Richard Berner on Growth of the Private Credit and the Role of Fiscal Dominance on Treasury Markets

Richard Berner is the former director of the Office of Financial Research and was a counselor of the Treasury Secretary. In Richard’s first appearance on the show, he discusses a career that included public service and Wall Street, the fragility of global liquidity, the implications of fiscal dominance, the expansion of private credit, the 2023 SVB banking turmoil, and much more. 

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Read the full episode transcript:

This episode was recorded on January 7th, 2025

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]. 

David Beckworth: Welcome to Macro Musings, where each week we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow with the Mercatus Center at George Mason University, and I’m glad you decided to join us.

Our guest today is Richard Berner. Dick is the former director of the Office of Financial Research from 2013 to 2017, and also was a counselor to the Treasury secretary. Dick is also a Wall Street veteran and a former Fed staffer. He joins us today to discuss the state of global liquidity, the growth and implications of private credit, Treasury markets, and more. Dick, welcome to the program.

Richard Berner: Thanks for the opportunity.

Beckworth: It’s great to have you on. Now, we have a common friend who has been on the show before and introduced us, andthat’sStephenKelly. I should give a shout out to Stephen. He now is at the FDIC, so he can’t come on the podcast anymore, but he brings on great suggestions like you. I’m excited, Dick, to chat with you. 

I have to tell the listeners, I first became aware of you back in the ’90s, I believe. You had a newsletter with Morgan Stanley that you and some colleagues wrote. It was my introduction to macroeconomic analysis. It was free as well. I owe you a debt of gratitude for helping me see how people on Wall Street think, how economists think.

Berner: Hopefully, it was worth a little more than what I charged for it.

Beckworth: Oh, definitely was, definitely was. Back then in the early days of the internet, there really wasn’t a whole lot being done on macro, at least for free, that I knew about. In fact, one of the reasons I started this podcast is because I felt there was a missing market, a podcast dedicated to macroeconomics. Your newsletter was an important part of that. 

Dick’s Career

Now, let’s talk about your career. You were at Morgan Stanley. You were a veteran of the Fed. You worked at Treasury, the OFR. Walk us through how you got to where you are today.

Berner: I’ve always been interested in economics and how using economics appropriately can help make people’s lives better, so that connected it immediately to policy issues. The policy issues, of course, for all my employers, three of them financial institutions prior to Morgan Stanley, everybody was interested in what’s the Fed going to do? What’s fiscal policy going to look like? What are our other policies going to look like? What are the implications for our business and for markets?

As an economist in those institutions, that was part of the job, for sure. Building relationships with policymakers and understanding how they thought and what influenced their thinking was really important. Getting to know them and build their trust was another aspect of it. I got to know a lot of different people. Of course, when I got to the OFR, being an official myself, that was necessary because the things that we were doing involved collaboration and cooperation across a variety of agencies, disciplines, and borders for that matter. Building those relationships was even more important there.

I retain that interest in what I’m doing now. At NYU, where I’ve been for about eight years, I run something called the Volatility and Risk Institute with my colleague, Rob Engel. We try to focus on assessing, measuring, analyzing the implications of a bunch of different kinds of risk. They’re all messy, and hard to analyze, and hard to measure. That’s why we do it. It’s like Mount Everest; you climb it because it’s there. We may not ever get to the top, but hopefully, we’ll make some progress and further our understanding and learning as we go on the way.

Beckworth: Yes, you guys are doing a lot of interesting work. You had a conference last year on private credit, what it means, and we’ll talk about that later as well.

Berner: Sure.

Beckworth: For the listeners who don’t know much about the OFR, the Office of Financial Research, maybe give a little back history about it and what it’s supposed to do by law. 

Berner: In the Global Financial Crisis, we discovered something that was pretty obvious in hindsight, which was the quality of financial data was really lacking. The volume and the extent to which we had data that described what was going on in markets and firms, it was also lacking. Third, the accessibility of those data to people who really needed them in order to make decisions was lacking. When Dodd-Frank was conceived as a set of remedies to make the financial system more resilient, one of the aspects of that was to improve the quality, and the scope, and the accessibility of financial data. That was the job of the OFR. 

In order to do that, OFR also had to do a few other things: assess threats to financial stability of the United States and its markets, and produce a report, testify in front of Congress, things like that, in cooperation with the financial regulatory agencies, and of course, the Fed, in the United States. Since a lot of the issues are global, cooperation and collaboration with overseas policy operations was also pretty important. Got to know a lot of those folks.

Beckworth: Now, as I understand it, the OFR by law can actually get data that otherwise couldn’t be brought together in one source. Is that right?

Berner: Yes. At the request of the Financial Stability Oversight Council, or FSOC, the OFR could fill gaps in data that other agencies, other bodies didn’t have the authority to do. The OFR could collect data from any financial firm operating in the United States, and typically at the request of the Council.

