Odd Lots - How Banks and Private Credit Became the Best of Frenemies

Episode Date: October 24, 2024

By now, everyone knows that private credit is a hot market. What's less known is that banks want in on it too. It's an odd state of affairs given that both these entities are in the business of making loans, so in theory they should be competing against each other. But instead we're seeing a bunch of deals, with more than a dozen big banks teaming up with private credit over the past year. So why are two seemingly natural competitors joining forces? And how much of an existential threat does private credit really pose for the banking industry? On this episode, we with speak with Huw van Steenis, vice-chair at Oliver Wyman and a long-time bank analyst at Morgan Stanley, about this new dynamic.Read More: The Macro Impact of the Private Credit BoomThe Black Hole of Private CreditBecome a Bloomberg.com subscriber using our special intro offer at bloomberg.com/podcastoffer. You’ll get episodes of this podcast ad-free and exclusive access to our daily Odd Lots newsletter. Already a subscriber? Connect your account on the Bloomberg channel page in Apple Podcasts to listen ad-free.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Bloomberg Audio Studios. Podcasts Radio News. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wisenthall. Joe, I feel like I start every private credit episode with the same point. But, I mean, private credit, it's everywhere right now. I think I counted like dozens and dozens of stories on private credit that came out just on the Bloomberg in the past week. There's two funny things that are going on, which is one private credit.

So these non-bank entities providing loans, et cetera, wanting to get into credit. And there's more and more about that every day. And then there's banks wanting to get more and more into private credit, which is this own thing of, okay, you're still at the bank, but you're doing it in some sort of balance sheet structure that resembles private credit. and what's up with that? What's up with that, indeed. This is the What's Up with that episode. I'm so glad you asked that question,

but we're going to be talking about the relationship between banks and private credit. Because the other thing that's been happening is every time we talk to a bank or a private credit entity on this show and we ask about the relationship between regulated banks and non-banks, you get this really diplomatic kind of awkward answer.

Like, well, we view our bank partners as opportunities and no one will really explain how they actually feel about each other. Totally. You know, the one other thing before we get into it that I think about it a lot is I look at the rise of private credit and there is a big part of me that says this is what regulatory success looks like. This is what post-Dodd-Frank success looks like that there is more of this risk-taking activity happening. Yeah, happening outside of the deposit-taking banking institution. on the other hand, if a lot of the leverage for private credit and a lot of these relationships is being plied by banks and so forth, then it makes me wonder, did we actually excrecate the risk

or in the end? We just put a wrapper on it. We put a wrapper on it. In the end, does all financial risk read down back to the banking system? That's exactly it. And I got to say, you know, there is a lot of discourse from which we can pull from a lot of historical analogies because, of course, bank disintermediated. is not a new thing. It's basically been happening for as long as we've had banks. And if I think back to like two big moments in the process of bank disintermediation, it has to be the invention of the

junk bond market in the 1980s. Securitization also in the 1980s and 1990s. Pure to pure to lending. That was a fun one. Remember that? Well, the other thing too, you know, it just occurred to me. And Bear Stearns was not a retail deposit-taking institution. But part of why they blew up is like they had these in-house hedge funds, right? And so even this idea of hedge funds and non-bank entities sort of existing within more larger traditional regulated financial institutions is not that new. That was a story of the great financial crisis. That's exactly right. So I'm very happy to say this is our banks and private credit, basically Frenomies episode. We're going to be speaking with really the perfect guest. It's someone that I've known for a long time. And we've actually had him on the

podcast before, but I don't think you were there. I promise you are really. going to love this. We're going to be speaking with Hugh Van Stenis. He is the vice chair at Oliver Wyman and also the former global head of banking research over at Morgan Stanley. That's where I got to know him during the depths of the Eurozone financial crisis when I was on FT Alphaville. He's also formerly an advisor to Mark Carney at the BOE. I think he won like a series of research awards at various points in his career, but really one of the smartest guys I know when it comes to banks and financials. So Hugh, thank you so much for coming on all thoughts. Well, Tracy, thanks so much for having me on.

We are very excited. First of all, maybe let's just start with the basic question, because everyone seems to have different opinions, different numbers around this. But how big is private credit at the moment compared to the traditional banking system? Oh, I mean, honestly, it's pretty tiny. So the official stats are about 1.7 trillion, and that's by Prequin, the company that BlackRock bought recently. That number, though, doesn't include insurers giving direct mandates to the private credit firms. So I think it's probably closer to $2.5 to $3 trillion, which is a drop in the ocean to what? Investment-grade bond markets, $9 trillion.

