How Regulations Meant to Make Banks Safer Fueled the Rise of Private Credit

In the wake of the 2008 financial crisis, regulators implemented a suite of new rules aimed at making the banking system safer. A recent research paper from the Bank for International Settlements (BIS) sheds light on an important, and perhaps unintended, consequence of these reforms: the explosive growth of the private credit market.

The study reveals that post-crisis liquidity regulations, specifically the Liquidity Coverage Ratio (LCR), have been a major driver of the shift in lending away from traditional banks and into the hands of non-bank lenders, such as private credit funds. Here are the key takeaways I noted after reading the research paper.

The Scale of the Shift: Private Credit Growth

The chart below illustrates the dramatic growth of loan assets held by non-bank financial institutions, a key proxy for the private credit market. The steep and sustained rise, particularly in the years following the adoption of the LCR (2014), visually captures the trend analyzed in the BIS research paper.

The Great Lending Shift

The core finding of the paper is clear: in areas with a heavy presence of large banks subject to the LCR, private credit volumes grew significantly more than in other areas.

When the LCR was introduced, it required banks to hold more high-quality liquid assets (HQLA). To meet these requirements, banks scaled back on holding illiquid loans for small and mid-size firms. This created a vacuum in the market, which private credit funds swiftly stepped in to fill.

The study used the leveraged loan market as a control group to prove this point. Leveraged loans are typically originated by banks but then quickly sold off to other investors, so they don’t weigh on a bank’s balance sheet in the same way. The research found that this market was unaffected by the LCR. This contrast reinforced the conclusion that the growth in private credit was a direct result of regulatory constraints on banks’ own balance sheets, not a general increase in loan demand.

A Safer System, Or Just a Different One?

A central question raised by this shift is whether it has truly made the financial system safer. The paper suggests that from one perspective, the answer is yes. However, it also supports a more nuanced view: risk rarely disappears; it simply moves and changes form.

On one hand, the shift has likely reduced a specific type of vulnerability. Private credit funds are typically funded by long-term capital from investors, which is locked in for years. This is a much more stable funding source for long-term, illiquid loans compared to a bank’s short-term deposits. This better matching of assets and liabilities reduces the “maturity mismatch” risk that makes traditional banks vulnerable to runs.

On the other hand, this doesn’t mean risk has vanished from the economy. As many have argued, the 2008 financial crisis demonstrated that transferring risk away from banks does not necessarily eliminate it. Prior to the crisis, former Fed Chair Alan Greenspan argued that derivatives helped transfer risk to those most capable of bearing it, but he later acknowledged that the crisis exposed a "flaw" in his understanding of how the financial system would manage those risks. The crucial question then becomes whether the non-bank entities taking on this risk are truly equipped to manage it.

Important Considerations for the New Landscape

While the findings are positive in some respects, the paper adds a few crucial caveats that align with this cautious view of risk.

First, this shift does not eliminate systemic risk entirely. The analysis doesn’t fully account for factors like deposit insurance or central bank backstops. More importantly, it highlights the potential for new, unforeseen risks to emerge. For instance, risks can return to the banking system through the back door via the credit lines that banks provide to private credit funds. If these funds face distress, they could draw down on these lines, transmitting stress right back into the regulated banking sector.

This creates a new channel for financial contagion, reminiscent of how derivatives were once thought to distribute risk before 2008 but instead amplified risk throughout the system.

Conclusion

The BIS paper provides compelling evidence that regulations designed to make banks safer have the profound side effect of fueling the private credit boom. This has fundamentally reshaped the world of lending. While the shift may have created a more resilient financial ecosystem by addressing specific liquidity risks, it also underscores a timeless lesson in finance: risk is rarely destroyed, only redistributed. The stability of the system now depends on a new set of factors and a new web of interconnectedness that we are only just beginning to fully understand. 

Inflation Remains Elevated as Markets Price in a December Rate Hike

According to the U.S. Bureau of Labor Statistics, the Consumer Price Index (CPI) increased 0.4% in October after rising 0.6% in September. On a year-over-year basis, inflation now stands at approximately 3.7%, remaining well above the Federal Reserve's long-run target of 2%.

While inflation has moderated significantly from its peak, recent data suggest that price pressures remain more persistent than policymakers would prefer. For the Federal Reserve, the latest CPI report provides little evidence that inflation has returned to a level consistent with its target.

Financial markets have responded accordingly. Current market pricing (as of Nov 10, 2026) indicates roughly a 91% probability that the Federal Reserve will raise interest rates by 25 basis points at its December 9, 2026 meeting.

