Brad Rogoff: Welcome to The Flip Side. I'm Brad Rogoff, Head of Research at Barclays, and I'm joined today by Pete Troisi, our financials analyst in investment grade research.

Pete Troisi: Thanks for having me on, Brad.

Brad Rogoff: Good to have you here, Pete. There's a lot we can talk about when it comes to financials right now. I know you've spent probably the last week or so talking about what banks will do with respect to adding more safe assets, potentially as a result of the changes The Fed is proposing with respect to SLR. It's made a lot of press, but for those who haven't seen it, supplementary leverage ratio is what I'm referring to there. And those changes are really just some post-GFC era banking rules that should help free up demand for namely, treasuries probably. But what I want to talk about is something that's been the result of other changes to capital rules that also came out of the financial crisis.

Pete Troisi: I think you mean your favorite topic these days, Brad. The rise of non-bank financial institutions, or NBFIs, as we often call them.

Brad Rogoff: Absolutely. And it sounds cool, “the rise”. So these days, I don't actually get to do much writing of Research. So I was very pleased when you let me contribute to your work on this particular topic.

Pete Troisi: Yeah. And I feel like the topic in financial markets that's really the most intriguing these days is, of course, private credit, and your expertise there was really helpful with this report. The common narrative here is that private credit is equal to disintermediation of banks, and of course, there's competitive tension between the two. But as it turns out, this isn't a zero-sum game. Banks can provide capacity to help the private market grow and actually earn a pretty good return on their capital by doing it. The category of loans in the banking system is now what is commonly referred to as NBFI lending, in which non-bank financial institutions, not banks, provide loans to borrowers such as main street businesses and consumers.

Brad Rogoff: And this is what I would call the paradox of NBFI lending. So banks are effectively helping their competitors by providing them with funding. For someone working in a bank, that sounds a little weird to say, but NBFIs then use the cash to extend loans to companies that historically have borrowed from banks. It doesn't sound like a sustainable strategy. To me, it sounds more like risky regulatory arbitrage. If that's done on a small scale, at least I don't think it's problematic, but I would get worried as it grows. How much are banks getting displaced by non-bank lenders now?

Pete Troisi: Look, there's no question that regulations have contributed to the decline in traditional forms of bank lending, such as commercial and industrial loans, which we refer to as C&I lending for many years. And this has pushed some lending activity outside of the banking system. Now, this trend has grown the stock of NBFI loans outstanding to over $1 trillion, exceeding 10% of total loans in the US banking system as of the end of March. So in a sense, indirect lending is replacing direct lending where NBFIs are better able to compete.

Brad Rogoff: So a lot of the $1 trillion you referred to is in the private credit area that you also mentioned earlier. NBFIs, in my opinion, have a lot of advantages over banks when it comes to lending in this arena. And I want to talk through those. So first, there's linkages to private equity sponsors, which give many NBFIs preferred access to loan origination pipelines. Increasingly, this is replacing the credit opportunities generated by banks through their branch networks. In addition, structural shifts in the credit market have worked to the advantage of NBFIs.

So innovations such as portfolio trading have reduced the need for liquidity premiums in public securities and have made private illiquid credit more attractive for buy-and-hold investors. Example being insurers. This is what we refer to, at least here at Barclays, as the equitification of credit, and it's contributed large part to the growth of NBFIs. Now, obviously, I don't need to remind avid listeners of The Flip Side about the trend since they all remember Zornitsa Todorova's thoughts on the debate, which she clearly won based on the trends we've seen since then in Episode 63 last summer.

Pete Troisi: Of course, and as an avid listener and Barclay's employee, I do remember that episode. But I want to come back to the trends you just mentioned. It sounds like you're admitting it's not just pure regulatory arbitrage that's leading to these changes.

Brad Rogoff: It's never that simple, Pete, but it is a huge factor. Think about it from the borrower's perspective. NBFIs may be able to offer them more flexibility on terms, structures, and leverage. Regulations post-GFC have become much stricter with how much leverage banks can provide to their customers. NBFIs don't face these constraints or other such side effects of prudential regulation.

Pete Troisi: Okay. So you've made the point that non-banks have some advantages over banks in making these direct loans, but the financial system has evolved. And NBFI lending is a way that banks are changing with it. They're no longer the only major participants in credit origination. NBFIs like private credit funds, business development companies, or BDCs, even insurance companies they've all stepped in to meet growing demand. Rather than competing head-on, banks have adopted by lending to these institutions.
This isn't a retreat. It's really a strategic pivot. By lending to NBFIs, banks can maintain exposure to credit markets while improving capital efficiency. These loans are often structured as senior exposures, meaning the bank is protected by a layer of subordinated capital that reduces risk and regulatory requirements, boosting return on equity. Frankly, it's a smart way to stay profitable in a competitive environment.