Banking assets in Europe are $32 trillion. These are really relatively small numbers. And so I think that's why many of these firms think they've got a long runway still to grow. So why do we care? It's not because they're so big. It's just because it's growing fast. Well, it's also because they're eating away a bank earnings. And I think that's where, you know, if I think about our conversations with bank CEOs and CFOs, and I literally just had one before coming on your show, they're worried about how much of their juice is being gobbled up. And I think that that's, you know, that's why, in a way Tracy's right has gone from sort of counterparts to frenemies. And one way to think about it is that we had a very unusual macro period, as you've spoken about many times, during 2023, private. credit players wrote about 90% of all leveraged loans. And they're also doing really well in

direct lending. And so they're looking for the next avenue of growth. And one theme that we come up across a lot is about asset bat lending. So in other words, financing, I don't know, aviation or auto loans or even royalties, that's a $5.5 trillion dollar market in the States. Private credit probably has less than 5% share. And they're really looking to mine this seam. And so if you're a banker thinking these guys are now after our investment-grade assets, not just the high-yield assets. So talk to us about how we got to this point, because Joe correctly, I think, attributed this to a lot of the post-2008 redesign of the financial system regulation. And I mean, this is what we wanted, right? We wanted the riskiest stuff, the riskiest activity to be pushed away from regulated

banks and into, I know they have the nefarious name of shadow banks, but, you know, mostly we're talking about like a business development company or a direct lender or someone like that. No, look, I think that's right. So, look, if you take it since the financial crisis where we change the regs for the banking system, a lot more capital, a lot less shortened the asset liability duration, a mismatch that went beyond an elastic limit into the financial crisis. So these private credit firms have created just over a trillion dollar parallel system to lend to corporate America and parts of corporate Europe. And it's around leverage lending, it's areas which were either too risky or in some cases where the Fed put in limits on how many leverage loans

or what was the maximum, you know, multiple of leverage that a bank loan could take on. And so these loans were being pushed outside of the banks. The other area, though, where private credit has been very active too is mid-market. So let's say a loan between, let's say, $30 million to $75 million. That's an area where for the top six banks, this is a lot. This is just too small fry for them to get excited. And therefore, so there was a kind of a missing piece, which the private credit firms picked up the crumbs, which are left on the table by the banks.

So you're right. I think the regulators push this. I think where we're going now is probably to the next level. And so the way I think about it is that we are now retrenching the banking system where the banks are laying off the junior risk to private credit. And that's allowing them to optimize their capital, but quite frankly also lend more. And so what's really interesting for me is there's like everything in life, people see things as an opportunity or a threat.

The top banks and CEOs that I talk to are now saying actually private credit allows me to recycle risk more quickly. I can lend more. And then there's a whole bunch of banks who are just sitting, licking their wounds, going, I'm not sure how I can do this. So I think there is a little bit of symbiosis now between the banks and private credit. Sorry, explain that a little bit further, at least on the opportunity side, when they can recycle their capital faster. Just sort of walk us through that. Yeah, so Joe, let's take one of the top U.S. banks or European banks. So there are three ways they can lay off risk.

The first would be to say, I will seed the loans that I don't really want to write to give to a third party. So in a way, what you've seen with Apollo and Citigroup is the leverage lending. Or Brookfield with Lloyds in Europe, again, it was around leverage lending. So it's stuff that they didn't really want to do. But they can arrange, they can get all sorts of origination fees, and then they can also keep the relationship. The second is if they, let's say, originate a loan, they then pass lead up, maybe get 100 loans, 120 loans,

and then do a synthetic risk transfer around this. In other words, start to basically, which I think you talked about two months ago on your show. So in that case, think about a bell curve. You're going to ensure the bottom 10%. You're going to take off the tail. And from a bank capital point of view, that dramatically optimizes your capital at risk.

So the Fed only permissioned this about nine months ago. You've already seen Morgan Sannie, Goldman Sachs, a number of firms start to do these synthetic risk transfers. That space, I think, is going to grow really strongly because for the largest firms, it allows them to lend and then do that. And then the third is then the more, you know, there's some more complexities as well around, you know, how else you can sort of lay off the risk. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra.