Beckworth: Now, just some concrete examples. My understanding is repo data is something the OFR has gone after and brought together in one place. Any other things worth noting?

Berner: That was a prominent example because, as you know, there are different flavors of repo. From the bilateral repo, some of which is cleared, some of which is not cleared, those data had not been collected, but they’re a substantial part of the repo market. Since we first envisioned filling that data gap, the repo market has grown dramatically in a variety of ways. The bilateral sector or bilateral part of it is roughly half of the transactions.

We’re talking about something that’s really important for the financing of financial activity. We didn’t have really good data to understand it, and that was a big gap that the OFR was empowered to fill. It was important when the transition from LIBOR to alternative reference rates was made, the transition to SOFR. SOFR is an amalgam, if you will, of a variety of short-term money market rates, including a repo rate. The OFR was instrumental in collecting the data needed to construct SOFR, and that was very important for its sustainability.

Beckworth: Thank you for your efforts on those data-collecting projects. The world’s a better place because of them. 

Fragility of Global Liquidity

Let’s move into global liquidity. Is it fragile? What’s the state of it? You had a paper recently titled “Fragile Global Liquidity: Sources and Policy Implications.” We’ll provide a link to it. Maybe we could begin by just defining what is global liquidity. What do you think of when you use that term?

Berner: There are two kinds of liquidity that really matter and that we think about, and they’re related to each other. The first is market liquidity, which is probably what’s most familiar to people, and that’s the ability of people who hold assets to convert them into cash at low cost and quickly and readily. Then there’s funding liquidity, which is the ability to fund a portfolio of assets. Every financial firm has a balance sheet that has assets and liabilities.

If you want to hold a portfolio of assets, like a bank or an investment manager, then you have to have liabilities on the other side that are used to fund those assets. Those can take various forms, obviously. Often, there’s transformation of liquidity and maturity in constructing those portfolios, and so the mismatch between the liquidity of the assets and the liabilities means there’s liquidity transformation. There’s maturity transformation, which means that often the liabilities are short-term in duration and the assets are longer term in duration. That’s often the case for a bank or a hedge fund, either way.

In normal times, when things are working well and there’s not stress in the system, that enables those firms to profit from those mismatches. In periods of stress, when markets are on the verge of becoming dysfunctional and asset prices are changing a lot and people have used those liabilities to provide leverage to their activities, that can create stress and, in the extreme, create what we call fire sales, when people sell what they can in order to raise cash to replace the rolling over of their maturing liabilities.

Those two things are important to think about. There’s an article that was written shortly after the Global Financial Crisis by Markus Brunnermeier and Lasse Pedersen that talked about market and funding liquidity and the relationship between them and how important that relationship really is. Both those things, I think, are important in thinking about stress in the financial system and how to make it more resilient.

Beckworth: Where are we today in terms of liquidity? Is it fragile? Is it still there functioning? Are there concerns on the horizon? Where would you put it?

Berner: I’d put it that it is still fragile. It’s been getting increasingly so. I started worrying about this along about 2014 when we saw some stress in markets. It was very short-lived. We had a so-called flash rally in the Treasury market with the release of some retail sales data, and people really didn’t understand what the nature of that price move was, which was short-lived, so people didn’t worry about it too much. There was a big study that was put out about it and indicated that in periods of dislocation or stress, you could see liquidity dry up in markets. 

We all know that, ultimately, the central banks are the source of the funding liquidity and market liquidity, both. When stress arises, the central banks are often called in to come over the hill, wave the flag, and provide the system with sufficient liquidity so it can function. That’s perfectly fine, except that knowing that the central bank, the ultimate source of liquidity, is going to be there always creates incentives for market participants to take on more risk, to use more leverage, knowing that in the extreme, they’re going to get bailed out.

The alternative is to make the system more resilient, and I think those things are worth pursuing. Now, there are a variety of ways to address some of these problems. But before we think about how we address them, we can think about at least two of the reasons that liquidity has become more fragile over, let’s say, the past 10 or 15 years. One is obvious to most people, and that is the growing issuance of sovereign debt in the wake of the Global Financial Crisis and other events like the pandemic has greatly expanded the issuance of sovereign debt. We’re running deficits here in the United States, 6% or 7% of GDP. The debt is virtually doubled in that period, if not grown by more, and the capacity of the system, the financial system, to intermediate it, to make markets, to provide liquidity that is used in the transactions that we need to do in order to issue and trade and invest in these securities, has not kept pace. That mismatch means that when there’s stress, you’re going to see markets become less functional and maybe even dysfunctional.

There’s a second reason that’s less widely publicized, and that is after the Global Financial Crisis, unsecured funding, that is funding that was not backstopped by collateral, became pretty unpopular. When you have unsecured funding, you look to the creditworthiness of the counterparty. People said, “Let’s collateralize the funding”—repo is a classic example of that—“so we can look to the value of the collateral instead of having the counterparty risk of the person with whom we’re dealing.”

