 4: capital behind an acronym. You know that that's just space
Speaker 4: is gone. You need to find partners and so I
Speaker 4: think they're forensic. They're hiring people to do bank's analysts
Speaker 4: for them, and then I look in to try and
Speaker 4: create a solution because I said, the top ten firms
Speaker 4: feel their origination constraint and so they need the access
Speaker 4: to more assets.
Speaker 3: So in a situation like a credit card deal, what
Speaker 3: the bank wants and the bank still has, and the
Speaker 3: bank will probably still have, is that brand, that relationship,
Speaker 3: that retail distribution network and so forth, and then the
Speaker 3: private credit entity just allows them to keep growing these
Speaker 3: lines and that they're presumably other lines without impairing their
Speaker 3: balance sheet.
Speaker 2: Exactly.
Speaker 4: It's about optimizing the castle as well, because you know
Speaker 4: it's at the end of the day, if you take
Speaker 4: off the riskiest piece, will take off the entire slice.
Speaker 4: Then you can just grow much faster.
Speaker 3: That's very helpful. Can you go further in talking about
Speaker 3: the role of insurance and all this, because one of
Speaker 3: the things that I still find actually completely strange is
Speaker 3: that we have these gigantic financial entities called insurance companies
Speaker 3: their bad meth and they're important all kinds of areas,
Speaker 3: and no one ever talks about insurance companies Either's like
Speaker 3: that you don't really see them in the media the
Speaker 3: same way you see banks.
Speaker 1: It's very stress that and accounting. Yea, like the two
Speaker 1: missing like major ingredients of financial.
Speaker 3: Financial of the financial ecosystem that seemed to like punch
Speaker 3: and maybe they like it and punch it like you know,
Speaker 3: ten percent of their weight in terms of our understanding
Speaker 3: of their role. But talk a little bit more about
Speaker 3: their role of insurance capital on a.
Speaker 4: This Oh, this is a great plot. And actually it's
Speaker 4: very different in Europe versus the US. But let's say,
Speaker 4: if you go back to Tracy point, the railways were
Speaker 4: funded mostly by insurance companies. I mean large, large capital
Speaker 4: projects were mostly funded by the insurers. So because they
Speaker 4: had long dated funding and you still had wildcat you
Speaker 4: know runs in the States as you as you may
Speaker 4: not remember, but I was there. So so thet you know,
Speaker 4: everyone's looked at Apollo and their arrangement with a theme
Speaker 4: and seeing that they've created a very they've got a
Speaker 4: very stable source of funding through their annuity business, much
Speaker 4: like you know you might have seen through the last
Speaker 4: actually before even before the financial crisis, hedge funds wanted
Speaker 4: permanent capital vehicles, right, everyone wants ee wants to be
Speaker 4: aligned to long data capital, and so I think, you know,
Speaker 4: most of the top ten now have an insurance business.
Speaker 4: So I mean I was just you know, I listened
Speaker 4: to the Blackstone call yesterday, two one hundred and twenty
Speaker 4: one billion other assets and now from insurers out of
Speaker 4: four hundred and thirty two, so over half of their
Speaker 4: credit assets come from insurers. Now, obviously that's great because
Speaker 4: these are investors with long duration liabilities who need long
Speaker 4: dated assets. So they're the right kind of people to
Speaker 4: fund data centers, infrastructure assets, you know, the long dated
Speaker 4: and stuff we need to fund our growth. But the
Speaker 4: interesting thing for private credit is, rather than having to
Speaker 4: go for i know, ten to thirteen percent return, if
Speaker 4: they can just simply get one hundred to two hundred
Speaker 4: basis points more than the insurer could have got through
Speaker 4: the public markets, there actually quits in. And so certainly
Speaker 4: the expectation for the CIOs of insurers I speak to
Speaker 4: is if they can get one hundred and fifty one
Speaker 4: hundred and seventy five basis points pick up on a
Speaker 4: single a bond by buying a private bond rather the
Speaker 4: public bond, if you compound that over ten years, that's
Speaker 4: huge for the insurance sector. And so as I said,
Speaker 4: I think about forty percent of the ass sets now
Speaker 4: of the majors come from insurance. I think for the
Speaker 4: industry as always between near thirty and so that's fueling
Speaker 4: the growth and it's changing the nature of where private
Speaker 4: credit can invest.