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Listen to Leading By Example, Executives making an impact on the IHeart Radio app, Apple Podcast, or wherever you get your podcasts. So one thing I'm always asking on the show is how these conversations begin, because Because, you know, I honestly have no idea. Like, clearly there's a lot of partnering that's happening between banks and private credit at the moment. But when did that start in your mind? What was the first kind of big, notable instance of a bank teaming up with some sort of private credit entity? Oh, that's a good question.

So as you were sort of hinted earlier on, Tracy, often in life, the history of these things is far longer than we like to believe. So just like actually 1973 was the peak of bank lending as a person. of lending to corporates. I mean, it's 50 years since that peak. So you're right. Some of these partnerships are actually about 15 years old. One or two of them predate the financial crisis. But if you think about today, in the 12 months to September, 14 banks tied up deals with private credit. And in the 12 months prior, it was only two. So it's basically about a year ago, suddenly it snapped. Now, why is that? I think it's because the private credit firms, particularly the top 10, felt they'd started to max out.

of, you know, leverage lending or direct lending. But I think the subplot is much more Shakespearean. I think there's a really interesting subplot, which is more of the top 10 private credit firms and now getting their assets from insurers. So take yesterday we had the Blackstone results, half their assets now come from insurance companies. Insurers can only invest in investment grade. So if you think about it from the point of view, the private credit player, they are structurally lowering their cost of capital, which means that they can then go after investment-grade assets on the bank's balance sheets. And so that subplot, I mean, I think now of the top 10 firms, on my numbers, about 40% of the assets come from insurers. They become much

more relevant to compete for the investment-grade pieces on the banks. And I think that's what, you know, whether it's the Barclays deal with Blackstone, whether it's Oak Tree, with Soch-Gen, whether it's City with Apollo, in a way the private credit is able to nibble away at more assets than they could in the past. I'm going to back up and ask the dumb question. I'm like, oh, I think maybe listeners will want a clarification, but it's actually just me. What's the difference between leverage lending and direct lending again? Oh, look, this is one of these where nomenclature is pretty poor.

Okay. I mean, it's really poor and it's pretty blurry. I think the way they think, most of them would think about it, is direct lending is I'm lending to a mid-market company, you know, $30 million to $100 million, the kind of area, mid-market finance. because lender lending is going to be acquisition related finance. Okay, got it. But Joe, it's a blurry-van diagram. No, the acquisition-related finance, that makes a lot of sense to me. So I'm going to go back to that conversation point and ask, okay, so, you know, a bank approaches a private credit lender or a private credit lender approaches a bank and says, hey, we need to do something in this environment.

You know, there's a lot of demand. I've got a bunch of insurance companies that are interested, whatever. how do they go about identifying what exactly they're going to do and which particular assets or loans might be realistic for this kind of partnership? Oh, that's a great question, Tracy. So, and look, some of these relations, these firms have been counterparts to the banks for many years. So there's a degree of relationship, even if maybe historically been a little bit antagonistic. And certainly one of the leaving credit credit firms, you know, has a swear box for every time they talk about a counterpart rather than a partner these days. Wait, how much do you have to put in?

Is it like $5,000 or $5,000? Well, it probably should be $5,000, but I think it's actually, it's the charity. It's a charity pot. And so if we think about those deals, half have been around asset back lending and half around the overflow, the leverage finance, or the more levered stuff. So I think what the private credit companies are doing is very shrewdly going through the, they're almost doing like my old job being a bank analyst. They're looking at a bank and saying, where is capital constrained?

At the end of the day, particularly in Europe, but even in the same, state, and even particularly think about U.S. regional banks or some of the European banks, they've become optimizers. They're optimizing for cost efficiency, capital efficiency and revenues. And in that mindset of optimization, they're always looking to try and lay off risk. And so the credit company often says, well, look, I see your capital constrained. You need to grow. An example would be, let's say, Blackstone with Barclays. They want to grow their credit card business, but equally want to keep lots of money in their investment bank by partnering up, they can now fuel the growth of the credit card business in a way they couldn't

do before or didn't, or at least didn't believe they could before. So I think this is, you know, in a very constrained world. In fact, I was at an event last week with a bunch of investors and private credit firms and one of the investors said, well, look, there is not enough capital for any bank to put capital behind an acronym. You know, that's just space has gone. You need to find partners. And so I think they're forensic. They're hiring people. to do banks analysts for them. And then I'm looking to try and create a solution because I said, the top 10 firms feel their origination constraint. And so they need the access to more assets. So in a situation like a credit card deal, what the bank wants and the bank still has and the bank

will probably still have is that brand, that relationship, that retail distribution network, and so forth. And then the private credit entity just allows them to keep growing these lines. and there are presumably other lines without impairing their balance sheet. Exactly. It's about optimizing for capital as well. Because at the end of the day, if you take off the riskiest piece or take off the entire slice, then you can just grow much faster. That's very helpful. Can you go further in talking about the role of insurance and all this?

