The Bank and Its Shadow

01 — Three Functions, One Institution

The commercial bank is one of the stranger organisms in economic life. It takes money from people who want it back tomorrow and lends it to people who need it for a decade. It accepts deposits of £1,000 and makes loans of £10 million. It issues credit to borrowers whose probability of default it can only estimate. None of these activities is obviously prudent. Together, they constitute the core of modern financial intermediation.

Economists have long described the bank in terms of three transformation functions (Diamond & Dybvig, 1983). The first is maturity transformation: the bank borrows at short tenors — overnight deposits, call accounts, short-dated certificates — and lends at long ones. The second is lot-size transformation: it aggregates many small deposits into large facilities, enabling credit at a scale that individual savers could not achieve. The third is risk transformation: it absorbs credit risk on its balance sheet, replacing the depositor's exposure to a borrower's default with exposure only to the bank itself — an institution subject to capital requirements and, in most jurisdictions, a state guarantee.

These three functions are not merely descriptive. They explain why banks exist, why they are regulated as they are, and why their credit is priced differently from any other source of funding. Understanding what private credit does — and does not — replicate is therefore not an academic exercise. It is the starting point for any serious comparison of the two.

The three transformation functions

1. Maturity transformation — Borrowing at short tenors (deposits, call accounts); lending at long ones (mortgages, corporate facilities). Generates a structural funding margin. Entails run risk if depositors withdraw simultaneously.
2. Lot-size transformation — Aggregating many small deposits into large credit facilities. Enables access to capital at scale unavailable through direct lending. Achieved through balance sheet consolidation.
3. Risk transformation — Absorbing borrower credit risk onto the bank's own balance sheet. Depositors hold a claim on the bank, not on the underlying loan portfolio. Enabled by capital buffers and backstopped by deposit insurance.

02 — Maturity Transformation: The Instability at the Heart of Banking

Maturity transformation is both the most powerful and the most dangerous of the three functions. A common misreading should be cleared away first: the bank's margin in corporate lending is not, for the most part, a term premium. Mid-market and leveraged loans float over Euribor or SARON; the interest-rate duration sits with the borrower or is swapped away. What the bank actually carries is funding liquidity risk. The deposits can leave tomorrow; the loans cannot be called for seven years. The margin the bank earns comes from the other side of the balance sheet — deposits that reprice slower and lower than the policy rate, while the loan book floats with it.

This is, on its face, an unreliable business. If a significant fraction of depositors demand their money simultaneously, the bank cannot honour them by calling in its loans. This is the bank run — identified formally by Diamond and Dybvig as an equilibrium outcome in any institution facing maturity mismatch, not a pathological event but a rational one (Diamond & Dybvig, 1983). The solution, as Diamond and Dybvig showed, is a credible external guarantee: deposit insurance converts a run equilibrium into a non-event by removing the depositor's incentive to withdraw first. If the state will make you whole regardless, there is no first-mover advantage to a run.

Two distinct forces hold the bank's deposit cost below the market rate, and it matters which is which. The first is the guarantee itself: the insured depositor does not charge the bank for default risk, because the guarantee has eliminated that risk from their perspective. A depositor at a Swiss cantonal bank, protected by a combination of cantonal guarantee and federal deposit insurance to CHF 100,000, demands no credit spread (Swiss Federal Deposit Insurance, 2023). The second force is the deposit franchise: payments convenience, switching costs and market power keep deposit rates well below the policy rate even for balances above the insured threshold, and even at banks where the guarantee is doing little work (Drechsler, Savov & Schnabl, 2017). The state subsidy is real, but it shares the funding advantage with a private franchise. This distinction will matter when we try to size the subsidy.

Private credit funds do not operate under maturity mismatch — at the fund level, at least. Their capital is locked up, typically for five to seven years, and cannot be recalled by investors mid-cycle. The fund lends long because its own liabilities are long. The structural instability of the bank is absent, and so is the guarantee that makes the instability survivable. The fund raises money from institutional investors at rates reflecting the true risk of illiquid, uninsured exposure. That is the clean version of the story. The qualifier — "at the fund level" — is where it becomes interesting, and we return to it in Section 06.

The maturity mismatch that makes banking fragile is also what makes it cheap. Remove the mismatch and you remove both the fragility and the subsidy — unless the mismatch quietly returns one level up the chain.

03 — Lot-Size and Risk Transformation: Where Private Credit Competes

The second transformation function — lot-size — is one that private credit replicates almost perfectly. A private credit fund pools capital from pension funds, insurance companies, family offices and sovereign wealth funds into vehicles large enough to write €50 million to €500 million facilities in a single transaction. The aggregation problem that justifies the bank's role as intermediary is solved by the fund structure rather than the balance sheet. On this dimension, private credit is a genuine functional equivalent.

Risk transformation is more complicated. A bank absorbs credit risk by holding loans on its own balance sheet, funded by deposits. The depositor's exposure is to the bank, not to the underlying borrower, and that exposure is capped and insured. The risk transformation is real: the depositor exchanges idiosyncratic credit risk for a capped, insured claim on the institution.