Brad Rogoff: We're not going to debate the logic behind this. Actually, totally understand the logic, but I think it's a dicey strategy. When banks lend to NBFIs, they're adding a layer of separation between themselves and the ultimate borrower. That distance makes it harder to assess the true risk in the system. Sure, loans may be senior, maybe collateralized, but if the underlying borrower's default en masse, even senior tranches can suffer. I made the point that NBFIs aren't subject to the same regulatory scrutiny as banks. They're likely providing more leverage into the system than banks, and some of it's through payment in kind or PIK interest, where the borrower can issue more debt instead of paying cash interest. These are macro risks that banks are indirectly enabling by funding NBFIs.

Pete Troisi: That's a fair concern, but I think it might be underestimating how carefully these deals are structured. Banks aren't just handing out money and hoping for the best. They apply haircuts to the collateral that they're lending against. They impose covenants. They also limit exposure to riskier assets such as the PIK loans that you mentioned, Brad. Plus, NBFI loans are often diversified across multiple borrowers, and that reduces idiosyncratic risk. And let's not forget the economics here. Banks can earn higher spreads on these loans compared with traditional C&I lending while holding less capital against them. That's obviously a powerful combination, especially because competition is high and regulatory capital is expensive.

Brad Rogoff: You've referred to capital efficiency of NBFI lending a few times now. To me, that sounds a bit like fancy language that really makes my point about regulatory arbitrage.

Pete Troisi: Well, I think about this as a term that I'm going to use air quotes for "equal capital for equal risk. " Banks are required to risk-weight assets when they calculate their capital requirements. Now, in the US, most commercial loans get 100% risk weight. However, NBFI loans are eligible for much lower risk weights as low as 20%.

Brad Rogoff: That doesn't sound fair.

Pete Troisi: Understandable comment, Brad. And so let me just clarify. The lower risk-weight asset density of NBFI lending reflects a number of factors, including the higher collateral requirements that I've been mentioning. Now, this allows banks to take senior exposure to a relatively diversified pool of assets with a defined amount of equity beneath them to absorb loss. As a result, the loan-to-value associated with NBFI lending is relatively low and that attracts lower capital. Now, that's the denominator effect on ROE, but the numerator matters too. Through NBFI loans, banks provide leverage to non-banks that help them meet their return hurdles and can charge for it accordingly. Given these dynamics, the ROE on NBFI loans can be three times the return on a standard commercial loan.

Brad Rogoff: So it's numbers like that that actually concern me. The pursuit of higher returns with lower capital charges eerily reminiscent to the pre-2008 era, which I remember all too well. Back then, banks loaded up on senior tranches of mortgage-backed securities convinced they were safe because of their structure and ratings. We all know how that turned out. The problem isn't just the structure. It's the systemic risk that builds up when everyone's doing the same thing. If NBFIs face liquidity crunch or a wave of defaults, the banks that lent to them could be hit hard. And because these exposures were often opaque, concentrated among a few large counterparties, the contagion risk is also real. It's not just about individual loan losses. It's about the potential for a broader financial shock.

Pete Troisi: I hear you. But I think the comparison to 2008 is a bit overstated. The underlying assets today are different. Secured corporate loans, not sub-prime mortgages and the regulatory environment is much stronger. Banks hold more capital. They conduct regular stress tests and have better risk management tools. Also, senior exposures banks take on today are often protected by substantial equity cushions, sometimes 40% or more on loans to NBFIs. That's close to the attachment points on triple A CLO tranches, which performed well even during the financial crisis. So while there's always risk, Brad, I'd argue that the current structures are far more resilient than what we saw in the past.

Brad Rogoff: Resilient maybe, but non-immune. And the bigger issue is the growing interconnectedness between banks and NBFIs. As banks lend more to those institutions, they become more exposed to the health of the non-bank sector. If a few large NBFIs stumble, the effect could ripple through the banking system. That's especially worrisome given how concentrated some of these relationships are. Banks may be diversifying across asset classes, but they're still relying on a relatively small number of counterparties. And if those counterparties are under-regulated and contributing to over-leverage, that's a recipe for trouble.

Pete Troisi: So you mentioned interconnectedness. I do think, though, that the systemic risk of NBFI lending is relatively contained despite the significant growth of the asset class in the banking system. The Fed actually acknowledged this as well by adding exploratory analysis on top of its usual stress tests this year with respect to NBFI lending. It concluded that large banks are generally well-positioned to withstand significant credit and liquidity stresses to major categories of NBFI lending exposures.