Because one of the things that I still find actually completely strange is that we have these gigantic financial entities called insurance companies. They're bad myth and they're important and all kinds of. of areas and no one ever talks about insurance companies. There's like, you don't really see them in the media the same way. You see banks. It's very strange. That and accounting is like the two missing, like major ingredients of financial journals. Of the financial ecosystem that seem to like punch and maybe they like it and punch it like, you know, 10% of their weight in terms of our understanding of their role.

But talk a little bit more about the role of insurance capital and all this. Oh, this is a great plot. And actually it's very different in Europe. versus the US. But let's say if you go back to Tracy's point, the railways were funded mostly by insurance companies. I mean, large capital projects were mostly funded by the insurers. So because they had long-dated funding and you still had Wildcat runs in the States, as you may not remember, but it was there. So, so the, you know, everyone's looked at Apollo and their arrangement with Athene and seeing that they've created a very, they've got a very stable source of funding

through their annuity business, much like, you know, you might have seen through the last Actually, even before the financial crisis, hedge funds wanted permanent capital vehicles. Right, right. I remember that. Everyone wants to be aligned to long-dated capital. And so I think, you know, most of the top ten now have an insurance business. So, I mean, I just met, you know, I listened to the Blackstone call yesterday, $221 billion other assets and now from insurers out of $432. So over half of their credit assets come from insurers.

Now, obviously, that's great because these are investors with long-duration liabilities who need long-dated assets. So they're the right kind of people to fund data centers, infrastructure assets, you know, the long-dated and stuff we need to fund our growth. But the interesting thing for private credit is rather than having to go for, I don't know,

10 to 13% return, if they can just simply get 100 to 200 basis points more than the insurer could have got through the public markets, they're actually quids in. And so certainly the expectation for the CIOs I speak to is

if they can get 150, 175 basis points pick up on a single A bond by buying a private bond rather a public bond, if you compound that over 10 years, that's huge for the insurance sector. And so, as I said, I think about 40% of the assets now of the majors come from insurance. I think for the industry as a whole, it's probably near a 30. And so that's fueling the growth. And it's changing the nature of where private credit can invest. By the way, Tracy, I didn't know that insurance. companies funded the railways. But I will say early on in my career, I do remember, and I'm,

I sort of pat myself on the back for this, I do remember having the realization that sort of like clicked how similar banks and insurance companies are, because with the bank, you know, you make a deposit of $1,000. And over the lifetime, the bank will probably give you back your $1,000 in the form of you take it out. Insurance companies basically the same. You buy a, collect premiums, pay it out. And you get the, you know, on average. No, but like on average, right, for the industry, they pay out roughly what they get in and they hope to like make it on the float. And so in the end, like the models in the ideal sense, it's just a matter of timing of when the cash comes back out. In aggregate, certainly.

It's not my individual experience. Some people get screwed and some people get way more than they put in. And then on average, anyway. Yeah. And sort of clicked to me one time in my younger. No, there's a lot of overlap here for sure. Okay. So I want to go back to the financial risk.

slash regulation points. So we've established a number of times that to some extent this is exactly what regulators wanted to see happen. But I think there's always a concern that maybe this will come back to bite them and the overall financial system in some unexpected way. And that maybe there are avenues that some of this risk is still entangled with the banking system, especially as we see these new partnerships develop. What are the avenues for private credit risk to, I guess, re-enter the banking system and potentially cause problems? Look, I think it's a great question. I think I've had almost every regulator pose this question.

This is one of the very hot buttons for them. So look, my take is that for a sector which is very low on leverage, doesn't have the big asset liability mismatches, is not systematically interconnected, and to be honest, it's still relatively small, less than $3 trillion. It's on the whole not a source of systemic risk. But the question you get are therefore, are there pockets of leverage that we can't see?

So for instance, the Bank of England's got an investigation to think about where is the hidden leverage because obviously having had the LDI problems under trust, they're worried about hidden leverage. So NAV finance is an area which the regulators are pouring over and are trying to get the data from firms just to see is there leverage on leverage in the system that may trip them up.