Given both the inflation data and market expectations, a quarter-point rate increase currently appears to be the most likely outcome. Although the probability remains relatively low, markets are still assigning a small chance that the Federal Reserve could choose a larger 50-basis-point increase if inflationary pressures prove more persistent than expected.

Conclusion

Today's CPI report reinforces the view that the Federal Reserve's fight against inflation is not yet complete. Barring a significant deterioration in economic conditions or an unexpected decline in inflation before the December meeting, the Federal Reserve appears likely to further tighten monetary policy.

The CPI-PPI Gap: More Evidence of a Profit Margin Squeeze

Several weeks ago, I wrote an article titled "Upstream Pressure, Downstream Reality: What the CPI vs. PPI Gap Means for Corporate Profits and the Economy." In that piece, I argued that the growing gap between producer inflation (PPI) and consumer inflation (CPI) suggested that businesses were absorbing a significant portion of rising costs rather than fully passing them on to consumers.

Over the weekend, ZeroHedge published an article by Lance Roberts titled "PPI Vs CPI: Are Record Profit Margins About To Get Squeezed?" that reached a remarkably similar conclusion.

The central thesis of both analyses is straightforward: when producer prices rise faster than consumer prices, businesses face pressure because their input costs increase faster than their selling prices. In other words, someone has to absorb the difference. When consumers are unable or unwilling to pay higher prices, corporate profit margins become the shock absorber.

As Roberts summarizes, “the PPI vs CPI gap says companies are absorbing costs their customers can't afford, and record margins leave very little room to absorb much more."

That is essentially the same conclusion I reached in my earlier article.

What I found particularly valuable in the ZeroHedge analysis was the historical context. Roberts examined prior episodes where producer inflation outpaced consumer inflation by a wide margin and found that “six times since 1950, producer inflation outpaced consumer inflation by 4 points or more. In four of them, the profit share of GDP fell 1 to 4.4 points within two years. The two exceptions had consumers with rising incomes. Today, real hourly earnings are down 0.7%.”

The historical evidence supports a point that I believe is especially important. The PPI-CPI gap alone does not automatically guarantee falling profit margins. The critical question is whether consumers have the financial capacity to absorb higher prices. If incomes are rising sufficiently, businesses can often pass costs through successfully. If incomes are stagnant or falling in real terms, passing through higher prices becomes much more difficult.

This is what makes the current environment noteworthy. We have rising upstream cost pressures, record corporate profitability, and evidence that real wage growth remains weak. If these conditions persist, history suggests that profit margins could come under increasing pressure over the next couple of years.

Conclusion 

I continue to agree with what I view as the article’s most important observation: “Costs can climb for a long time before margins crack. The crack comes when the customer stops paying.”

Time will tell whether businesses ultimately succeed in passing these higher costs on to consumers or whether profit margins absorb a larger share of the adjustment. For now, the PPI-CPI gap remains one of the indicators I am watching closely.

After the Selloff: Has the Market Become Too Dependent on AI?

After the midweek market rout, the Financial Times reported:

"US stocks shed $3.2tn in a day of chaotic trading which saw the tech-heavy Nasdaq 100 plunge 6.4 per cent after Democrats' sweeping midterm election victory upended Wall Street's mammoth AI bet... The market value drop on the S&P Composite 1500 index, a broad basket of America's publicly traded companies, was the biggest since the turn of the millennium... Selling among chipmakers was brutal, with Nvidia, the company most closely associated with the AI surge, tumbling 9.3 per cent, pushing its market value down more than $400bn."

Reading this reminded me of a post-2026 Midterm Election conference I attended, where several market leaders shared their views on the sharp decline in equity markets. One speaker argued that a significant portion of the S&P 500's recent performance has become tied, directly or indirectly, to AI-related investment, particularly in the semiconductor industry.

That observation struck a chord with me. The AI sector has become deeply interconnected with broader corporate spending, investment plans, and market expectations. As a result, I expect that weakness in AI-related industries will not remain confined to a handful of technology companies. In my view, a sustained slowdown would likely spill over into broader market sentiment and potentially affect other sectors as well.

Looking ahead, I suspect policymakers will face increasing pressure to address public concerns surrounding AI, including issues related to privacy, employment, and safety. One possible response would be the development of regulatory frameworks intended to provide greater oversight and clearer rules for businesses operating in the space.