That works fine except when you collateralize intermediation. That makes the process more pro-cyclical. Now, pro-cyclicality means that when you have a move in asset prices, if people are using leverage in their activities, that amplifies the move in asset prices because they will typically have to unwind some of that leverage. The classic example is suppose that you bought a stock on margin or you bought a bond on margin and the value of that asset fell, then you’d be subject to a margin call. You’d have to post more collateral. That adds to the pro-cyclical move in asset prices if you have to raise cash in order to do that. That’s true across the financial system. 

Moving to a collateralized system of finance is a good thing because it reduces counterparty risk. And central clearing, which is an aspect of that, instead of having bilateral transactions that are cleared, that is, they’re validated and settled on a one-by-one basis, if we have central counterparties through which we can mutualize all those transactions and net the transactions, then that’s very helpful. It minimizes or reduces at least counterparty risk. 

It also, in periods of stress, because of the pro-cyclicality of the process, it actually increases the demand for liquidity. Now, as long as the system has the capacity to raise the extra liquidity, that’s not an issue. If it doesn’t and it becomes system-wide, then it can become an issue. We saw some of that in the LDI episode in the UK in 2022, when the fact that collateralized funding was used and margin was used or leverage was used by some of the pension funds who were affected by the decline in asset prices, that amplified what was going on in markets, created dysfunction in the gilt market, and the Bank of England had to step in and address that.

The two things together, huge volumes of sovereign debt, less capacity to intermediate it, a system that involves collateralized finance and is about to go through central clearing for our Treasury market, means that we’re going to have more liquidity demand and more liquidity stress when shocks hit in the future. We have to think about ways to make the system more resilient.

Beckworth: That is so fascinating, the part about collateralized financial system becoming more pro-cyclical. I think it’s really interesting because, as you noted, it’s a move away from unsecured lending. As someone who follows the debates about central bank operating systems, there’s been this push in some parts of the world, not here, but in other parts, to go back to something with a smaller footprint for the central bank so that there can be a resurrection of unsecured lending between banks, overnight, unsecured lending, so there’s some price discoveries, banks have some incentive. There’s missing markets. There’s both tradeoffs, there’s benefits and disadvantages as well to both approaches, but that’s interesting to hear that perspective. 

Post-GFC Regulations

On your first point, the huge volume of public debt being issued, in your paper, you noted that what complicates that as well is all these post-GFC regulations, Dodd-Frank, that shrinks the capacity of the intermediaries to carry all this debt. Maybe speak to that and how consequential that is as well.

Berner: Yes. Some of it was the ability to carry, some of it was just the ability to transact. One of the things that people have identified, which is being addressed by regulators, is the supplementary leverage ratio, which is designed to be, or was designed to be, a backstop to more traditional capital requirements that use risk-weighted assets as the basis for calculation. The leverage ratio, or the so-called enhanced supplementary leverage ratio, has become a binding constraint for some firms, and the result is that they become less interested, they become disincentivized to intermediate in low-risk activities, one of which is repo. It’s generally thought to be low-risk, particularly in Treasury collateral. You see the banks pulling back from that. 

Generally speaking, as well, I think the system of liquidity regulations that was put in place, which were designed to make the institutions more resilient—things like the liquidity coverage ratio says you have to hold a certain proportion of high-quality liquid assets in order to cover 30 days’ worth of transactions in a very complicated calculation of your exposure—that too means that there can be some hoarding of liquidity by institutions.

Each institution has to hold sufficient liquidity, and if markets are not functional and everybody’s hoarding it, then that means there’s less to go around for the people who don’t have it. Again, that means the central bank is going to step in. The safety valves for that process are, first, that the people can go to the Fed if they have reason to do so, but sometimes people are reluctant to do that. They may find it less costly and more convenient to go to the federal home loan banks, which they’ve done, and that’s another source of liquidity and stress.

To address these problems, the Fed set up a standing facility, the Standing Repo Facility, which was designed to help provide liquidity in the repo market. Because that was set up under the authority of the Federal Reserve Act, it had to be connected to monetary policy, and so it had to be connected to the counterparties who were engaged in monetary policy or maybe some of the primary dealers in Treasury debt who were engaged in repo activities. That limited the scope of the extent to which the SRF could be used to alleviate liquidity constraints.

Along the way, instead of doing one daily transaction in the SRF, the Fed has started doing morning and afternoon transactions. Some firms have started offering repo on an intraday basis in order to alleviate some of these constraints. If they have a lot of collateral with which they can do repo transactions, that may be helpful during the course of activities during the day because sometimes the stress occurs late in the afternoon when it’s past the time when the traditional activities have taken place. All these things are useful in addressing the problem, but if the fundamental issue is a lot of debt, not that much capacity to intermediate it, then either we address it with fiscal policy and get back to fiscal sustainability, or we increase the capacity to intermediate it, and relaxing the supplementary leverage ratio has been one of the things that has done that.