I think second would be, on the whole, if you've got 10 plus two, if the funds are 10 year in duration, or even if they're six years, and you're lending to five-year loans, there isn't a big asset liability mismatch. But to the extent that private credit may potentially be put into retail vehicles or even to ETFs, is there going to be an asset liability mismatch? And certainly the more that private credit looks to raise money from retail, the more there's going to be questions around the structure. And we can come out to that because there's a Cambrian explosion of interest. of traditional asset managers and private credit players teaming up to create commingle vehicles.

And then the third, though, but Tracy, to your point is, how do the tentacles overlap? So there was a good piece by Liberty Street, so like the Fed in New York, that 27% of bank loans are now to non-bank financial institutions. So hedge funds, private credit, private equity and the like. And it's been growing like a weed. And so they're warranting, you know, at one level, they're very happy that firms are laying off risk to private credit. But the question, in fact, one of the big central banks is asking the banks to try and tot up every loan to private credit firm, A, every loan to private credit firm. In reality, they're not making the loan to the firm. They're doing it to the underlying asset. But they won't have a consolidated tape because, you know, what you don't know, scares you.

And so they're trying to get a much better transparency on this space. This kind of reminds me of the conversation we had with Mickey Schemi about synthetic risk transfers where, you know, it's sort of the same idea. the bank is like selling off part of the risk of a loan portfolio to another entity. And that sounds fine, except sometimes those other entities who tend to be hedge funds or someone like that are borrowing from banks in order to apply leverage to boost the yield. Yeah, see more about that 27%. I have to go read that Liberty Street economics report. But what is, from the bank's perspective, that specific type of lending, what are the risk characteristics, what are the capital cost characteristics of this kind of activity?

Well, look, so, by the way, I'll send you the notice. I think it's about where does banks end and private markets begin? As all non-banks begin is the title. So I think, look, it's very heterogeneous at the moment. So it's hedge funds. And I know that my good friend, Tawson-Slock, said that's to a new high. It's to private equity firms. So it's all over the place. But, so I'm just thinking, sorry, Joe, go back again. No, I'm sorry. I know my question wasn't particularly. I'm sorry. I know my question wasn't particularly cogent here. My answer was it was worse. No, no, no, no, it's fine. It's fine.

I'm just trying to understand, like, right, okay, so banks are optimization vehicles. They're capital optimization vehicles and so forth. And they want to, like, they want to do the lending that creates the fewest constraints on the size for regulators and all that stuff. So where does lending to financial institutions fit into this sort of, like, matrix of costs and benefits? Okay. So the way bank regs work these days. is to encourage the banks to do senior or high-quality lending and to try and limit the amount of riskier lending,

either to try and originate and distribute it very quickly or to lay it off through derivatives of some sort. And so, let's say it's lending to hedge funds. Now, as you've spoken about before, with Arcagos, they got that wrong, but the idea was up until then, hedge fund lending, I mean, very low risk for a great long time. So this is kind of what I, hedge fund lending is considered to be low risk. Absolutely.

Why? Although, but I think that is changing. But why? Exactly. There's more scrutiny of the prime brokerage business. Yeah, but why? Well, because they had had a 15-year-old run with almost no credit losses. And obviously they had good collateral with haircuts.

And if, and this was the big question with the firms who got the wrong way around on Arkegos was, if they got the right haircuts, then it was secured lending. So on the whole, they could seize the assets and sell them off. What they got wrong was this was such a concentrated pool and they were all stampeding. So I think actually the risk here is not. so much the belly, it's actually the tail. So is there a scenario where there's a major credit event and that many companies go bust and then that works its way through? And that's where the regulators are trying to piece it through. But my take is on the whole, the banks are trying to retrench, keep the senior risk. And I cheekily put in the system, this is with the

Zem pick of the system because this was a way for them to lay off risk. This was actually very helpful because in my mind just sort of very naively, I don't necessarily think, oh, lending to hedge funds is really safe lending because aren't they taking all kinds of crazy risks and doing all kinds of stuff that may go wrong? But to your point, obviously beyond just the run, the fact that it's backed by actual assets typically or typically the bank knows what the assets are, I can understand more conceptually why lending to financial institutions is more frequently perceived as safe. So thank you for that. Joe, I think we should do a prime brokerage episode of All Thoughts where all we do is a dramatic reading of the report on Credit Suisse and Arkegos. Yeah, let's do that. We just do that because that was amazing.