The challenge is that meaningful regulatory efforts often take time. Policymaking, implementation, and compliance do not happen overnight. Markets, however, can move much faster than the political process. If investor enthusiasm for AI weakens significantly before greater regulatory clarity emerges, the adjustment could be painful.

That does not mean an AI-driven downturn is inevitable. However, as AI has become one of the market's primary growth engines, investors will continue to pay close attention to the risks associated with that dependence. The question is not whether AI will remain an important technology. The question is whether current expectations for AI-related growth are sustainable.

The 2026 Midterms: Why Economic Reality Still Matters

As of November 5, 2026 (~5pm), the midterm election results have yielded a net forty-seat increase in the US House of Representatives for the Democratic Party, which puts their total at 252 and 155 for Republicans. There are still 28 seats remaining to be decided. In all likelihood the Democratic Party will end up with a seat count somewhere in the mid-260s after all votes are counted. A similar pattern emerges out of the US Senate: Democrats have secured 54 seats, a gain of seven seats, compared with 44 seats for Republicans. There are 2 seats remaining to be decided. That means that the Democrats will control what happens in Congress. Their legislative agenda should pass with relative ease through Congress, as all they need is a simple majority to pass bills. But when it comes to overriding a presidential veto, they need a two-thirds majority in both chambers (290 votes in the House and 67 votes in the Senate). Therefore, the hurdle increases significantly to achieve the override.

Against this background, it was not surprising that US stock markets went up a lot on the day after the election (e.g., on November 4, the Dow ended the day at 53,356, up 1,520 from the previous day (November 3); and the S&P ended the day at 7,688, up 120 from the previous day). I believe that was the result of expected gridlock (i.e., nothing of meaningful economic consequence will occur) in Washington DC over the remaining presidency of Donald Trump. I also think markets expected that the Iran conflict would materially subside, leading to a continued decline in fuel prices, and thus taming inflationary pressures and future interest rate increases by the Fed. Or so goes the hypothesis, because today (November 5) the Dow, the S&P500, and the NASDAQ closed deep in the red at about 3.45%, 4.47%, and 5.52% respectively.

The equity market’s behavior could be one of those where you “buy the rumor” and “sell on the news”. Perhaps. But I don’t think so. Granted, it has only been a couple of days since the midterm elections occurred, but I view this as a harbinger of a broader recognition that there are deep structural economic imbalances that no Democratic or Republican agenda can fix in one election cycle. Simply examine the US federal debt and you will see that the upward trend has happened across multiple administrations under different parties.

The Austrian view of the economic cycle, which I lean toward, says that artificially low interest rates lead to a misallocation of capital across the economy. That misallocation is what ultimately creates the boom and bust economic cycle. The artificially low interest rates over most of the 2010s, coupled with the massive increase in liquidity after the COVID pandemic, have led to a massive misallocation of capital. In other words, projects that should not have taken place occurred simply because the cost of capital was relatively low.

Conclusion:

In my view, the Democratic Party's control of the US Congress should not automatically be interpreted as a mandate to promote its political agenda. The midterm election results reflect widespread voter dissatisfaction with the Trump administration. I am deeply skeptical that the Democratic Party will do anything meaningful to try to meet the expectations of the voters. I expect they will pursue partisan agendas that will not help steer the economy to where it should be. The truth is that all grand plans must meet economic reality. That is why I like to analyze what is happening in the economy. There are significant economic concerns, whether they are the size of the federal debt, massive increases in AI capital expenditures (capex), or decades-low consumer confidence, all of these point to profound structural issues whose gravity I doubt politicians fully grasp, or about which they have limited ability to do much. But I could be wrong. I hope I am.

Why the 2019 Repo Shock Happened and Whether It Could Happen Again

The repo market is the financial system’s plumbing, a multi-trillion-dollar market where banks, hedge funds, and dealers lend cash in exchange for collateral. In September 2019, this plumbing suddenly clogged, sending short-term borrowing rates spiking from 2% to 10% in a matter of hours. Take a look at the Secured Overnight Financing Rate (SOFR) for the month of September 2019:

Today, many of the underlying structural pressures that led to the 2019 crisis have returned, but with one critical new safety valve installed by the Federal Reserve.

What Really Happened in September 2019?

The 2019 spike was not caused by wild panic or an economic recession; it was caused by rational, regulation-driven behavioral gridlock:

A Perfect Storm Drained Cash: A major corporate tax deadline and a surge in U.S. Treasury debt auctions pulled over $150 billion in cash out of the banking system in just a few days, right as the Fed was winding down its bond holdings (Quantitative Tightening, or QT).