Speaker 3: By the way, Tracy, I didn't know that insurance companies
Speaker 3: funded the railways, but I will say early on in
Speaker 3: my career I do remember, and I sort of pat
Speaker 3: myself on the back for this, I do remember having
Speaker 3: the realization that sort of like clicked how similar banks
Speaker 3: and insurance companies are. Because with the bank, you know,
Speaker 3: you make a deposit of one thousand dollars and over
Speaker 3: the lifetime the bank will probably give you back your
Speaker 3: one thousand dollars in the form of you take it out.
Speaker 3: Insurance companies basically the same. You buy a collect premium
Speaker 3: and you get the you know on no but like
Speaker 3: on average right for the industry, they pay out roughly
Speaker 3: what they get in and they hope to like make
Speaker 3: it on the float kind of. And so in the end,
Speaker 3: like the models, in the ideal sense, it's just a
Speaker 3: matter of timing of when the cash goat comes back.
Speaker 1: Out but in aggregate, right, aggregate, but not my individual experience.
Speaker 3: Some people get screwed and some people get way more
Speaker 3: than they put in and then on average anyway, Yeah,
Speaker 3: sort it sort of clicked to me one time in
Speaker 3: my own.
Speaker 1: There's there's a lot of overlap here, for sure. Okay,
Speaker 1: So I want to go back to the financial risk
Speaker 1: slash regulation points. So we've established a number of times
Speaker 1: that to some extent, this is exactly what regulators wanted
Speaker 1: to see happen. But I think there's always a concern
Speaker 1: that maybe this will come back to bite them and
Speaker 1: the overall financial system in some unexpected way, and that
Speaker 1: maybe there are avenues that some of this risk is
Speaker 1: still entangled with the banking system, especially as we see
Speaker 1: these new partnerships develop. What are the avenues for private
Speaker 1: credit risk to I guess, re enter the banking system
Speaker 1: and potentially cause problems.
Speaker 4: Look, I think it's a great question. I think I've
Speaker 4: had almost every regulator post this question. This is this
Speaker 4: is one of the very hot buttons for the issue
Speaker 4: for them. So look, my take is that for sector
Speaker 4: which is very low on leverage, doesn't have the big
Speaker 4: asset liability mismatches is not systemically interconnected, and to be honest,
Speaker 4: is still relatively small, less than three trillion. It's on
Speaker 4: the whole, not a source of systemic risk. But the
Speaker 4: question you gather therefore, well, are there pockets of leverage
Speaker 4: that we can't see? So, for instance, the Bank of
Speaker 4: England's got an investigation to think about where is the
Speaker 4: hidden leverage because obviously having had the LDI problems under trust,
Speaker 4: they're worried about hidden leverage. So nav finance is an
Speaker 4: area which the regulators are pouring over and are getting
Speaker 4: trying to get the data from firms just to see
Speaker 4: as their leverage on leverage and the system that may
Speaker 4: be you know, may trip them up. I think second
Speaker 4: would be on the whole. If you've got ten plus two,
Speaker 4: if the funds are ten year in duration, or even
Speaker 4: even if they're six years and you're lending to five
Speaker 4: year loans, there isn't a big asset liberty in mismatch.
Speaker 4: But to the extent that private credit may potentially be
Speaker 4: put into retail vehicles or even or even to ETFs,
Speaker 4: is there going to be an asset liability mismatch. And
Speaker 4: certainly the more that private credit looks to raise money
Speaker 4: from retail, the more there's going to be a questions
Speaker 4: around the structure. And we can come out to that
Speaker 4: because there's a Cambrian explosion of interest of traditional asset
Speaker 4: managers and private credit players teaming up to create commingle vehicles.
