FRM Exam Part II · The Rise and Risks of Private Credit

Private Credit vs Banks and Public Debt Markets

Updated 11 October 2026 · Fact-checked

Private credit is lending by non-bank funds directly to firms, usually in illiquid, negotiated, floating-rate loans held to maturity. Banks lend from deposits under capital and liquidity rules. Public markets (broadly syndicated loans, bonds) sell standardised, tradable debt to many investors. To answer questions, compare funding, regulation, flexibility, covenants and borrower profile.

Understand Private Credit vs Banks and Public Debt Markets

Start with who lends and with whose money. A bank funds loans mostly with deposits and wholesale debt. It faces Basel capital and liquidity rules and deposit-insurance and supervisory oversight. A private credit fund raises money from institutions such as pension funds, insurers and sovereign wealth funds. It lends directly to borrowers, often mid-sized firms owned by private equity sponsors. Its funding is typically long-term capital commitments, with limited run risk at the fund level, though some funds use leverage.

Now the public market. In a broadly syndicated loan (BSL), a bank arranges a loan, then sells slices to many investors, including CLOs and loan funds. In a bond deal, the issuer sells securities to the public or to institutions. Both are larger, rated or widely monitored, and tradable. Borrowers are usually bigger and better known. The cost is that terms are standardised and the process is slower and more public.

Direct lending is the core private credit strategy. One lender or a small club negotiates the whole loan. This gives speed, certainty of execution, tailored terms and confidentiality. The borrower often pays a higher spread, usually floating-rate, in return. The lender gets a liquidity premium and an illiquidity risk it must manage. Direct loans are held, not traded, so valuation relies on models and marks, not market prices.

Covenants differ in practice. Private loans, with few lenders, typically carry tighter maintenance covenants (tested regularly, for example leverage or interest cover) and easier renegotiation when they are breached. BSLs and bonds are often covenant-lite or use incurrence covenants, which only bite when the borrower takes a specific action such as issuing more debt. A breach in a private loan usually leads to a quick, bilateral talk, not a dispersed creditor process.

For regulation, the key idea is that rules differ by entity type, not by risk. Banks hold capital against loans. Many private credit funds are not subject to bank-style capital or liquidity rules. This can look like regulatory arbitrage: activity moves to where rules are lighter. But banks remain linked to the sector through loans to private credit funds, backup lines and fund financing. That connection is why supervisors watch interconnectedness and opacity.

Key formulas to remember

Borrower trade-off: Private credit: higher spread + speed + flexibility + tailored terms vs Public markets: lower spread + liquidity + scale; A qualitative rule. Use it to justify why a borrower picks one route; it is not a pricing formula.
Covenant types: Maintenance covenant = tested on a schedule; Incurrence covenant = tested only when an action is taken; Covenant-lite loans have no maintenance financial covenants, typically only incurrence tests.
Funding comparison: Bank: deposits + wholesale funding; Private credit fund: investor commitments (plus possible fund leverage); BSL/bond: capital-market investors; Run risk is a bigger concern for deposit-funded banks than for closed-end funds with locked capital.
Spread decomposition: Spread ≈ expected credit loss + liquidity premium + complexity premium + risk premium; Illustrative decomposition. Private loans usually carry a larger illiquidity and complexity premium.

How to solve Private Credit vs Banks and Public Debt Markets questions

Use the same five-lens method for any comparison or case question on this topic.

1Identify the lenders and the borrower in the question: bank, private credit fund, BSL or bond market; and the size and profile of the borrower.
2Compare funding: deposits and wholesale debt, locked investor capital, or capital-market investors, and note any leverage.
3Compare regulation: Basel capital and liquidity rules for banks versus lighter or different oversight for funds, and name regulatory arbitrage if rules differ for similar risks.
4Compare flexibility and structure: speed, negotiation, customisation, floating rate, hold-to-maturity versus tradable and standardised.
5Compare covenants and monitoring: maintenance versus incurrence versus covenant-lite, and how a breach is resolved.
6Link to the risk: illiquidity, valuation opacity, concentration in sponsor-backed borrowers, and bank-fund interconnectedness.
7Choose the option that matches the lens the question asks about, and discard options that overstate a tendency as an absolute.

Quickest way: Four-word scan: Money, Rules, Terms, Size

When to use it: Use for MCQs asking which statement about private credit versus banks or public markets is correct.

Money: who funds it (deposits, investor capital, market investors)?
Rules: is it under Basel bank rules or lighter fund rules?
Terms: negotiated and tight, or standardised and covenant-lite?
Size: mid-sized sponsor-backed borrower, or large widely held issuer?
Eliminate options with words like always, never or only unless the text supports them.

