Study finds in wake of pandemic, all stable so far with leveraged lending – but reason for future caution remains

A predicted collapse of some financial institutions and others due to over-investment in leveraged loans and collateralized loan obligations (CLO) as a result of the financial impact of the coronavirus crisis did not materialize largely because of large banks’ strong capital positions and other factors, a new report issued Wednesday from the congressional watchdog has found.

However, the Government Accountability Office (GAO), in its report, stated that federal regulators remain cautious about financial stability and urged the Treasury Secretary and Congress to take action.

More specifically, in its report “Agencies Have Not Found Leveraged Lending to Significantly Threaten Stability but Remain Cautious Amid Pandemic,” (GAO-21-167), the GAO recommended that the Treasury Secretary, as chair of the Financial Stability Oversight Council (FSOC), which monitors leveraged-lending-related risks primarily through its monthly Systemic Risk Committee meetings, conduct scenario-based exercises intended to evaluate capabilities of regulators and financial institutions for responding to crises.

The congressional watchdog also reiterated recommendations it made in 2016 that Congress consider legislative changes to align FSOC’s authorities with its mission.

According to the findings outlined in the GAO report, regulators monitoring the effects of the pandemic as of September 2020 said they had not found that leveraged lending presented significant threats to financial stability. There were at least three reasons for that, the report stated:

  • Based on regulators’ assessments, leveraged lending activities had not contributed significantly to the distress of any large financial entity whose failure could threaten financial stability. They said that large banks’ strong capital positions have allowed them to manage their leveraged lending exposures, and the exposure of insurers and other investors also appeared manageable.
  • Mutual funds experienced redemptions by investors but were able to meet them in part by selling leveraged loan holdings. The paper stated that while this may have put downward pressure on already-distressed loan prices, based on regulators’ assessments, distressed leveraged loan prices did not pose a potential threat to financial stability.
  • Present-day CLO securities appear to pose less of a risk to financial stability than did similar securities during the 2007–2009 financial crisis, according to regulators and market participants. For example, the paper noted, CLO securities have better investor protections, are more insulated from market swings, and are not widely tied to other risky, complex instruments.

However, regulators told GAO according to the paper, they remain cautious about the future impact on leveraged lending. The report asserted that opportunities exist to enhance FSOC’s abilities to respond to financial stability threats.

“FSOC identified leveraged lending activities as a source of potential risk to financial stability before the COVID-19 shock and recommended continued monitoring and analysis,” the report stated. “However, FSOC does not conduct tabletop or similar scenario-based exercises where participants discuss roles and responses to hypothetical emergency scenarios.”

As a result, GAO stated, FSOC is missing an opportunity to enhance preparedness and test members’ coordinated response to financial stability risks. “Further, as GAO reported in 2016, FSOC does not generally have clear authority to address broader risks that are not specific to a particular financial entity, such as risks from leveraged lending,” the report stated.

Financial Stability: Agencies have not found leveraged lending to significantly threaten stability but remain cautious amid pandemic