Speaker 4: And then the third though, but tracy to your point,
Speaker 4: is how do the tentacles overlap. So there is a
Speaker 4: good piece by liberty streets. So like the Fed in
Speaker 4: New York that twenty seven percent of bank loans are
Speaker 4: now too non bank financial institutions, so hedge funds, private credit,
Speaker 4: you know, a private equity and the like, and it's
Speaker 4: been growing like a weed. And so they're war and
Speaker 4: doing you know, you know, at one level they're very
Speaker 4: happy that firms are laying off.
Speaker 2: Risk to private credit.
Speaker 4: But they but the question in fact, one of the
Speaker 4: big central banks is asking the banks to try and
Speaker 4: tos up every loan to private credit firm, every loan
Speaker 4: to private credit firm, be in reality they're not making
Speaker 4: the loan to the firm. They're doing it to the
Speaker 4: underlying asset. But they won't have a consolidated tape because
Speaker 4: you know what you don't know, you scares you, And
Speaker 4: so they're trying to get a much better transparency on
Speaker 4: this space.
Speaker 1: This kind of reminds me of the conversation we had
Speaker 1: with Mickey Shemy about synthetic risk transfers, where you know,
Speaker 1: it's sort of the same idea. The bank is like
Speaker 1: selling off part of the risk of a lone portfolio
Speaker 1: totally to another entity. And that sounds fine, except sometimes
Speaker 1: those other entities who tend to be hedge funds or
Speaker 1: someone like that, are borrowing from banks in order to
Speaker 1: apply leverage to boost the yield.
Speaker 3: You say more about the twenty seven percent, I have
Speaker 3: to go read the Liberty Street Economics report. But what
Speaker 3: is from the bank's perspective that specific type of lending?
Speaker 3: What are the risk characteristics?
Speaker 2: What are the.
Speaker 3: Capital impairment the capital cost characteristics of this kind of activity?
Speaker 4: Well, look, so by the way, I'll send you THEA.
Speaker 4: I think it's about where do banks end and let
Speaker 4: and private markets begin? All banks begin is the title,
Speaker 4: So I think, look, it's very heterogeneous at the moment.
Speaker 4: So it's hedge funds, and I know that my good
Speaker 4: friend Tosin Slocke said that's to a new high it's
Speaker 4: to private equity firms.
Speaker 2: So it's all over the place. But so I'm just
Speaker 2: like what, Sorry.
Speaker 3: Jake, my question wasn't particularly sorry. I know, my particular
Speaker 3: question wasn't particularly cogent.
Speaker 2: Here, it was worse.
Speaker 3: It's like, no, no, no, it's fine, it's fine. I'm just
Speaker 3: trying to understand, Like, right, Okay, So banks are optimization vehicles,
Speaker 3: they're capital optimization vehicles and so forth, and they want
Speaker 3: to like, they want to do the lending that creates
Speaker 3: the fewest constraints on the size for regulators and all
Speaker 3: that stuff. So where does lending to financial institutions fit
Speaker 3: into this sort of like madetrix of costs and benefits?
Speaker 4: Okay, So the way bank REGs work these days is
Speaker 4: to encourage the banks to do senior or high quality
Speaker 4: lending and to try and limit the amount of riskier lending,
Speaker 4: either to try and originate and distribute it very quickly
Speaker 4: or to lay it off through you know, derivatives of
Speaker 4: some sort. Yeah, and so let's say it's it's lending
Speaker 4: to hedge funds. Now, you know, because you've you've spoken
Speaker 4: out before with archaegos, they got that wrong. But the
Speaker 4: idea was up until then hedge fund lending. I mean
Speaker 4: very low risk.
Speaker 3: For el So this is kind of what hedge fund
Speaker 3: lending is considered to be low risk.
Speaker 1: Absolutely, although but I think that is changing, like there's
Speaker 1: more scrutiny of the prime brokerage business.
Speaker 4: Yeah, exactly, Well, because they had a fifteen e run
Speaker 4: with almost no credit losses, and obviously they had good
Speaker 4: collateral with haircuts and if and this was the big
Speaker 4: question with the firms who got the wrong way around
Speaker 4: to our chaegoss was if they got the right haircuts,
Speaker 4: then there was secured lending. So on the whole, they
Speaker 4: you know, they could seize the assets and sell them off.