In an unlevered private credit fund, the investor retains direct exposure to the loan portfolio. There is no balance sheet interposition. The LP is, in economic terms, closer to a bond investor than a depositor — an undiversified claim on a pool of illiquid corporate loans, with no recourse to any state guarantee. The fund manager transforms information risk, through due diligence and structuring, but does not transform the underlying credit exposure. The investor absorbs it directly.

The qualifier "unlevered" is doing real work in that paragraph. Levered vehicles — BDCs funded with debt, funds drawing NAV facilities, strategies built on asset-level back-leverage — reinterpose a balance sheet between investor and loan after all. And the institution providing that leverage is, in most cases, a bank. The pure dichotomy between bank intermediation and fund disintermediation describes the unlevered base case, not the asset class as it actually exists. We return to this in Section 06.

The distinction has practical consequences for pricing. A bank's loan spread reflects, among other things, the cost of holding regulatory capital against the exposure (Basel Committee, 2017). A private credit fund's spread reflects the cost of illiquid, all-equity capital with no guarantee behind it. The two spreads are not measuring the same thing — and, as the next section argues, neither are the borrowers.

04 — The Rate Gap: Four Prices, Not One

The observable interest rate difference between bank loans and private credit facilities is substantial. In European leveraged finance, a broadly syndicated bank loan to a mid-market issuer might price at Euribor plus 375–425 basis points. A direct lending facility will typically price at Euribor plus 525–650 basis points (Preqin, 2024). The gap — roughly 150 to 225 basis points in normal conditions — requires explanation, and the explanations on offer are usually either too simple or arithmetically wrong.

Start with the arithmetic that is wrong, because it is seductive. A bank funds itself at roughly the policy rate plus 30 basis points; a private credit fund raises capital at LP required returns of perhaps 350 basis points over risk-free. The naive conclusion is a funding cost differential of over 300 basis points, attributable to the state guarantee. But this compares the bank's deposit cost to the fund's total cost of capital, and the comparison is apples to oranges. The fund's capital is all equity. The bank also holds equity — regulatory capital against every loan, at an expected return of 10–12% — and a proper comparison blends it in. Weight the bank's funding at its actual capital structure and the differential narrows dramatically. What survives the adjustment is the genuine subsidy: the portion of cheap deposit funding attributable to the guarantee and the franchise, net of the equity the regulator forces the bank to hold precisely because it enjoys that funding.

The second correction concerns the borrowers, who are not in fact comparable. Direct lending portfolios skew systematically toward smaller companies, higher leverage, and sponsor ownership relative to the syndicated market (IMF Global Financial Stability Report, 2024). A portion of the spread gap is not a price for the same risk delivered through a different channel — it is a price for more risk. Any decomposition that omits credit selection inflates whatever residual it is trying to isolate.

Approximate decomposition of the rate gap — mid-market senior credit (Europe, 2024)

• Broadly syndicated bank loan — Euribor + 375–425 bps. Funded by deposits at policy + ~30 bps, blended with regulatory equity at 10–12% expected return.
• Direct lending / private credit — Euribor + 525–650 bps. Funded by locked-up, all-equity LP capital at ~350 bps over risk-free.
• Implied gap: ~150–225 bps — Attributable to: credit selection — smaller, more levered, sponsor-backed borrowers (~40–60 bps); illiquidity premium — hold-to-maturity, no secondary exit (~50–75 bps); bank funding advantage net of regulatory equity cost — guarantee plus deposit franchise (~40–60 bps); execution certainty and bilateral structuring (~20–30 bps).

The honest conclusion is less dramatic than the popular one but more useful. The rate gap is the sum of four prices: a risk price, a liquidity price, a subsidy, and a convenience yield. Private credit is not expensive because its managers are extracting rent; it is expensive because its capital is genuinely costlier, its borrowers genuinely riskier, and the guarantee that cheapens bank funding is not for sale. The subsidy is one component among four. But it is the only one of the four that appears in no prospectus, is priced by no market, and is paid, ultimately, by a fiscal backstop that most participants have stopped noticing.

But the larger and less discussed component is the implicit subsidy in bank funding. Consider the following decomposition. A bank funds itself at the central bank rate plus roughly 30 basis points (for a strong European commercial bank with deposit guarantees and a strong retail base). A private credit fund raises capital at returns expected by its LPs — typically 300–400 basis points above risk-free, reflecting illiquidity, credit risk, and the absence of any guarantee. The funding cost differential alone — before any consideration of loan spread — is 270–370 basis points. This is largely the monetised value of deposit insurance — and, to a lesser extent, the implied state backstop that investors price into bank debt on the assumption that systemically important institutions will not be allowed to fail disorderly.

05 — Can Private Credit Replace Bank Lending?

The question of whether private credit can replace bank lending has been debated with increasing intensity since 2015, when the asset class began to grow rapidly in response to post-crisis bank retrenchment (IMF Global Financial Stability Report, 2024). By 2023, global private credit assets under management exceeded $1.5 trillion, with direct lending — the closest substitute for bank term loans — representing the largest segment. The growth is real. But the substitution is partial and structurally constrained.

