Abstract

This paper examines whether regulatory arbitrage can explain the growth of private credit.
We show that business development companies (BDCs) — closed-end funds that provide a
significant share of nonbank loans to middle market firms — are very well capitalized according
to bank capital frameworks. They have median risk-based capital ratios of about 36% and, under
the Federal Reserve’s stress testing framework, they have median excess capital in the severely
adverse scenarios of about 26%. While there is little risk to solvency, during stress scenarios,
BDCs may deleverage to remain in compliance with the SEC regulatory leverage limits and
bank loan covenants. Our baseline estimates suggest that over eight quarters the median (25th
percentile) BDC would reduce assets by 8% (20%) in addition to the reduction of the fair value
of their assets. More conservative compliance policies lead to more rapid and more significant
deleveraging: up to 10% by the second quarter of the stressed period. Finally, our evidence cuts
against the view that private credit has grown because nonbank financial intermediaries have to
hold less capital than banks. Instead, we argue that banks find lending to middle-market lenders
more attractive than middle-market lending. This is, in part, because over-collateralized loans
to BDCs and other nonbank financial intermediaries get relatively favorable capital treatment,
enabling banks to exploit their low-cost funding. It is also attractive because the loans are
relatively large and thus less costly to originate, underwrite, and service than a portfolio of
middle-market loans.

Authors

Sergey Chernenko, Purdue University
Robert Ialenti, Harvard Business School
David Scharfstein, Harvard Business School