We also should probably take a good, hard look at our liquidity regulations, because in a stress period, it’s useful to have high-quality liquid assets. The problem is what was designated as HQLA may not be so liquid in periods of stress. Silicon Valley Bank found that out in 2023 when they had a lot of either mortgage-backed securities or Treasuries on their books, but they didn’t want to sell them because they declined in value as interest rates went up a lot. They didn’t prove to be very liquid at all. That mismatch became much more pronounced for that institution. Of course, they had their problems on the other side of their balance sheet with uninsured deposits, from which many of the depositors just yanked their money out in a very short period of time. 

When you start looking at all the pieces of the system that we put in place, some have had unintended consequences. Some have not really addressed the fundamental problem; they’ve addressed the symptom rather than the problem. Addressing the fundamental issue from a systemic or a system-wide perspective is something that we really have yet to do. That was the point that I tried to make in the paper on fragile liquidity.

Beckworth: Yes, those are all great points. I agree with you wholeheartedly that the fundamental issue is our primary deficits that we continue to run. We’ve got to rein those in, but I also understand the practitioner, the policymaker’s dilemma. They’ve got to also manage monetary policy, control interest rates. They’ve got to be pragmatic about it, make these changes to their facilities and the tools they have with them. 

Berner: Let me add one more thing, if I could, David. 

Beckworth: Sure.

Berner: That is, our current Treasury secretary has taken a strategy, instead of spreading issuance across the curve, has continued to focus, as his predecessor did, on issuing at the short end of the curve. Part of that’s on the anticipation that short rates are going to come down, which will reduce the cost of servicing the debt. Typically, the way the Treasury has issued debt is to be regular and predictable across the maturity spectrum so as not to incur a rollover risk in the future for the taxpayer and to keep those segments of the curve all across the curve as liquid as possible because they’re used for hedging, they’re used for benchmarking the pricing of other securities and so on.

Having a deep and liquid Treasury market is one of the things that Alexander Hamilton wanted to do when he first started issuing debt. He said we want to make it safe and sound and trustworthy. If you pack a lot of the issuance at the front of the curve, that may help you in the short run, but it may not be helpful over time. We’re going to see what the outcome of that looks like. I think that having lots and lots of bills, that may be viewed as beneficial, but it may also create distortions in money markets, which again has its own set of problems.

Beckworth: Yes, absolutely. The danger is that these primary deficits at some point will cause a shock to inflation expectations. Inflation will go up. Rates will have to go up as well to accommodate that. Then we’re stuck with a bunch of T-bills that get repriced really high, and the government has a bigger tax bill than it otherwise would.

Berner: And quickly.

Fiscal Dominance

Beckworth: Yes. That’s a real possibility. Since we’re on this, I want to jump ahead to something we were going to talk about later, but fiscal dominance in general. This is what we’re touching on here. Janet Yellen had a recent talk at the AEA meetings. She actually brought this up, which was really interesting, maybe even surprising for a former Fed chair to acknowledge this concern, because typically they won’t say this is a concern. In fact, they probably should never say it’s a concern because otherwise it would indicate they’re losing control.  

She brought this up, and she did say in her talk we’re not there yet, but man, all the warning signs are there. The list I would include would be the increased Treasury bill issuance. You just mentioned that. You rely on that more and more. That’s one sign. Some others, you mentioned the tweak to the supplemental leverage ratio. Why do we have to do that? Because we’re issuing so much debt.

Stablecoins—I like stablecoins. I like the GENIUS Act, but one of the big arguments given for it is it will be a source of extra demand for Treasury bills and Treasury debt. President Trump’s call for interest rate cuts. Why was he doing that? Initially, it was to lower the interest bill on the federal debt. You see all these warning signs on top of the dire outlook from the CBO. What are your thoughts on fiscal dominance and what it would mean for the financial system?

Berner: Most fundamentally, we economists, many of us have worried about our unsustainable fiscal path for decades. When I was at Morgan Stanley, I wrote something called “America’s Fiscal Train Wreck,” and that was in 2004. That was a while ago. Obviously, things have only gotten worse since that time. We haven’t reached a tipping point yet on that score, primarily because when you think about it, we still are, relatively speaking, the most liquid, the deepest, and the most trustworthy Treasury market, sovereign debt market, in the world. That’s why the dollar continues to retain its reserve currency status. It’s why Treasuries continue to be the benchmark for pricing securities in the global financial system. 

We’re lucky in that respect, but those things may not last forever, and we have no idea exactly when we might reach the point of slipping away from that. My view is that it won’t happen suddenly, that it will happen gradually. There is some research, a paper by Arvind Krishnamurthy, by Ken Rogoff, and others, who have started to detect a decline in what’s called the convenience yield on Treasury debt, which is the extra premium that investors are willing to sacrifice in order to hold Treasury debt because they think it’s a safe asset. It is the benchmark safe asset. If that starts to erode, then the convenience yield goes away. 

