Large banks have offloaded riskier loans to private credit, which is now more accessible to retail investors. According to Crossmark's Victoria Fernandez, this concentration of risk in a less transparent market, where "cockroaches" may be hiding, is a primary systemic concern.

Private credit grew by taking on riskier loans that banks shed after Dodd-Frank, making the core banking system safer. However, banks now provide wholesale leverage to these private credit funds with minimal due diligence, creating a new, less transparent concentration of risk.

Sheila Bair argues private credit's dangers lie in investor protection, not systemic risk, due to its lower leverage compared to banks. She points to conflicts of interest, valuation opacity, and liquidity issues as reasons why the asset class is unsuitable for retail investors and 401(k) plans.

Despite headlines blaming private credit for failures like First Brands, the vast majority (over 95%) of the exposure lies with banks and in the liquid credit markets. This narrative overlooks the structural advantages and deeper diligence inherent in private deals.

Post-2008 regulations were meant to de-risk banks by pushing risky lending outside the system. However, banks have developed a "frenemy" relationship with private credit funds, both competing and partnering, leading to a massive $1.4 trillion in bank exposure to the sector and reintroducing systemic risk.

The fundamental model of private credit is sound. The primary risk stems from the sector's own success, which has attracted massive capital inflows. This creates pressure for managers to deploy capital, potentially leading to weakened underwriting standards and undisciplined growth.

Regulatory leverage lending guidelines, which capped bank participation in highly leveraged deals at six times leverage, created a market void. This constraint directly spurred the growth of the private credit industry, which stepped in to provide capital for transactions that banks could no longer underwrite.

The massive growth of private capital was a direct consequence of post-2008 regulations like Basel III and Dodd-Frank. By imposing strict capital and liquidity rules on banks, regulators curtailed their risk-taking, creating a vacuum that the private capital industry expanded dramatically to fill.

The Basel III regulations, intended to de-risk the financial system by making risky lending expensive for banks, had an unintended consequence. The demand for risky loans didn't vanish; it simply migrated from the regulated banking sector to the opaque, unregulated private credit market, creating a new systemic risk.