Speaker 4: What they got wrong was this was such a concentrated
Speaker 4: pool and they were all stampeding. So so I think
Speaker 4: actually the risk here is not so much the belly,
Speaker 4: it's actually the tail.
Speaker 2: So is there a scenario where there's.
Speaker 4: A major credit event and that many companies go bust
Speaker 4: and then that works its way through and that's where
Speaker 4: the regulators are trying to piece it through. But my
Speaker 4: take is on the whole, the banks are trying to
Speaker 4: retranch keep the senior risk and I cheekily put in
Speaker 4: and the zen pick of the system because this was
Speaker 4: a wave for them to lay off risk local.
Speaker 3: Directory very hard. Well, because in my mind, just sort
Speaker 3: of very naively, I don't necessarily think of lending to
Speaker 3: hedge funds is really safe lending, because aren't they taking
Speaker 3: all kinds of crazy risks and doing all kinds of
Speaker 3: stuff that may go wrong. But to your point, obviously
Speaker 3: beyond just the run, the fact that there it's backed
Speaker 3: by actual assets typically or typically the bank knows what
Speaker 3: the assets are, I can understand more conceptually why lending
Speaker 3: to financial institutions is more frequently perceived as safe. So
Speaker 3: thank you for that, Joe.
Speaker 1: I think we should do a prime brokerage episode of
Speaker 1: All Lots where all we do is a dramatic reading
Speaker 1: of the report on credit Swiss and our ke ghost.
Speaker 2: Yeah, let's do it.
Speaker 1: We just do that, because that was amazing and actually,
Speaker 1: well actually a really good insight into how it all works,
Speaker 1: or you know, a bad example of how it should
Speaker 1: not work. Anyway, Hugh, I'm going to ask a really
Speaker 1: basic question, but I find, you know, the changing answers
Speaker 1: to this one always really interesting. But how are banks
Speaker 1: making money?
Speaker 4: Now? Oh? It's that Look, that's that's a really good question.
Speaker 4: So after fifteen years of zero or negative rates, We've
Speaker 4: had a wonderful couple of years where spread income, so
Speaker 4: the spread between the assets liability once again became profitable,
Speaker 4: and that really hurt the banks. But you know, if
Speaker 4: the majority of my conversations, both Stateside and Europe and
Speaker 4: even in Asia, as the banks want to make more
Speaker 4: fee income, so that could be asset management, could be
Speaker 4: private banking, could be originate to distribute. They want to
Speaker 4: continue to shift more and more of their earnings towards
Speaker 4: fees and less from just common and garden banking. And
Speaker 4: that's partly cyclical. As interest rates are being cut now,
Speaker 4: the anticipation is the kind of the spread is going
Speaker 4: to be under a little bit of pressure, but you know,
Speaker 4: as we've seen actually it's continued to be very good.
Speaker 4: But it's more and more fees that's where that's really
Speaker 4: where the banks are focused, and then within the loan income.
Speaker 4: My sort of take is that the kind of winner takes.
Speaker 4: Most dynamics we've seen in tech are starting to come
Speaker 4: to banking. The more of a bank cost base, which
Speaker 4: is the systems, the cloud data, you know, it's more
Speaker 4: and more the cost space is tech well quite frankly,
Speaker 4: it's very scalable, and so what you're starting to see
Speaker 4: if you look at the roe. I actually did a
Speaker 4: piece the other day where I looked at the ros
Speaker 4: for the banks in every country by the number one player,
Speaker 4: number two, number three, umber five. The top three players
Speaker 4: in each market are doing so much better than the
Speaker 4: tails than they wear a decade ago. And I think
Speaker 4: it's that winner takes most win, it takes more behavior.
Speaker 3: That's really interesting. Actually, let's talk a little bit more
Speaker 3: about this, because I have also from time to time
Speaker 3: pull up the chart of JP Morgan and compare it
Speaker 3: to other banks, and it is it looks kind of
Speaker 3: like a tech dog. I mean, it's not really quiet
Speaker 3: as good because it's not a techt Doug, but it
Speaker 3: sort of seems to exhibit And I wondered about this,
Speaker 3: this sort of winner take on this of the market
Speaker 3: and whether there is a similar dynamic. And I hadn't
Speaker 3: thought about it quite so literally in terms of the
Speaker 3: actual tech stack of the bank, and I was wondering
Speaker 3: if it was more sort of like a network effects.