Obviously, that’s going to have implications for yields overall. They’ll go up, as you described. When that happens gradually, and people start to see alternatives, then we may see less interest and less attractiveness in buying Treasury debt. There’s not a lot of sign of that. Central banks around the world who have reserve portfolios, particularly China, have been moving away from Treasuries gradually over time. Given that they’ve got huge reserves, it makes sense for them to diversify their reserve portfolios. 

If we look around the world, we see that fiscal issues are starting to play a role, as they did in the European sovereign debt crisis, but more gradually in countries like France and the UK, where the fiscal situation is unattractive, where the growth to support the issuance of debt is just not there. UK is struggling. France is not doing much better. You’ve seen a widening of their yields over other sovereign debt yields in response to that, as investors start to worry a little bit about the risk. I think that’s a cautionary tale about what might happen here. It doesn’t mean that even if they have problems, we will follow automatically, but I think that’s something that we ought to pay attention to. That’s the fundamental issue.

Then, of course, the temptation for governments who are faced with debt that becomes more difficult to finance is to inflate its value away. To the extent that the central bank is urged to do that, then that becomes a problem. Now, in 1951, we moved away from an environment in which the central bank in the United States, the Fed, was required to help finance the debt by making monetary policy more independent. That so-called accord has prevailed since that time, but it doesn’t mean that it’s going to persist forever if people feel like this is a change worth making.

Beckworth: Yes. Something else you bring up in your article about global liquidity is the role of dollar dominance, which is tied into this point. I’ve always been skeptical when people say, “Oh, this is it, the dollar’s days are numbered,” just because there’s no one else who can compete on scale with dollar assets around the world.

You mentioned Europe. That may be why this can go on a long time before we actually do truly hit fiscal dominance. I look at the 10-year Treasury yield, it’s not that far above 4%, given how bad the outlook is, the list of things I went over. In fact, I’ve gotten pushback, “Oh, David, you worry too much about fiscal dominance. Why isn’t the Treasury market? Are you smarter than the Treasury market?” No, I’m not. I have to concede that point.

Maybe one of the things is what you just mentioned is there’s not a good alternative. A question I have for you is, as we look to Europe—and they might be one place that could provide an alternative safe asset to Treasury bills, but we don’t see that happening—one country would be Germany. I guess my question, when you look around the world, is it really just a matter of we are the prettiest pig in the pig pen? There’s no good alternatives, even if they wanted to issue safe assets?

Berner: Well, you look back in history and you see what happened in Japan. Japanese government bonds, or JGBs, used to be trading at very low yields, high prices, because they were mostly bought by Japanese pension funds and Japanese residents. When you lived in an environment of deflation in Japan, those yields looked pretty attractive in real terms. Japanese savers wanted them, and everybody tried to say, “These yields are ridiculously low, I’m going to short this market. Yields are going up, prices are going down.” Those people got carried out on those trades.

There’s an important change going on in Japan. Inflation has gone up a little bit. The Bank of Japan is faced with raising interest rates. They’re the only central bank recently that’s been raising rates among the large central banks. That’s because they want to normalize their interest rate structure in line with what’s happening in inflation. It’s meant that JGB yields have gone up considerably in the process.

We haven’t seen dysfunction in markets as a result. In Japan, where the debt is 200% of GDP, again, you start to think about, “Okay, what happens when inflation and large debt and deficits relative to the size of the economy start to weigh on investor sentiment?” and see what happen. I think that change in the global environment is something worth watching.

Beckworth: We can’t rest on our laurels. We need to be cautious, forward-looking, and encourage our policymakers to make those tough tradeoffs, those tough choices when it comes to our budget.

Berner: No sign of that lately, right?

Beckworth: Right. Now, before we move on to another area, I do want to ask just one more question about liquidity. You talked about this repo facility. I want to go back to that. One thing that has not happened yet, although there’s been a lot of talk about it, like in the Fed minutes, speeches, and talks, is to use central clearing there. That would open up more counterparties because, as you mentioned, right now it’s limited to primary dealers, deposit institutions. Do you think that’s what’s necessary to make it really pack a punch?

Berner: I think that would help a little bit. Remember, if you use central clearing, what it does is it mutualizes the counterparty risk so that people don’t have to worry about that as much. The netting of balance sheets that you achieve through central clearing can help. President Logan at the Dallas Fed has been a particularly vocal proponent of that idea. I think it’s fine to do it, but I don’t think it’s a panacea for expanding the use.

What we’ve seen, which people, let’s call it a year ago, were making light of, was at the end of quarters when people needed to address what was going on in their balance sheets and when liquidity was more plentiful. At the end of quarters, that changed and so people were making much more use of the SORF, which is fine. After all, that’s its purpose. The question is, is that an indication of stress?