Common mistakes in Private Credit vs Banks and Public Debt Markets

Saying private credit is unregulated.
Students hear that funds face lighter rules than banks and stretch it.
Fix: Say funds face different regulation, often without bank-style capital or liquidity rules, but are still subject to securities and investor-protection oversight.
Treating all private credit loans as having tight covenants.
The general tendency is learned as an absolute rule.
Fix: Say private loans tend to have tighter maintenance covenants and easier renegotiation, but terms vary and some large deals loosen protections.
Confusing direct lending with broadly syndicated loans.
Both are leveraged loans to corporates.
Fix: Direct lending is negotiated with one lender or a small group and held. A BSL is arranged by a bank and sold to many investors, including CLOs, and is tradable.
Assuming private credit has no link to banks.
Focus on the shift of lending away from banks.
Fix: Remember banks lend to funds, provide credit lines and fund financing, so stress can come back to banks.
Assuming fund-level funding means no liquidity risk.
Locked capital reduces run risk, so students think risk disappears.
Fix: Illiquid assets, valuation by models, fund leverage, redemption features in some vehicles and borrower stress still create liquidity and valuation risk.

Worked examples

Example 1

A mid-sized, sponsor-owned software firm needs ₹ equivalent of USD 150 million quickly for an acquisition and wants confidentiality and flexible terms. Which funding route is most likely, and why? (A) A public investment-grade bond, (B) A direct loan from a private credit fund, (C) A broadly syndicated loan to be sold to many investors, (D) A deposit-funded bank retail loan.

Show the solution

Read the borrower profile: mid-sized, sponsor-owned, not an investment-grade public issuer.
Read the needs: speed, confidentiality, flexible terms.
A public bond needs a rating, disclosure and a marketing process, so it is slower and less confidential, and is unlikely for this issuer.
A BSL needs syndication to many investors and carries market-flex risk, which reduces certainty and confidentiality.
A retail bank loan does not fit a USD 150 million acquisition loan.
A direct loan is negotiated with one lender or a small club, gives speed and certainty, and allows tailored terms.

Answer: (B) A direct loan from a private credit fund.

Example 2

A risk manager notes that a bank cuts leveraged lending because of higher capital charges, while private credit funds expand in the same segment and the bank lends to those funds. Which description is best? (A) Regulatory arbitrage with remaining bank interconnectedness, (B) Complete transfer of risk out of the financial system, (C) Evidence that private credit has stricter regulation than banks, (D) A reduction in valuation opacity.

Show the solution

Notice that activity moves to entities facing different rules, which is regulatory arbitrage.
Notice that the bank still lends to the funds, so risk returns to it via credit exposure.
Option B ignores the bank's exposure to the funds.
Option C is the opposite of the usual finding: funds typically face lighter bank-style capital and liquidity rules.
Option D is wrong because private loans are held and valued by models, which increases opacity.

Answer: (A) Regulatory arbitrage with remaining bank interconnectedness.

Exam tips

Expect case-style questions asking you to match a borrower profile to a funding route; read size, speed and confidentiality cues first.
Know the difference between maintenance, incurrence and covenant-lite terms; options often mix them up.
Watch for absolute words in options; the correct answer usually states a tendency.
When regulation appears, name the concept: bank capital and liquidity rules versus lighter fund oversight, and regulatory arbitrage.
Always link to financial stability: opacity, illiquidity and bank-fund links.

Practice questions from The Rise and Risks of Private Credit

Private Credit vs Banks and Public Debt Markets in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Private Credit vs Banks and Public Debt Markets: frequently asked questions

What is the main difference between private credit and bank lending?

Private credit comes from non-bank funds using investor capital, while banks lend mainly from deposits under Basel capital and liquidity rules. Private loans are often negotiated, floating-rate and held to maturity. Banks also lend to private credit funds, so the two are linked.

How is direct lending different from broadly syndicated loans?

Direct lending is negotiated by one lender or a small group that usually holds the loan. A broadly syndicated loan is arranged by a bank and sold to many investors, including CLOs, and trades in a secondary market. BSLs tend to be larger and more standardised.

Why do borrowers choose private credit over the public bond market?

They get speed, certainty of execution, confidentiality and tailored terms, and avoid ratings and public marketing. Smaller or sponsor-backed firms may not access public markets easily. The usual cost is a higher spread.

Does private credit involve regulatory arbitrage?

It can look that way, because activity shifts to funds that face different rules from banks. But banks still have exposures through loans and credit lines to these funds. Supervisors therefore focus on opacity and interconnectedness.