Speaker 3: And of course in finance work effects are important just
Speaker 3: like they are in software. But talk to us a
Speaker 3: little bit about the dynamics that you think are contributing
Speaker 3: to this. Winner take on this in any country banking system.
Speaker 4: So look, I think obviously there's part of it is
Speaker 4: the is the tech stack. Of course, you know, if
Speaker 4: they're trading assets, there's always going to be some network effects.
Speaker 4: If you can take you know, thirteen fourteen, fifteen percent
Speaker 4: for market, you just see more, you can price better,
Speaker 4: you've got better source of flow. So I think in
Speaker 4: investment banking markets and in sort of wealth markets, there's
Speaker 4: definitely some network effects, but also just there's scale in origination.
Speaker 4: I mean, you just need loan officers, loan processors. I
Speaker 4: mean it's very typically, it's very manual, and in fact,
Speaker 4: one of the not for me, but some of our
Speaker 4: colleagues are doing a lot of work actually using AI
Speaker 4: to automate loan procedures for banks because that's an area
Speaker 4: which is very physical, historically been very labor intensive. And
Speaker 4: actually one of the reasons why private credit is trying
Speaker 4: to team up with the banks is because they don't
Speaker 4: have enough people to originate, so they're trying to lean
Speaker 4: on someone else's origination STAF. Now, look, but just there's
Speaker 4: one nuance here for every power, there's an equal and
Speaker 4: opposite power. So in the States, let's say for regional
Speaker 4: back for the smallest banks, they're all basically sitting on
Speaker 4: one of three players like five serv So they're enjoying scale,
Speaker 4: but they're just outsourcing it. And then the other thing is,
Speaker 4: of course, you know the Google's alphabets and as you're
Speaker 4: within Microsoft are getting a winning handover fist because if
Speaker 4: you're a MidCap bank, the way you try to capture
Speaker 4: scale is by outsourcing to one of the superscalers.
Speaker 1: I think you anticipated my next question perhaps when you
Speaker 1: brought up AI. But one thing I often think about
Speaker 1: the financial sector, so banks and insurance companies, is if
Speaker 1: AI is Obviously it's about the technology, but it's about
Speaker 1: the data too. Who has the most data? It's got
Speaker 1: to be insurers and banks, right, they just have noodles
Speaker 1: and oodles of it. How excited are banks in particular
Speaker 1: getting about, you know, the actual data component of their
Speaker 1: business here?
Speaker 2: Well, hopefully Bloomberg's got one of the best data staffs.
Speaker 2: Well us too.
Speaker 4: Oh no, this is so there's a huge amount of
Speaker 4: automation going on. I mean, look, let's take one step back.
Speaker 4: The banks need to make sure that their data is
Speaker 4: organized in a lake or in a way it can
Speaker 4: be used effectively. And then number two, you need to train.
Speaker 4: So actually one of the largest banks now has every
Speaker 4: new graduate doing AI prompt training as part of their
Speaker 4: core curriculum as they join. So one of my son's
Speaker 4: flatmates just done eight weeks of AI training. It's extraordinary.
Speaker 4: So the way, of course, if the more data you've got,
Speaker 4: the better. But Tracy, there's some really subtle things in here,
Speaker 4: because the regulators want to know how you made the
Speaker 4: decisions right, and is the a optimizing just on past
Speaker 4: experience or is it right?
Speaker 1: This is the black box alg point, right, where like
Speaker 1: if you have all this data going into a black
Speaker 1: box and algorithm and it's spitting out an answer, you
Speaker 1: actually have to know whether that answer is valid, like
Speaker 1: whether it might violate regulations on biased lending based on
Speaker 1: like racial or age characteristics or gender or something like that.
