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THE ECONOMICS OF THE PRIVATE MARKET

Banks as Competitors of Private Placement Lenders

Although banks do not buy many private placements of debt, they do compete with buyers of private debt. Firms that can borrow in the private placement market can also typically borrow in the bank loan market. The two sources of funding are not perfect substitutes in that terms typically differ, but a sufficient cost differential can persuade borrowers to choose the alternative with otherwise less-attractive terms.

Available data do not support an empirical analysis of the extent of substitution between the two markets. Market participants indicated that the competition is greatest for borrowings at intermediate maturities of three to seven years. Private market lenders do not usually offer competitive terms at shorter maturities, and banks are not usually competitive at longer maturities. This difference in competitive advantage is most likely due to economies of scope between lending and the differing liabilities for the two classes of lenders, as part 1 discussed. Typical private market lenders have long-term, often fixed-rate liabilities and thus can make long-term loans more cheaply than can banks, which must bear the cost of swaps and other hedges. Banks are naturally most competitive for short-term, floating-rate loans.

According to market participants, at intermediate maturities, the decision between a bank loan and a placement depends on a borrower's preference for a fixed or floating rate, on the current cost of interest rate swaps, and on prevailing rates in the two markets. Rates and swap costs vary enough that a borrower's decision may be different at different times. In other words, the maturity beyond which a qualified borrower desiring a fixed rate is almost certain to go to the private placement market varies with market conditions.

No substantial change in the nature of this competition or in the comparative advantages of banks and private market lenders appears in the offing. The average maturity of insurance company liabilities has grown shorter during the last decade, making the private placement market more competitive at shorter intermediate maturities.  Differences in the maturity structures of banks and private market lenders are likely to persist, however, at least until the legal restrictions that separate banking and other forms of commerce are removed.

Appendix A.  Definition of Private Placement, Resales of Private Placements, and Additional Information about Rule 144A

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