The Real Threat Isn’t Private Credit—It’s Regulatory Amnesia

The shadow banking story of 2008 is really a myth, but now it's being used to call for more regulation of the private equity industry.

One of the enduring myths from the 2008 financial crisis is that federal regulators were blindsided by the disaster because all the risky speculation started in the “shadow banking” sector, the unregulated part of the market.

This tale has been repeated so many times that most people think it’s true. But it’s basically complete nonsense.

No massive deregulation had occurred, America’s financial markets were not unregulated, federal policy had a huge hand in what took place, and federal banking regulators knew exactly what was going on. From 1990 to 2008, commercial banks’ market share of the main functions of securitizing assets was over 90 percent. Commercial banks were not operating in the shadows.

But facts have never mattered with this story. And now it’s being used to call for more regulation of the private equity industry. Specifically, these new attacks are aimed at what’s known as private credit, a practice that is nothing more than direct lending by non-banks.

As this new Open Banker article explains, private credit is nothing new. But the article gets the origin date—and practically everything else—completely wrong.

For starters, private credit was around in America long before even the 20^th century. As my coauthor and I document in our book, Financing Opportunity, the use of deposit credit in America is practically as old as America itself, and it often took place outside of the formal banking sector. And it wasn’t just on the East Coast—private bankers were present as far west as Missouri as early as 1808.

Still, compared to the rest of the article’s missteps, the dating problem is a mere quibble.

The article questions whether private credit is truly expanding credit or replacing corporate loans that banks would otherwise be making to distressed companies. Pointing to new research from the Boston Fed, the article suggests that it’s the latter and that the lending is “actually being fueled in large part from revolving credit lines provided to private credit” by banks.

So, risky or not, it’s not occurring in the shadows.

Worse, the article states that this kind of private lending “precipitated the most disastrous financial collapses the world has ever experienced.” No, not the 2008 crisis. Instead, it’s referring to the Panic of 1907, which it labels as “perhaps the first truly global financial crisis.”

One problem here is that the US alone experienced a bank panic in 1907. A second problem is that the global downturn associated with 1907 occurred before the banking panic. And as my former colleague George Selgin has repeatedly pointed out, harmful US bank regulations, such as prohibitions on branching and bond requirements for bank notes, were a main cause of that banking crisis. Canada, which didn’t have those kinds of regulations and restrictions (or a central bank), avoided the panic (as did other major countries).

On a positive note, the article admits that “Failure of one or a few of these [private] funds, therefore, are unlikely to create systemic damage to the banking system,” and “private credit lending remains a minority within overall corporate borrowing.”

But it quickly loses points by warning that “…private credit exists in an underregulated, shadow sector of the financial services system.” Proponents of more regulation want federal officials to know what everyone is doing with their money—that’s what they call transparency—and they want to be able to stop people from making certain investments in the name of some greater good.

But this position is based almost entirely on mistaken history and the false premise that federal regulation can stop financial crises and panics.

US history has definitively demonstrated that financial regulation can do little more than serve as a sort of Whac-A-Mole game. It sporadically lets federal officials clamp down on what people do with their own money, and it makes it harder for newer innovative firms to compete. But it has never resulted in financial stability.

The only way to ensure stability is to stop people from taking risks. That’s against human nature and it’s incompatible with a free enterprise system rooted in limited government.

Moving further in that direction would be a mistake. Increasing control over what people do with their money gives the people in charge immense power over everyone else. And that’s much more dangerous than making risky investments.