Speaker 4: Absolutely, and so there's all sorts of bites. So at
Speaker 4: the moment, most of it is for co piloting, but
Speaker 4: you know, some of the use cases, Tracy, are fascinating.
Speaker 4: It's like one of the big banks I was talking with,
Speaker 4: they're actually using AI now in the right sharp departments
Speaker 4: to just basically automate and a thing. If they want
Speaker 4: to fask someone, they just they click a big thing
Speaker 4: less and then try and work it out.
Speaker 1: Oh wow, dystopia is here.
Speaker 3: Yeah, it really is. There's some great articles, by the way,
Speaker 3: done by Bloomberg, not related to banks or anything, but
Speaker 3: like on the sort of like Amazon auto hiring and firing,
Speaker 3: and just this idea of all that being the assumption
Speaker 3: of liquid labor markets and the you know, it's okay
Speaker 3: to make mistakes if there's just an endless supply of
Speaker 3: people who want to work at your company. Anyway, that's
Speaker 3: its own digression, you know, just on this point. So obviously, okay,
Speaker 3: the big banks have their gigantic text ex. I had
Speaker 3: a conversation recently with someone who worked for a very
Speaker 3: small bank. Actually it was just like someone over coffee
Speaker 3: and I'm curious and so it's like kind of like
Speaker 3: doing an odd lots except over coffee with no microphone,
Speaker 3: like how it all works and how a region or
Speaker 3: a small local bank actually has a business. And it
Speaker 3: was really striking in the conversation how many of the
Speaker 3: specific things that came up were literally about third party
Speaker 3: modeling or software packages and stuff like that, and how
Speaker 3: much the sort of all kinds of risk management, et cetera.
Speaker 3: It was really a job of plugging their numbers in
Speaker 3: to various packages that they buy. And I have to
Speaker 3: imagine that the companies that sell these modeling services or
Speaker 3: software services or data services to any of the banks
Speaker 3: that aren't like JP Morgan and a few others must
Speaker 3: be making a mint.
Speaker 4: Oh absolutely, Look, I mean that's not my area. No,
Speaker 4: But just in the same way, the MSCI has made
Speaker 4: an absolute fortune by being the day you know, the
Speaker 4: premier data company for markets.
Speaker 2: See.
Speaker 4: One way to frame it is in this of fifteen
Speaker 4: years post financial crisis, the banks you know, in many
Speaker 4: at least certainly for the first seven or eight, which
Speaker 4: is focused on capital repair, improving process, improving risk management,
Speaker 4: that the amount of discretionary that they had to invest
Speaker 4: in new textacs was really quite low, and so a
Speaker 4: lot of the innovation was happening outside banks and being
Speaker 4: sold back in. Now, as you say, look from maybe
Speaker 4: twenty sixteen onwards, the US banks got back on the
Speaker 4: front foot, and the leading ones are investing disproportionately in
Speaker 4: tech and their own solutions but there's an enormous amount
Speaker 4: which is brought in and again that's sort of that's
Speaker 4: why if you go back to private credit, one of
Speaker 4: the areas they hope is is that they certainly the
Speaker 4: leading firms are also investing in tech stacks because they
Speaker 4: want to make sure they have an information edge. And
Speaker 4: so also you're starting to see, i want to say,
Speaker 4: hollowing out of the middle in private credit. But definitely
Speaker 4: the larger firms are investing very significantly in treasury management
Speaker 4: data and underlike.
Speaker 3: By the way, Tracy, check out look over a chart
Speaker 3: of five five serves duck, which does a bunch of
Speaker 3: various payment things for smaller and credit union banks and
Speaker 3: stuff like that, and check out the Oh geez, yeah,
Speaker 3: check out their stuck I just pulled it up.
Speaker 1: I have to compare it to in video.
Speaker 3: Yeah right, I know it looks like it hasn't it.
Speaker 3: It's probably well anyway.
Speaker 1: Yeah, that's amazing. Why don't we get back to private credit.
Speaker 1: We're in danger of just making this an AI episode.