I would take not just the usage, but I would also say, let’s look at how SOFR rates and the preponderance of SOFR rates are behaving relative to other repo rates, relative to the Fed’s benchmark rate, whether it’s the funds rate or the interest on reserve balances. We should look at those spreads and see how they’re behaving. At some points, like the third quarter of last year, we saw a pretty substantial widening of those spreads, which indicated some liquidity stress.

If the Fed comes in and addresses it, again, that’s fine. If it’s short-lived, that’s fine. I think we should think about those things as canaries in the coal mine or indications that there’s more stress there than people have discussed in the past.

Private Credit

Beckworth: Okay, well, let’s move on to another area that you spent a lot of work on, and that is private credit, the growth of nonbank financial intermediaries providing funding as opposed to traditional banks. In fact, you had a conference at your Volatility and Risk Institute last year on this very topic. We’ll provide a link to that. I went to it and I looked at your agenda, a lot of big names there, so imagine some really interesting conversations. Maybe spell out for the listeners who don’t know, what is private credit and why has it become such an issue?

Berner: Private credit has, in part, grown substantially because the private credit firms are not regulated the way that banks are. They’re very different from banks. They don’t have capital requirements. They may prudentially, on their own, hold reserves against redemptions, but they limit the redemptions that investors can take. If we look at certain private credit activities, they require their investors to surrender liquidity in exchange for getting perhaps higher returns.

I think there’s a lot of merit to a world in which you can have both private credit and publicly traded debt because private credit tends to be by virtue of the way that the issuers behave, it tends to be more patient capital, so it may be suited for longer-term investment needs, infrastructure and other things. It also is not subject to a whole bunch of disclosure requirements. It’s not traded from minute to minute.

If you’re a private credit investor, you do give up the liquidity in that asset, but you can achieve, potentially at least, better returns, adjusted for risk, other kinds of risk, because the private credit manager is typically very involved with the borrowers. They can mutualize some of the risk because they will invest in portfolios of assets that are beneficial for mutualizing credit risk and counterparty risk.

In normal times, I would say, the functioning of these markets can be very beneficial. I think a couple of things to take note of. One is that because the growth of private credit has been the response of heavy regulation, I’ll call it that, or higher regulations, particularly with regard to capital requirements, in banks relative to other kinds of institutions, you’ve gotten regulatory arbitrage that has moved assets off the books of banks.

Banks have become more originators, syndicators, and they’re not so interested in holding those assets on their balance sheet as they might have been in the past. In fact, a lot of the banks have gotten together with private credit firms and said, “Let’s work together to optimize our balance sheet.” Think about how we can originate, we can distribute, and in the origination process, we assess the creditworthiness of the borrower. Then you’re good at managing the assets. We’re going to shift the assets to you in a transaction that exchanges that for a price. The private credit manager then manages those portfolios. 

Private credit also originates lending to firms directly. In both senses, it can be beneficial for the right kind of borrowing. The problem arises, of course, when there’s stress and the private credit folks are funding their portfolios. There’s the same kind of liquidity and maturity transformation going on with them, in part, and their investors may want to redeem.

Of course, what we’ve seen in real estate funds is the redemptions have been closed off. They put up gates and they limit the extent to which the investors can redeem. It’s worked out okay when the stress passes, but it’s an indication of the fact that there’s just less liquidity in the private credit transaction than there is in other kinds of publicly traded markets. The other thing is that sometimes the banks who are shedding these assets to the private credit firms will then actually turn around and provide the liquidity, the lending, to the private credit firms.

In fact, when you look at bank balance sheets from say the Y14, which is the Fed’s source of detailed bank data beyond the call reports, that they use for stress tests, you see that the growth to nonbank financial firms on the asset side of bank balance sheets has been extraordinarily rapid, virtually doubled in the last six or seven years. That speaks to the growth of private credit, and it also speaks to the extent to which the differences in regulatory requirements are influencing the way that people organize their business model.

My colleagues Viral Acharya, Bruce Tuckman, and a guy at the Fed, Nicola Cetorelli, have a very good paper of a couple of years ago basically talking about where banks end and nonbank financial intermediaries begin. That line has been blurred over time by virtue of these activities. I’ll mention one more thing, and that is particularly in Europe but also here in the United States, even if they are not getting together and formalizing this sort of optimization of the balance sheets, sometimes the banks, in order to reduce their capital requirements, will do credit risk transfers or synthetic risk transfers, sometimes called systematic risk transfers. Effectively, they do the same thing but more like a repo. In other words, they’ll transfer the risk, and then it may come back when the securities mature. Or they may transfer it, and there are questions about the transparency of those transactions and whether or not the transfer genuinely involves risk. 

Or it may be that, again, the bank turns around and actually lends to the firm with whom they’ve done the SRT or the CRT, creating a circular relationship between them and really making it clear that while they move some assets off the balance sheet, they increase their liabilities to these guys, so their exposure to them has not been made clear, and they may be even more exposed to the private credit firm. If there are issues with the assets that they transferred, then the bank is going to get some blowback from the problems in that regard.