We can get actors. We can get actors for it. Yeah. Well, actually a really good insight into how it all works or, you know, a bad example of how it should not work. Anyway, Hugh, I'm going to ask a really basic question, but I find, you know, the changing answers to this one always really interesting. But how are banks making money now? Hmm. Oh, it's a really good question. So after 15 years of zero or negative rates, we've had a wonderful couple of years where spread income, so the spread between the assets liability once again became profitable.

And that really hurt the banks. But, you know, if the majority of my conversations, both states, side and Europe, and even in Asia, is the banks want to make more fee income. So that could be asset management, could be private banking, could be originate to distribute, they want to continue to shift more and more of their earnings towards fees and less from just common and garden banking. And that's partly cyclical. As interest rates are being cut now, the anticipation is the kind of spread is going to be under a little bit of pressure. But, you know, as we've seen, actually, it continues to be very good. But it's more and more

fees. That's really where the banks are focused. And then within the loan income, my sort of take is that the kind of winner takes most dynamics we've seen in tech are starting to come to banking. The more of a bank's cost base, which is the systems, the cloud, data, you know, it's more and more the cost base is tech. Well, quite frankly, it's very scalable. And so what you're starting to see, if you look at the ROE, I actually did a piece the other day where I looked at the ROEs for the banks in every country, like the number one player, number two, number three, number five, the top three players in each market are doing so much better than the tail than they were a decade ago. And I think it's that winner takes most, winner takes more behavior.

That's really interesting. Actually, let's talk a little bit more about this because I have also from time to time pull up the chart of J.P. Morgan and compare it to other banks. And it is, it looks kind of like a tech stock. I mean, it's not really quite as good because it's not a tech stock. But it sort of seems to exist. And I wondered about this of this sort of winner take oneness of the market and whether there is a similar dynamic.

And I hadn't thought about it quite so literally. in terms of the actual tech stack of the bank. And I was wondering if it was more sort of like a network effects. And of course, in finance, network effects are important just like they are in software. But talk to us a little bit about the dynamics that you think are contributing to this winner take on this in any country's banking system. So, look, I think obviously there's part of it is the tech stack. Of course, you know, if they're trading assets, there's always going to be some network effects.

If you can take, you know, 13, 14, 15 percent of a market, you just see more. you can price better, you've got better source of flow. So I think in investment banking markets and in sort of wealth markets, there's definitely some network effects. But also just there's scale in origination. I mean, you just need loan officers, loan processes. I mean, it's very, typically, it's very manual. And in fact, one of the, not for me, but some of our colleagues are doing a lot of work actually using AI to automate loan procedures for banks, because that's an area which is very historically been very labor intensive. And actually, one of the reasons why private credit is trying to team up with the banks is because they don't

have enough people to originate, so they're trying to lean on someone else's origination stack. Now, look, there is a nuance here. For every power, there's equal and opposite power. So in the states, let's say, for regional, for the smallest banks, they're all basically sitting on one of three players like FISAV. So they're enjoying scale, but they're just outsourcing it. And then the other thing is, of course, you know, the Google's alphabets and Azure within Microsoft are getting a winning hand over fist because if you're a midcap bank, the way you try

to capture scale is by outsourcing to one of the super scalers. I think you anticipated my next question perhaps when you brought up AI. But one thing I often think about the financial sector, so banks and insurance companies, is if AI is obviously it's about the technology, but it's about the data too. Who has the most data? It's got to be insurers and banks, right? They just have oodles and oodles of it. How excited. are banks in particular getting about, you know, the actual data component of their business here? Well, hopefully Bloomberg's got one of the best data stacks. Oh, well, us too, of course.

Oh, no, this is, so there's a huge amount of automation going on. I mean, look, let's take one step back. The banks need to make sure that their data is organized in a lake or in a way it can be used effectively. And then number two, you need to train. So actually one of the largest banks now has every new graduate doing AI prompt training as part of their core curriculum as they join. So one of my son's flatmate has just done

eight weeks of AI training. It's extraordinary. So the way, of course, if the more data you've got, the better. But Tracy, there's some really subtle things in here because the regulators want to know how you made the decisions. Right. And is the AI optimizing just on past experience?

Right. This is the black box algo point, right? Where, like, if you have all this data going into a black box, an algorithm and it's spitting out an answer, you actually have to know whether that answer is valid, like whether it might violate regulations on biased lending based on like racial or age characteristics or gender or something like that. Absolutely. And so there's all sorts of biases. So at the moment, most of it is for co-piloting.