Speaker 1: But Hugh, you know, we've seen growth in private credit,
Speaker 1: although to your point, it's still relatively small, so you know,
Speaker 1: it's coming up from a low base. We've seen more
Speaker 1: partnerships between banks and private credit entities. What's next in
Speaker 1: terms of this dynamic? What are you watching out for
Speaker 1: as the next big thing?
Speaker 4: So for me, private credit's next act is around asset
Speaker 4: back lending and secondly commercial real estate, and I think
Speaker 4: they're the two big asset classes which the private credit
Speaker 4: firms are really trying to either gain origination or do
Speaker 4: partnerships or get into and just go back to it. So,
Speaker 4: if specialty finances are five and a half trillion market,
Speaker 4: private credit has about a five point share. If you
Speaker 4: then include consumer mortgages and commercial real estate, it gets
Speaker 4: to about twenty five trillion in the States, of which
Speaker 4: private credit has probably about a two percent share. So
Speaker 4: this is an area where they are really trying to say,
Speaker 4: with insurance led assets, with also some of the assets
Speaker 4: for the wealthy. This is where they're really gunning for
Speaker 4: it now. At the moment, commercial real estate is probably
Speaker 4: less picked over because the areas where the banks are
Speaker 4: shedding is more the distressed or stressed, particularly if it's
Speaker 4: a US regional bank. But the asset back lending piece
Speaker 4: is they're going absolutely gung ho, and that's the area
Speaker 4: which I think is probably one of the most interesting
Speaker 4: areas to spend time on. And then the second bit
Speaker 4: trace is that's obviously on origination on the where they're
Speaker 4: getting the assets from. As we've spoken about many times before,
Speaker 4: Let's be honest, the endowments and pension funds are still
Speaker 4: a lot of bit of have got a bit of
Speaker 4: indigestion to private equity and venture capital. Now that indigestion's passing,
Speaker 4: but most endowments I speak to still say they're abroout
Speaker 4: five points over allocated to VC. Would love to put
Speaker 4: that to private credit, but they just don't want to
Speaker 4: do more I liquid assets today. So the private credit
Speaker 4: firms are doing three things. Going international, so going to
Speaker 4: the Middle East in particular, where there is just a
Speaker 4: ton of new money, and actually that those clients really
Speaker 4: like fixed income. They're going to insurers, and I still
Speaker 4: think there's a good runway to raise money from insurers
Speaker 4: we could discuss. And third and finally, it's the wealthy.
Speaker 4: And I think at the moment there's a little bit
Speaker 4: of misnomer. When they say wealthy, they mean seriously wealthy.
Speaker 4: I mean they talk about you know, family offices, people
Speaker 4: with fifty million dollars plus there's about a nine trillion
Speaker 4: dollar market of family offices globally. That's their sweet spot,
Speaker 4: but they're going to look increasingly towards the decently wealthy,
Speaker 4: and I think their product innovation around, you know, whether
Speaker 4: it's Capital International with KKR, where it's Black Crop with
Speaker 4: Partners Group, whether it's Apollo with State Street Global, there's
Speaker 4: some really interesting innovation about how you slice up private
Speaker 4: credit to some of like affluent clients, and that's something again,
Speaker 4: you could do a whole episode.
Speaker 3: On Tracy we've never done. I don't think a family
Speaker 3: office episode. No, we should.
Speaker 1: Yeah, we should go to Singapore, Yeah and do it
Speaker 1: from there. Yes, because I want to go back to Asia. Okay, Well, Hugh,
Speaker 1: thank you so much for coming back on this show.
Speaker 1: It was lovely to catch up with you as always,
Speaker 1: and you walked us through that perfectly. So thank you
Speaker 1: so much.
Speaker 2: Thanks for having me.
Speaker 3: Thanks you. That was fantastic.
Speaker 1: Joe, that was great. I love catching up with you again.
Speaker 1: Like I've known him for a long time and he's
Speaker 1: always had really interesting thoughts on the financial sector and
Speaker 1: a great way of kind of explaining them. I do
Speaker 1: think his idea of retranching of risk in the financial
Speaker 1: system is definitely like the way to think about what's happening.