Beckworth: A lot of interlocking balance sheets here is what you’ve just described. This sounds a lot like what we learned in 2008, shadow banking, or they said shadow money creating. Is this just the more current version of that, aided and abetted by regulations after the Great Financial Crisis?

Berner: I think in broad terms, you could say that it is. Each situation is different. This more institutionalizes what was being done with special purpose vehicles and funds. Those were very opaque because they were setting up hundreds of them in the Global Financial Crisis or before it. People really didn’t know whose assets were involved or whose liabilities were involved.

That characteristic may also be true of some of these activities, where you’re not quite sure where the risk really lies. That’s part of the issue. If I’m an investor, I want to know where’s the risk and what risk do I own, and am I getting paid for that risk?

Beckworth: If we look at private credit, and again, you just described all these connections and linkages back into the banking system, the financial system, should we be worried? Is this a big enough issue? Maybe it’s a small issue, but the connections are so important that it could trigger something larger. How do we think about it?

Berner: It could trigger something larger when something is growing rapidly and it becomes very popular and enables people to make a lot of money. In good times, normal times, that’s fine, but it’s something that you want to keep an eye on and think about what some of the risks involved are. There’s been a lot of work done not just on private credit, but also a lot of the lending by the banks and by others to funds that are doing leveraged transactions.

Again, it’s the use of leverage that really is part of the key to making this riskier that is something that we need to keep an eye on. There are hidden aspects to the leverage. Sometimes you don’t see all the things that are going on. If it’s all out there and it’s exposed and reported and declared, that’s one thing. In the wake of the financial crisis, the SEC and the CFTC required hedge funds, private funds, commodity pool operators, and others to report, depending on their size, at least on a quarterly basis, what their holdings look like and what their risk in those holdings look like.

There were lots of flaws in the way the data were collected, but in principle, the idea was a good one, which is to have more disclosure for large funds who would be the most likely to create some problems if they’re heavily leveraged and subject to shocks. The private credit firms are not part of that nexus. They’re not required to report under that rule. If they were, then we’d have more information and we could really probably better assess what’s going on.

Beckworth: A big issue here is that we simply don’t know the extent of what they’re doing, the connections. How are regulators to handle that? Do we go back to the OFR and say, “Hey, get us some more information,” or does Congress need to act? What do you see as the next step forward?

Berner: You’re going to need some legislation that says, “We should be collecting information about this,” and then you’re going to need some rules that come out that give people the authority to go collect the data. The FSOC, for example, could say to the OFR, “Go collect data on these guys,” but you’d have to have a purpose. When the data were collected for bilateral repo, the purpose was voiced really straightforward and very clear.

In this case, you’d have to have the purpose well defined so that the OFR would know what it had to do, and the SEC could participate, and others could participate in this. The OFR could collect the data on behalf of the SEC and others. You can include an informed PF, which is the private funds, if you expanded the definition of what a private fund was. It’s always the case that you need the authority to do that, and that doesn’t exist at the moment.

Banking Turmoil of 2023

Beckworth: Dick, as we wind down this show and come near its end, I want to go to an area that you’ve also worked on, and that is the banking turmoil of 2023. We all know SVB, Silvergate, an exciting time. How do you see that experience, and what are the lessons we can draw from it?

Berner: I think that experience represented a failure of risk management at the firms that were involved. They really did not manage well the risk that they had. You had big declines in asset prices. You had firms like SVB that had accumulated a lot of assets, whose prices fell when interest rates went up a lot. You had SVB on the liability side of their balance sheet with a lot of large depositors that were uninsured. We know that uninsured deposits are very runnable.

That was a recipe for problems when interest rates didn’t come down and when they stayed higher or went up further. The risk management aspect was important. The supervisory aspect also was important because the supervisors had identified the problems with these institutions, but they failed to take action to force them or to compel them to correct that. I think primarily those were the two failures.

What are the remedies? We outlined some of those in a book that we did in the summer of 2023. I think those remedies really involve paying more attention to risk management, having the supervisors really requiring the firms over whom they have jurisdiction to pay more attention to risk management, particularly when it comes to things like interest rate risk and market risk, which for banks people hadn’t paid that much attention to but which became very important when we issued all this sovereign debt.

When the Fed expanded its balance sheet, and the counterpart of expanding bank reserves was that you had a lot of deposits that went into the banking system, a lot of those, at Silicon Valley Bank at least, were uninsured deposits. The nexus of issues surrounding that, the macro issues, the supervisory, the risk management issues, were really important.

There are a couple of other things that I mentioned earlier that were important. One is our deposit insurance system for small depositors has worked quite well. Where we saw shortcomings, and people have started to talk about reform here, is for firms that have large periodic payments like payroll, for example, and they need to keep millions of dollars in their accounts while they accumulate the cash to make the payroll every two weeks. Those need to be addressed, and there are some other aspects of the deposit insurance system that need to be addressed.