But, you know, some of this, some of the use cases, Tracy, are fascinating. It's like one of the big banks I was talking with, they're actually using AI now in their HR departments to just basically automate anything. If they want to fire someone, they just click a big thing, a button and try and work it out. Oh, wow. Dysopia is here. here. Yeah, it really is. There's some great articles, by the way, done by Bloomberg, not related to banks or anything, but like on the sort of like Amazon auto hiring and firing and just this idea of all that being the assumption of liquid labor markets and the, you know, it's okay to make mistakes if there's just an endless supply of people who want to work at your company. Anyway, that's its own digression. You know, just on this point. So obviously, okay, the big banks have their gigantic tech stacks. I had a conversation recently with someone who worked for very, for a very small bank, actually. It was just like I met someone over coffee. Because, you know, I'm curious. And so it was like kind of like doing an odd lots except over coffee with no microphone, like how it all works and how a regional or a small local bank actually has a business. And it was really striking

in the conversation how many of the specific things that came up were literally about third party modeling or software packages and stuff like that. And how much the sort of all kinds of risk management, et cetera, it was really a job of plugging their numbers in to various packages that they buy. And I have to imagine that the companies that sell these modeling services or software services or data services to any of the banks that aren't like JPMorgan and a few others must be making a mint. Oh, absolutely. Look, I mean, that's not my special... Yeah, no, I know, yeah. But just in the same way that MSCI has made an absolute fortune by being the, you know, the premier data company for markets. So, I mean, why? Why, I was it? I mean, why,

way to frame it is in the sort of 15 years post-financial crisis, the banks, you know, at least certainly for the first seven or eight, were just focused on capital repair, improving process, improving risk management. The amount of discretionary budget they had to invest in new tech stacks was really quite low. And so a lot of the innovation was happening outside banks and being sold back in. Now, as you say, look, from maybe 2016 onwards, the US banks got back on the front foot and the leading ones are investing disproportionately in tech and their own solutions. But there's enormous amount. which is bought in. And again, that's sort of, that's why if you go back to private credit,

one of the areas they hope is that they, certainly the leading firms, are also investing in tax tax, because they want to make sure they have an information edge. And so also you're starting to see, I wouldn't say hollowing out of the middle in private credit, but definitely the larger firms are investing very significantly in treasuring management, data management, and the like. By the way, Tracy, look up a chart of FI, five-serve stock, which does a bunch of various payment things for smaller and credit union banks and stuff like that. And check out that. Oh, geez.

Yeah, check out that stock. Wait. I just pulled it up. I have to compare it to Invideo. Yeah, right. I know. It looks like it, doesn't it? It's probably.

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What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executive. like Grace Chen of Birdie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to leading by example, executives making an impact on the IHeart radio app, Apple podcast, or wherever you get your podcasts. Why don't we get back to private credit? We're in danger of just making this an AI episode. But Hugh, you know, we've seen growth in private credit, although to your point,

it's still relatively small. So, you know, it's coming up from a low base. We've seen more partnerships between banks and private credit entities. What's next in terms of this dynamic? What are you watching out for as the next big thing? So for me, private credit's next act is around asset back lending and secondly commercial real estate. And I think they're the two big asset classes which the private credit firms are really trying to either gain origination or do partner. or get into. And just go back to it. So if specialty finance is a five and a half trillion market, private credit has about a five point share. If you then include consumer mortgages and commercial

real estate, it gets to about 25 trillion in the states, of which private credit has probably about a 2% share. So this is an area where they are really trying to say with insurance-led assets, with also some of the assets for the wealthy, this is where they're really gunning for it. Now, at the moment commercial real estate is probably less picked over because the areas where the banks are shedding is more the distressed or stressed, particularly if it's a US regional bank. But the asset back lending piece is they're going absolutely gung-ho, and that's the area which I think is probably one of the most interesting areas to spend time on. And then the second bit, Tracy, is that's obviously on origination on where they're getting the assets from.