Dealers Needed Cash: Wall Street primary dealers were flooded with new Treasury bonds and urgently needed overnight cash to finance them.

The “Hoarding” Paradox: The four largest U.S. banks held plenty of cash, approximately $1 trillion at the Federal Reserve. Normally, banks would eagerly lend that cash into the repo market to earn high interest. However, they refused to lend even at 10% return.

Why Banks Held Back: Internal risk rules and post-2008 banking regulations (such as resolution liquidity rules and strict leverage limits) required bank treasurers to keep a hard minimum cash buffer directly at the Fed. Crossing below that limit would trigger regulatory alarms.

The combination of all these factors led to what is called a “fallacy of composition”. In other words, each bank acted rationally by protecting its own cash cushion, but their collective refusal to lend caused the entire overnight lending market to freeze until the Fed stepped in to provide cash directly.

Are We At Risk Today?

Today’s financial plumbing exhibits several unmistakable similarities, along with a few vulnerabilities:

Vulnerability Driver	What Happened in 2019	What is Happening Today
Fed Balance Sheet Run-Off (QT)	QT had been draining excess cash down to a critical tipping point.	QT and massive U.S. Treasury debt issuance have drained the Fed’s cash buffer (Overnight Reverse Repo Facility) from $2.5 trillion to near zero. Questions remain, however, whether reserve levels have fallen enough to approach banks’ minimum comfort level.
Record Supply of Treasury Bonds	Heavy Treasury issuance clogged dealer balance sheets.	Multi-trillion-dollar federal deficits are forcing dealers to warehouse even larger volumes of government debt.
Hedge Fund Leverage (The Basis Trade)	Present at moderate levels	An estimated $1.2 trillion Treasury cash-futures “basis trade” relies on overnight repo borrowing, creating a massive daily demand for cash. And in a period of constrained balance sheets and insufficient cash supply, we’ll likely see a severe funding crisis.
Bank Caution on Cash	Banks guarded cash due to regulatory requirements.	Following the 2023 regional banking turmoil (e.g., Silicon Valley Bank) bank treasurers may be more cautious about maintaining ample liquidity buffers.

While the pressures on overnight cash are just as high today as in 2019, the Federal Reserve introduced a safety valve in 2021 by what is called a Standing Repo Facility (SRF), which allows primary dealers and banks to exchange Treasuries for cash directly from the Fed at a pre-set maximum rate.

Conclusion

The transition toward tighter reserves, combined with massive government bond supply and leveraged hedge fund demand, increases the likelihood of generating periodic volatility and upward pressure on short-term rates. As 2019 demonstrated, having hundreds of billions in cash across the banking system does not guarantee that cash will flow where it is needed, especially when regulations penalize banks for deploying it.

While the Fed’s SRF should mitigate extreme spikes (like the 10% clip we saw in 2019), non-bank financial players (like hedge funds) cannot access the facility directly. I suspect pressure will eventually mount to broaden liquidity access beyond traditional banking institutions. If such support ultimately requires a significantly larger Federal Reserve balance sheet, concerns about long-term dollar purchasing power could become increasingly relevant.

Economic Risk Dashboard: What the Numbers Suggest as of October 30, 2026

Here I am showing what the Economic Risk Dashboard suggests based on data as of October 30, 2026. The data is sourced from the St. Louis Fed FRED database, and I used my proprietary Python program to extract and analyze the data, as shown below. For the conceptual foundation of the dashboard, see my previous post where I explain the framework in greater detail. 

Our macro assessment remains largely unchanged from when we last examined the dashboard on October 2, 2026: The dashboard presents a mixed but generally stable picture of the US economy. At present, the dashboard suggests an economy that is not exhibiting broad-based stress, but one in which consumer sentiment remains exceptionally weak.

There is no change to household health (remains solid), with unemployment at 4.2% and no evidence of deterioration in either the six-month or twelve-month trend. The October 2026 unemployment rate will be reported on November 6, 2026. The consensus forecast is for the rate to remain unchanged at 4.2%, so we don’t expect any meaningful update from what we currently see in our dashboard. Having said that, we will analyze those results to observe how it stands vs. our dashboard.

Credit markets also continue to function normally, as high-yield spreads, investment-grade spreads, commercial paper spreads, and bank lending standards remain well below stress thresholds.

The one area that continues to warrant closer attention is consumer confidence. The University of Michigan Consumer Sentiment Index remains near multi-decade lows, even as other indicators remain stable.