Speaker 1: It seems like, in some respects seeing more and more
Speaker 1: specialization in the system where maybe it used to be,
Speaker 1: you know, back in nineteen seventy when bank lending was
Speaker 1: at its height, the bank would do all sorts of
Speaker 1: things right, But now it kind of breaks up all
Speaker 1: those different businesses into different pieces and has different partners
Speaker 1: for each one of those.
Speaker 3: No, I think that makes a lot of sense. Look,
Speaker 3: I would still say, and you know famous last words
Speaker 3: that someone will make fun of me, but I would
Speaker 3: still say that by and large, I am of the
Speaker 3: view that the post grade financial crisis evolution of the
Speaker 3: financial system has probably been a net good in terms
Speaker 3: of overall financial stability risk. That to your point about
Speaker 3: the tranching, that the financial system has gotten better about
Speaker 3: putting the right form of risk in the right hands.
Speaker 3: There's never total delinkage or anything. But even hearing them
Speaker 3: explain why financial lending to financial institutions is a safer
Speaker 3: form of lending that is really helpful, and so why
Speaker 3: that's grown like why you know, this emergence of his
Speaker 3: specific mid market type lending and the right entities for that.
Speaker 2: I don't know.
Speaker 3: I'm still of the view that probably things are better.
Speaker 1: It's one of those things where there could always be
Speaker 1: something that we're missing, yeah, of course, right, and that
Speaker 1: regulators are missing. I do think at the moment we
Speaker 1: seem to be in a sweet spot where a lot
Speaker 1: of this is happening. So risk is getting divided up
Speaker 1: and you know, distributed differently in the financial system to
Speaker 1: where it was in two thousand and eight. But it's
Speaker 1: still relatively small, like he was saying, despite all those
Speaker 1: headlines about private credit, like, we're still talking about a
Speaker 1: relatively small market. It could be that as it gets
Speaker 1: bigger and bigger, it becomes more problematic in various ways.
Speaker 1: But the other thing that I think is interesting about
Speaker 1: private credit, and I think we've talked about it a
Speaker 1: couple of times at this point, is the idea that
Speaker 1: it kind of has acted as an additional cushion of
Speaker 1: financing during the past couple of years where we had
Speaker 1: really high rates and banks were still relatively capital constrained,
Speaker 1: so you could still get a lot of you know,
Speaker 1: middle market businesses have this addition layer of financing or
Speaker 1: funding that they could still tap even if the banks
Speaker 1: weren't necessarily doing it.
Speaker 3: The winner take all in this of banks.
Speaker 2: Oh yeah, really interesting.
Speaker 3: I think it's one of those things that you can
Speaker 3: see and you can look at the comparison of large
Speaker 3: caps for small caps or whatever, or JP Morgan versus
Speaker 3: literally everyone else in you guys. But it is like
Speaker 3: still sort of a little bit under discussed and underdiscussed
Speaker 3: why And I get the point about the tech stack,
Speaker 3: and I get the point about you know, capital markets.
Speaker 3: There's a natural network effects, but it's still interesting. We
Speaker 3: live in this network effects world and in almost any
Speaker 3: industry this seems to be a phenomenon. And why that
Speaker 3: is across so many different areas where you have a
Speaker 3: number of companies in any industry that look like tech
Speaker 3: stocks is an interesting under discussed phenomenon.
Speaker 1: Joe's theory of network effect.
Speaker 3: You know what I said, all companies are banks except banks.
Speaker 3: Banks are media company.
Speaker 1: That's perfect. Yeah, I love that. Okay, let's leave it
Speaker 1: there on a high note. Yeah, all right, this has
Speaker 1: been another episode the Authoughts podcast. I'm Tracy Alloway. You
Speaker 1: can follow me at Tracy Alloway, and.
Speaker 3: I'm Joe Wisenthal. You can follow me at the Stalwart,
Speaker 3: follow our guest Hugh von steinas He's at Hugh Steinas,
Speaker 3: Follow our producers Carmen Rodriguez at Carman Ermann Dashel Bennett
Speaker 3: at dashbod In Kelbrooks at Keilbrooks. And thank you to
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Speaker 1: Thanks for listening, Bend