The model generated about a 7% overall loss rate on NBFI loans at the subject banks and through the nine-quarter projection of the stress model, total loan losses from NBFI exposures were about $490 billion. Now, I appreciate that sounds like a large number, but that's actually fairly modest from the perspective of an extreme stressed scenario in the model considering the current capital ratios of banks.

Brad Rogoff: My concerns, though, are less about the current systemic risk of NBFI lending. At this stage, they very well may be small, but they will grow with the size of that lending. Loans to NBFIs are increasing the amount of leverage in the financial system. More overall leverage means that less severe shocks can cause greater losses. Increased use of the leverage provided by NBFIs could eventually increase the probability of a shock large enough that causes correlated losses and thus affects banks to a point where the capital backing those loans is no longer sufficient.

Pete Troisi: I don't think I'm being too complacent with the structure of NBFI lending and overstating the benefit of over-collateralization, banks are getting on the loans

Brad Rogoff: Overall, I agree, but we need to think about what it would take to get into the part of the tale where NBFI lending becomes a problem. I mentioned PIK loans earlier. Often, these PIK features are used to avoid or delay default. As more of the pool picks, the volatility of the realized losses increases, given the potential for lower recoveries. This shift from potentially lower defaults to lower recoveries raises the probability that the banks could take losses on their second loss piece.

Even then, I do understand your point on corporate lending having a long history and the better performance of things like CLOs versus mortgages, but banks are already showing signs of venturing further afield. And here's where my concerns get a lot larger, and SRTs are a prime example of that.

Pete Troisi: Okay. So now, you've decided we're going to get into full alphabet soup in this debate.

Brad Rogoff: There's no way I can leave that stone unturned. So SRT, that stands for significant risk transfer. It's a concept similar to what we have been talking about with respect to banks lending to NBFIs, where they maintain the senior portion of the loan, and others take the riskiest part. Except this time, the banks have made the loan and are now trying to offload some of the risk. Once again, regulatory factors are at play here. I bring this up because SRT transactions are not just about corporate loans. The underlying are often consumer loans.

Pete Troisi: So here's another acronym, Brad. SRTs are a way to translate RWAs or risk-weighted assets into something that attracts less capital. So in the US, we first saw banks using SRTs primarily with consumer loans. So I'll use that just as an example. Let's say a bank originates a pool of auto loans in the US. Those banks get 100% risk weight, but by transferring the first loss exposure to those loans to the SRT investor, the RWA associated with the loans drops dramatically by as much as 60% to 75%, depending on the attachment point of the SRT.

Brad Rogoff: Now, this is starting to get closer to those mortgage loans, which you admitted cause problems in the financial crisis. Also, it doesn't stop at consumer loans. There have even been transactions where loans to NBFIs are included in SRTs as the concentration of those risk increases for banks. So I guess it's a positive for banks that they can lay off these risks, but I'm starting to lose track because it sounds like that's leverage on top of leverage, on top of leverage. Not my favorite recipe in markets.

Pete Troisi: Definitely fair comment, Brad, but I just want to talk about both sides of this. There's no question that referencing NBFI loans in SRTs creates circular risk because the biggest investors in SRTs tend to be non-banks. But consider the motivation for such a transaction from the perspective of the bank. I have argued that NBFI loans can be both lower risk and higher ROE for the banking system. So it seems counterintuitive that banks would offload exposures that offer those benefits into the SRT market.
Well, one reason why they might do that is to create balance sheet capacity to do more NBFI lending. And one question we've been asking ourselves is, given how quickly NBFI lending is growing, at what point will banks have too much exposure to the asset class in absolute or relative terms? Now, that's probably a debate for a separate podcast, but safe to say, with outlets such as SRT still available to banks, that could help them continue to grow NBFI portfolios as they replenish their capacity.

Brad Rogoff: I agree. We've probably bit off enough for this podcast. Financial innovation often outpaces regulation, and we've seen time and again how that can lead to unintended consequences. I'm not saying banks should avoid NBFI lending, but they need to be cautious, transparent, and proactive in managing the risks. Stronger oversight, unlikely to come from regulators anytime soon. So it'll require a willingness to pull back if the risks start to outweigh the rewards, as this lending migrates to asset classes without the robust history of corporate loans.

Thanks for listening to this episode of The Flip Side. Please don't forget to subscribe if you like what you hear, and clients of Barclays can learn more about the topic by reading our recent research, Risk and Opportunities of NBFI Lending.