Private credit can replace the term loan component of bank credit — the five-to-seven year facility, bilateral or lightly syndicated, used to fund acquisitions, capital expenditure or refinancing. It is making inroads into adjacent products: delayed-draw tranches, and increasingly first-out revolvers within unitranche structures. What it cannot replace is the genuinely short-duration infrastructure — the operating revolver, the overdraft, the trade finance line, the payments system. These products depend on the bank's ability to create instantly accessible claims — the deposit — and to honour them regardless of underlying asset quality. Private credit funds do not issue deposits. They cannot. Maturity transformation outside the banking system requires either a state guarantee or a willingness to absorb run risk, and institutional fund structures are designed to eliminate the latter.

The claim that private credit represents a systemic risk because it is conducting bank-like activities without bank-like regulation is therefore partly wrong — at least in its usual form. Unlevered private credit conducts lending activities without conducting bank-like funding activities. The risk profile is different: less susceptible to runs, more susceptible to mark-to-model valuation opacity, and potentially more pro-cyclical in its capital allocation (Financial Stability Board, 2023). These are genuine regulatory concerns, but they are not the concerns that animate bank regulation, which exists primarily to prevent deposit runs and protect the payments system. The bank-like funding risk does exist in private credit — but it enters through fund leverage, not through the funds themselves. That is the subject of the final section.

06 — Banks as Lenders to Their Shadow

There is a more interesting possibility than simple substitution: that banks respond to private credit's growth not by competing with it but by becoming its capital providers. This is already occurring. Several large European banks — including BNP Paribas, Deutsche Bank, and Société Générale — have established private credit platforms or entered distribution arrangements with direct lending funds (Bloomberg, 2024). The logic is clear from the balance sheet perspective: originating a loan and holding it to maturity requires capital. Providing warehouse financing to a private credit fund, or distributing its paper to insurance clients, generates fee income at a fraction of the balance sheet cost.

The intermediate model is the originate-to-distribute structure, in which a bank originates the loan using its relationships, its underwriting capability and its regulatory licence, then sells it — in whole or as a participation — to a private credit fund. The bank earns an arrangement fee; the fund earns the running spread; the borrower receives execution certainty. Each party contributes what it does best: the bank contributes origination infrastructure and regulatory standing; the fund contributes patient capital willing to hold illiquid exposure.

But the cleaner division of labour conceals a structural sleight of hand. Look at what the bank is actually providing in the converged model: warehouse lines to funds ramping portfolios, NAV facilities secured against fund assets, subscription lines bridging capital calls, back-leverage to levered strategies and BDCs. All of this is short-term or callable credit, funded by deposits, extended against long-dated illiquid loans. That is maturity transformation — performed by the bank, one level removed from the borrower. The mismatch that private credit was supposed to have eliminated has not been eliminated. It has been relocated to the lender-of-leverage layer, where it is funded by the same insured deposit base and enjoys the same implicit guarantee, but attaches to exposures that sit outside the perimeter of loan-level supervision.

This reframes the decomposition of Section 04. The subsidy embedded in deposit funding does not stay neatly on the bank's side of the ledger. To the extent that private credit portfolios are financed with bank leverage, a portion of that subsidy flows through to the fund's cost of capital — and to its borrowers. The asset class defined by the absence of the state guarantee turns out to be partially funded by it. The FSB and the ECB have flagged valuation opacity and concentration risk in private credit (ECB Financial Stability Review, 2023); the more precise concern is bank credit exposure to levered fund structures whose collateral is marked to model and cannot be sold.

— What the Comparison Reveals

The comparison between bank credit and private credit is usually framed as one of cost and convenience: bank loans are cheaper, private credit is faster and more flexible. This framing is accurate but shallow. The deeper difference is structural. Banks perform maturity transformation, viable only because the state guarantees the short-term liabilities that fund it. Unlevered private credit funds do not perform maturity transformation; they lock up capital for years and price accordingly. The rate gap between the two is the sum of four prices — credit selection, illiquidity, the funding subsidy, and execution — of which the subsidy is the one nobody can see on a term sheet.

But the static comparison understates what is actually happening, because the two models are not standing still. Banks are becoming originators, distributors, and — critically — leverage providers to the funds that hold the loans they no longer wish to keep. The deposit insurance system was designed to stabilise the bank that holds the mortgage, not the bank that finances the fund that holds the loan. As holding migrates outward and leverage flows back inward, the protective architecture built around the loan book becomes misaligned with the location of the actual risk: short-term, deposit-funded bank credit secured against illiquid, model-marked private portfolios.

The shadow, in other words, is not a separate institution. It is the bank's own maturity transformation, displaced one level up the chain and dressed in the language of disintermediation. The run risk has not left the system; it has moved to where the supervisors are not yet looking. That is a slow, structural risk — and, characteristically, the kind that reveals itself only after the fact.