Risk remains elevated in leveraged lending, report finds, with ‘weak structures’ for transactions

Material economic downturn could result in a significant increase in exposures, losses

Credit risk associated with leveraged lending remains elevated, with lenders having have fewer protections and risks having increased in leveraged loan terms since the last recession, according to a report released jointly Friday by the federal banking agencies.

In fact, the report notes, rising risk in leveraged lending could lead to higher exposure, and losses, when an economic downturn develops.

According to the Shared National Credit (SNC) Program Review released by the Federal Deposit Insurance Corp. (FDIC), Federal Reserve, and the Office of the Comptroller of the Currency (OCC), most banks have adopted credit risk-management practices to monitor and control “evolving” leveraged loan risk.

“However, some of these controls have not been tested in an economic downturn,” the report states. “The agencies require banks to have risk-management processes that can identify and adapt to changing market conditions.”

According to the report, the SNC reviews found that many leveraged loan transactions possess weak structures. “Underwriting risks are often layered and include some combination of high leverage, aggressive repayment assumptions, weakened covenants, or permissive borrowing terms that allow borrowers to draw on incremental facilities and further increase debt levels,” the report states.

“Many of these credit risk factors are market driven and were not materially present in previous downturns. The agencies are focused on assessing the impact of layered risks in leveraged lending transactions and on determining whether bank risk management practices continue to evolve to address emerging risks.”

The report states that the volume of leveraged transactions exhibiting the layered risks has increased significantly over the past several years. It cites the reason for the growth as strong investor demand enabling borrowers to obtain less-restrictive terms.

“Given the accumulated risks in these transactions, a material downturn in the economy could result in a significant increase in classified exposures and higher losses,” the report states.

The report also notes that nonbank entities “continue to participate” in the leveraged lending market as they seek credit exposure via loan purchases. “These nonbank entities hold a significant portion of non-pass leveraged SNC commitments and mostly non-investment grade equivalent SNC leveraged term loans,” the report states. “Banks primarily hold investment grade equivalent revolving SNC leveraged exposures. The agencies note these investment preferences are not universal as some banks seek higher yields in this relatively benign environment.”

The report points out that loan commitments analyzed were reviewed and grouped into four categories by the severity of their risk, from less severe to more severe: special mention, substandard, doubtful, or loss. The last three are known as “classified,” the report states. (This latest report includes reviews of first- and third-quarter 2019 financial information from banks.)

“Overall, the level of loans rated below ‘pass’ as a percentage of the total SNC portfolio increased slightly from 6.7 percent to 6.9 percent,” the agencies said. “Bank-identified leveraged loan commitments represent 49 percent of total SNC commitments. Leveraged lending was the primary contributor to the overall special mention and classified rates. Investors outside the banking industry held the greatest volume of special mention and classified commitments, followed by U.S. banks and foreign banking organizations.”

Shared National Credit Review finds risk remains elevated in leveraged loans

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