The second thing that needs to be addressed is, there’s been a lot of talk about how, after 2018, there was an attempt to tailor in the banking act that passed at that time, to tailor regulatory requirements and supervisory requirements, like stress testing and so on, more in line with the size of the institution. The flaw in that is that size is not always a good proxy for risk. We saw that these were medium-sized regional banks. They weren’t the globally systemic banks like Bank of America, J.P. Morgan, Wells Fargo, et cetera, but they were big, and they were growing fast. Particularly, SVB was growing very fast. 

The speed with which they moved from one bucket of size related to risk was very slow on the supervisory side, even though they were growing fast. The supervisory structure lagged well behind their rapid growth, and they weren’t overseen as well as they should have been. The last piece that I think needs to be addressed in this is, for small banks, if a bank gets into trouble and it has material, financial distress, or if it’s about to go out of business, the FDIC has a way of  “resolving” those institutions.

They close it down on Friday. They open it up with a new management and a new shingle on Monday. It doesn’t create problems. For the financial system, that’s not so easy to do with a larger, more complicated institution. In Dodd-Frank, we put in new resolution authority under Title II of Dodd-Frank, which was called Orderly Liquidation Authority, which was designed to be able to wind down a larger institution without disrupting the financial system.

It’s never been used. It’s never been tested, in part because people are very reluctant to mess around with this, and they’d rather use the more traditional tools, including bailing out the uninsured depositors and so on, and making everybody whole, which is what happened in that banking turmoil. That’s probably not the best way to go about that. The so-called BTP, the Bank Term Funding Program, was a good remedy to prevent runs on these institutions in the short run, but it created that moral hazard that I talked about earlier, which basically said, “Okay, when things get really bad, the Fed’s going to come in.”

Generally speaking, the banking regulators and supervisors and others across the financial system need to address in a better way how they think about what they’re going to do when things go badly wrong. They need to spell out for themselves, at least, even if they don’t publicize it, what they’re going to do and how to think about, how to plan for bad things happening. So far, we’ve only seen a very limited response to that from that banking experience.

Beckworth: Well, Dick, one last question before we end. This is related to the SVB crisis and actually goes back to our discussion earlier about the supplemental leverage ratio, the tweak that was made to it to exempt Treasury securities. I’ve had conversations with a number of people, including some Fed officials, and they have differing views on this, but one Fed official told me SVB and 2023 is exactly why we shouldn’t exempt Treasuries from the supplemental leverage ratio because we’ve learned that even Treasuries can create problems if there’s this interest rate risk that we need to fund.

Berner: Absolutely. No, look, I agree with that. The other piece that’s in the SLR is reserves at the Fed, right?

Beckworth: Yes.

Berner: There’s nothing more liquid or safer than bank reserves, than reserves at the central bank. Nobody disagrees that we ought to address that issue. You could also be a little more nuanced about the Treasury issue by saying you can exempt Treasury securities with a maturity of up to a year, whose price doesn’t fluctuate as much when interest rates change.

It’s the longer-term stuff that really, where people reach for yield and their prices went down by a lot when rates went up. That’s the stuff that you don’t want to mess with because there’s rate risk in the securities. I agree with that.

Beckworth: Bill Nelson, he’s been on the show a few times, he was at the Fed when they were writing the rule, the leverage ratio rule. He said, “Man, we had no expectation whatsoever that the Fed’s balance sheet would get so large and therefore be so many reserves in the system,” yet here we are. I ask you about Treasuries because I think this goes back to the point made initially, those problems were fundamentally about a business model and maybe supervisory issues, because there were a number of other banks that did not fail.

Maybe you could say it was the Fed’s response, but there were a number of other banks that also had Treasuries and also had interest rate risk and they managed to get through. I guess my caution would be, we shouldn’t be hesitant to change rules or to make rules based on one data point.

Berner: Agree.

Beckworth: Sure, Treasuries were in. I guess I would say, yes, we need to acknowledge Treasuries can create problems, but as you said, maybe tweak it to maybe one year or less. Also acknowledge there’s a bunch of banks that did survive 2023.

Berner: Absolutely. I think that’s why I emphasized the failure of risk management and the failure of supervision as really the big failures in the bank in that banking turmoil. The failure was not so much that we had the supplementary leverage ratio; the failure was in these other things where the banks that did well didn’t have 93% of their deposits that were uninsured.

They didn’t experience runs and they were subject to the same accounting rules that SVB was, but they hadn’t been so greedy about the mismatch that they had on their balance sheet. You put those things together and that’s why a holistic approach is really something that is really needed. It’s a lesson we should have learned after the Global Financial Crisis. We keep learning it over and over again and yet we tend to address these things in a piecemeal way.

Beckworth: With that, our time is up. Our guest today has been Dick Berner. Be sure to check out his work at the Volatility and Risk Institute at NYU. Dick, thank you so much for coming on the program.

Berner: Thank you. I look forward to maybe another engagement.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth, and follow the show @Macro_Musings.