When the Bank Says No
Regional banks have spent the past two years quietly shrinking their loan books. Squeezed by higher funding costs, tighter capital requirements under proposed Basel III endgame rules, and lingering anxiety from the March 2023 bank failures, mid-sized lenders have pulled back from commercial real estate, middle-market lending, and construction financing at a pace not seen since the aftermath of the 2008 financial crisis. The credit gap they have left behind is real, and it is wide.
Into that gap has stepped private credit – a broad category covering direct lending funds, business development companies, and asset-backed financing vehicles managed by alternative asset managers. What was once a niche corner of institutional finance now sits at the center of how many American businesses actually get funded. The shift did not happen overnight, but the acceleration over the past 18 months has been striking enough to draw attention from the Federal Reserve, the Treasury, and increasingly from lawmakers who are only beginning to understand what they are looking at.
Why Banks Pulled Back
The regional bank stress of 2023 did more than shake depositor confidence. It prompted a broad reassessment inside lending institutions about which assets they wanted on their balance sheets heading into an uncertain rate environment. Commercial real estate loans, already under pressure from office vacancy rates and rising cap rates, became particularly unwelcome. Banks that had grown their CRE portfolios aggressively during the low-rate years found themselves staring at mark-to-market losses and the prospect of regulators asking pointed questions during examinations. The rational response was to stop making new loans in the category, and many did exactly that.
The capital requirement picture made things worse. Even before final rules were adopted, the anticipation of higher risk-weighted capital charges prompted banks to pre-emptively reduce exposures. Loans to middle-market companies – typically defined as businesses with annual revenues between $10 million and $1 billion – carry meaningful capital costs under any framework, and when the cost of holding those assets rises, the economics of originating them deteriorate quickly. A bank that earns a spread of 300 basis points on a middle-market loan but must hold significantly more capital against it earns a far less attractive return on equity than the headline rate suggests.
Private Credit Steps In
Direct lending funds do not face the same capital framework. They raise money from institutional investors – pension funds, sovereign wealth funds, insurance companies, endowments – lock it up for a defined period, and deploy it into loans without the regulatory overhead that comes with a bank charter. That structural difference allows them to price loans competitively on spread while still generating returns that satisfy their investors, who are typically targeting net returns in the high single digits to low double digits.
The mechanics work because private credit lenders can move faster and underwrite more flexibly than a bank credit committee operating under compliance constraints. A regional bank might take 60 to 90 days to approve a $50 million term loan for a mid-sized manufacturing company seeking to finance an acquisition. A direct lender can often close the same deal in three to four weeks, with fewer covenants and more certainty of execution. For a business owner in the middle of a time-sensitive transaction, that speed premium justifies paying a higher all-in rate.
The asset-backed side of private credit has grown alongside direct lending, and in some ways it is the more consequential story. Specialty finance – covering consumer loans, equipment leases, royalty streams, and even auto lending portfolios – has historically relied on banks as both originators and warehouse lenders. As banks have reduced their appetite for warehouse lines and whole-loan purchases, non-bank asset managers have stepped in to provide that liquidity. The result is that an increasing share of everyday consumer and commercial credit is now funded through private channels rather than through the deposit-taking institutions that most people picture when they think about where credit comes from.
Scale is no longer a limiting factor for the largest private credit managers. Several firms now manage direct lending platforms with assets exceeding $100 billion, giving them the capacity to write checks large enough to compete with syndicated loan markets on certain deals. The traditional investment-grade bond market and leveraged loan market still dwarf private credit in total volume, but for transactions in the $25 million to $500 million range – the sweet spot of middle-market finance – private lenders now set the terms as often as banks do.
Who Bears the Risk Now
The migration of credit risk from bank balance sheets to private funds changes who absorbs losses when borrowers default. Banks, for all their regulatory frustrations, are backstopped by deposit insurance and can access Federal Reserve liquidity facilities in a crisis. Private credit funds have no such backstop. When a direct lending vehicle marks down a portfolio company or faces an inability to refinance a matured loan, the loss falls directly on the institutional investors who committed capital. Pension beneficiaries, university endowments, and insurance policyholders are, in the end, the ultimate holders of that risk.
That concentration of risk in less-regulated, less-transparent vehicles is the central concern regulators have voiced publicly. The Financial Stability Oversight Council flagged private credit as a monitoring priority, pointing specifically to the lack of real-time data on leverage levels, credit quality deterioration, and interconnections with the banking system through subscription credit lines and fund financing facilities. The worry is not that private credit is inherently dangerous but that its opacity makes early warning signals harder to read.
Borrowers in the Middle
For the businesses actually borrowing the money, the private credit wave has been largely welcome, even with higher rates attached. A regional manufacturer that six years ago would have walked into its local bank and negotiated a revolving credit facility now deals with a fund manager based in New York or Chicago. The relationship dynamic is different – less personal history, more documentation, more emphasis on financial covenants – but the capital is available, and for many operators that availability matters more than the terms around the edges.
The harder cases involve borrowers at the margin of creditworthiness who now face a starker binary. A business that banks would once have stretched to accommodate – extending a mature line of credit for another year, waiving a technical covenant violation – may find private lenders less forgiving. Direct lending funds have their own investors to answer to, and their credit agreements are written precisely because fund managers do not carry the decades-long deposit relationships that once gave community bank officers flexibility in workout situations.
Small business owners in particular have felt the squeeze most directly. The pullback in regional bank lending has been most acute at the lower end of the market, in loan sizes below $5 million, where the economics of private credit deployment do not work as well. Large direct lenders are not interested in a $2 million equipment loan for a printing shop. That borrower is now competing for a much thinner pool of bank capital, or turning to higher-cost alternatives like merchant cash advances and online lenders operating at rates that would have seemed extreme a decade ago.
What Comes Next
Regulatory attention on private credit is intensifying. The Securities and Exchange Commission has already expanded reporting requirements for large private fund advisers, and the Federal Reserve has made clear it will scrutinize banks’ exposure to private credit through fund financing lines and co-investment structures. The question is not whether oversight increases but how quickly rules can be written and enforced for an industry that has been specifically structured to operate outside the perimeter that governs traditional banking.
Some institutional investors are starting to ask harder questions about liquidity. Private credit funds typically lock capital up for five to seven years, and in a benign environment that illiquidity premium looks attractive. But as interest rates have stayed higher for longer than many models assumed, some portfolio companies that were underwritten at lower cost-of-capital assumptions are under real pressure. A fund that marked its book at par in 2021 may be carrying loans today that a secondary buyer would purchase at a meaningful discount – a gap that is not always visible in quarterly valuations.
The private credit industry’s core argument – that it provides stable, long-term capital free from the pro-cyclical pressures of bank regulation – is genuinely compelling on its own terms, but it depends entirely on institutional investors maintaining their appetite through a full credit cycle. That cycle has not fully turned yet, and the defaults that test it most seriously have not arrived at scale. When they do, the question of whether private credit is a structural improvement over bank lending or simply a repackaging of the same risks in a less transparent wrapper will finally get a real answer.