As you've, we've spoken about many times before, let's be honest, the endowments and pension funds are still a little bit of, have got a bit of indigestion to private equity and venture capital. Now, that indigestion is passing, but most endowments I speak to still say they're about five points over allocated to VC. We'd love to put that to private credit, but they just don't want to do more illiquid assets today. So the private credit firms are doing three things. Going international, so going to the Middle East in particular where there is just a ton of new money, and actually those clients really like fixed income. They're going to insurers, and I still think there's a good runway to raise money from insurers we could discuss. And third,

and finally it's the wealthy. And I think at the moment there's a little bit of misnomer. When they say wealthy, they mean seriously wealthy. I mean, they talk about family offices, people with $50 million plus. There's about a $9 trillion market of family offices globally. That's their sweet spot. But they're going to look increasingly towards the decently wealthy. And I think their product innovation around, whether it's capital international with KKR,

whether it's BlackRock with Partners Group, whether it's Apollo with State Street, Global. there's some really interesting innovation about how you slice up private credit to sort of like affluent clients. And that's something again you can do a whole episode on. Tracy, we've never done, I don't think, a family office episode. No, we should. Yeah. We should go to Singapore and do it from there just because I want to go back to Asia. Okay, well, Hugh, thank you so much for coming back on this show.

It was lovely to catch up with you as always, and you walked us through that perfectly. So thank you so much. Thanks for having me. Thanks, Hugh. That was fantastic. Joe, that was great. I love catching up with you. Again, like, I've known him for a long time, and he's always had really interesting thoughts on the financial sector and a great way of kind of explaining them. I do think his idea of retrenching of risk in the financial system is definitely like the way to think about what's happening. It seems like in some respects, you're seeing more and more specialization in the system where maybe it used to be, you know, back in 1970 when bank lending was at its height. the bank would do all sorts of things, right? But now it kind of breaks up all those different businesses into different pieces and has

different partners for each one of those. No, I think that makes a lot of sense. Look, I would still say, and, you know, famous last words that someone will make fun of me, but I would still say that by and large, I am of the view that the post-grade financial crisis evolution of the financial system has probably been a net good in terms of overall financial stability risk. To your point about the tranching, that the financial system has gotten better about putting the right form of risk in the right hands.

There's never total delinkage or anything, but even hearing him explain why financial lending to financial institutions is a safer form of lending. That's very helpful. And so why that's grown like why, you know, this emergence of a specific mid-market type lending and the right entities for that, I don't know. I'm still of the view that probably things are better. It's one of those things where there could always be something that we're missing. Yeah, of course, of course, right?

And that regulators are missing. I do think at the moment we seem to be in a sweet spot where a lot of this is happening. So risk is getting divided up and, you know, distributed differently in the financial system to where it was in 2008. But it's still relatively small, like he was saying. Despite all those headlines about private credit, like we're still talking about a relatively small market. It could be that as it's. gets bigger and bigger. It becomes more problematic in various ways. But the other thing that I think is interesting about private credit, and I think we've talked about it a couple times at this point,

is the idea that it kind of has acted as an additional cushion of financing during the past couple of years where we had really high rates, and banks were still relatively capital constrained. So you could still get a lot of, you know, middle market businesses have this additional layer of financing or funding that they could still tap, even. if the banks weren't necessarily doing it. The winner take-allness of Bankrupt is really interesting. I think it's one of those things that you can see and you can look at the comparison of large caps versus small caps or whatever or J.P. Morgan versus literally everyone else in the U.S.

but it's like still sort of a little bit under discussed and under-discussed why. And I get the point about the tech stack. And I get the point about, you know, capital markets. There's a natural network effect. But it's still interesting. We live in this network effects world and in almost any industry this seems to be. a phenomenon and why that is across so many different areas where you have a number of companies in any industry that look like tech stocks is an interesting under-discussed phenomenon.

Joe's theory of network effect was all in business. What do you say? Have I told you? My line. All companies are banks except banks. Banks are media companies. That's perfect. Yeah. I love that. Okay. Let's leave it there on a high note. Yeah. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Allo. You can follow me at Tracy away. And I'm Joe Wisenthall. You can follow me at the stalwart. Follow our guest, Hugh Von Steenis. He's at Hugh Steenis. Follow our producers, Carmen Rodriguez, at Carmen Erman, Dashel Bennett at Dashbot and Kelbrooks at Calbrooks. And thank you to our producer, Moses Ondom. And for more Oddlots content, go to Bloomberg.com slash oddlots, where we have transcripts, a blog and a daily newsletter. And you can chat about all of these

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But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacan, wherever you can. get your podcasts. What separates good leaders from transformational ones?

I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to Leading By Example, executives making an impact on the IHeart Radio app, Apple Podcast, or wherever you get your podcasts.