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Home Commercial Lending

Leveraged Lending Is Rising, But Bank Exposure Is Limited

May 10, 2019
Reading Time: 3 mins read
Leveraged Lending Is Rising, But Bank Exposure Is Limited
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By Curtis Dubay
ABA Senior Economist

Leveraged lending—loans made to businesses that are already highly indebted—has been growing rapidly in recent years. That growth has raised alarm bells in some circles, including among bank regulators. The Federal Reserve’s recent financial stability report made clear that regulators have their eyes on the loans, and FDIC Chairman Jelena McWilliams recently said that regulators are talking about the risks posed by leveraged lending “all the time.”

Given the rapid growth of leveraged lending—16.8 percent annual growth over the past 20 years—it is sensible for regulators to look carefully at the risks. At the same time, it’s important to note that the rapid growth is attributable largely to nonbanks and that the banking industry’s exposure, should this group of loans start underperforming, is relatively low. This conclusion was evident in both the Fed’s financial stability report and the Shared National Credit Program report (from the prudential banking regulators), and it was reiterated by Federal Reserve Vice Chairman for Supervision Randal Quarles in recent remarks.

Leveraged lending has increased due to nonbank providers

Leveraged loans grew more than 20 percent in 2018 and stand at almost $1.2 trillion according the stability report. However, banks’ share of originations of leveraged loans has been declining, and they only hold a fraction of them on their balance sheets. It is nonbanks that are fueling the growth in issuances according to the SNC. From the report: “Nonbank entities have increased their participation in the leveraged lending market via both purchases of loans and/or direct underwriting and syndication of exposure. More leveraged lending risk is being transferred to these non-bank entities.”

Moreover, as the chart from the financial stability report above shows, almost all leveraged loans are held in collateralized loan obligations—securitized loans that are held by a range of investors other than banks. Those investors have stable funding bases, which limits their systemic risk. From the financial stability report: “The investor base for CLOs has become more stable than in the past. CLOs are now predominantly held by investors with relatively stable funding. In contrast, before the financial crisis they were commonly held by leveraged structured investment vehicles that relied heavily on short-term wholesale funding.”

To the extent banks are holders of CLOs with leveraged loans, they hold the least risky portions of the securities. “Roughly one-half of the newly issued triple-A-rated CLO tranches are held by foreign and domestic banks,” the financial stability report says, “while the more risky tranches are primarily held by asset managers, insurance companies, hedge funds, and structured credit funds.”

Banks’ risk is limited

Banks face limited risk from leveraged loans in three primary ways. The first is “pipeline risk,” when banks hold leveraged loans on their books for a period of time before they can sell them. The second is the risk posed by the minimal amount of leveraged loans banks maintain on their books. Third, banks face counterparty risk if their customers are exposed to CLOs.

However, the financial stability report makes clear banks are well-positioned for all three risks. It states that “large banks have improved their management of syndication pipelines,” reducing the risks of banks being caught with leveraged loans on their books should the market turn quickly. And from a high-level perspective, according to annual stress-test exercises [which] stress a range of participating banks’ direct and indirect exposures to shocks from the business . . . banks appear well positioned to deal with [leveraged loan] exposures.”

Further backing the findings of the financial stability and SNC reports are recent comments from Quarles. Leveraged loans risk “is not really a direct analogue to the subprime [mortgage] lending that caused the financial crisis and hasn’t grown to a level that is inconsistent with historical precedent for this point on an expansion,” he said in remarks at Yale University. He added that banks have some exposure to CLOs, but it is limited and small enough that it does not create financial stability concerns.

Conditions can change rapidly, so it is appropriate for the banking industry to keep an eye on leveraged loans and its exposure to them. At this point, however, the industry does not appear overexposed. Rather, it is nonbank lenders whose exposure appears to be greatest and that should be the subject of scrutiny.

Tags: ABA Data BankFinancial stabilityLeveraged lendingNonbanksRisk managementShadow bankingSyndicated credit
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