On Dec. 19, 2019, the Financial Stability Board issued a report titled “Vulnerabilities Associated with Leveraged Loans and Collateralised Loan Obligations”. The Financial Stability Board (FSB) coordinates at the international level the work of national financial authorities and international standard-setting bodies in order to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. The Report notes that the markets for leveraged loans and Collateralised Loan Obligations (CLOs) have grown significantly in recent years, with the majority of issuance activity concentrated in the US and to a lesser extent the European Union (EU).
The Report further notes that, recently, several authorities and international financial institutions, including FSB members, have expressed concerns about the rapid growth in the leveraged loan market and the lower credit quality of corporate debt more generally.
The Report assesses the vulnerabilities and potential financial stability implications of developments in the leveraged loan and CLO markets.
The main conclusions from the Report are as follows:
- A number of factors suggest that vulnerabilities in the leveraged loan and CLO markets have grown since the global financial crisis. The degree of borrowers’ leverage has increased and, although loans tend to have lower credit ratings, there is some evidence that certain changes to loan documentation that weaken creditor protection are not fully priced in by market participants and investors. This has the potential to not only increase default rates and decrease recovery rates for leveraged loans, but also to exacerbate investor reactions to shocks. Furthermore, changes to the composition of creditors (i.e. a shift from banks to a range of non-banks) may have increased the complexity and opacity of the leveraged loan and CLO markets, potentially introducing new risks and avenues for shock transmission. As a result, these markets may be more vulnerable to macroeconomic shocks than in the past, and stress in leveraged loan markets could disrupt other markets.
- Available data indicates that banks have the largest direct exposures to leveraged loans and CLOs. These exposures are concentrated among a limited number of large global banks and have a significant cross-border dimension. The exposures could increase further in stress as a result of revolving credit facilities being drawn down by leveraged borrowers and banks being unable to syndicate loans they intended to distribute, which could adversely affect bank capital and liquidity. Banks are also exposed through the financing of non-bank investors in leveraged loans and CLOs. Moreover, the banks most active in these markets play a significant role in other financial markets. While banks are more resilient to these risks due to higher levels of capital and liquidity as the result of postcrisis reforms, the degree of bank resilience against downturns may be difficult to judge, considering the changes in risk characteristics in leveraged loan and CLO markets.
- A number of non-bank investors are also exposed to leveraged loan and CLO markets. These include investment funds, insurance companies, pension funds, broker-dealers and holding companies. Investments in these relatively illiquid instruments by open-ended investment funds could involve liquidity transformation. While redemptions from such funds have not caused strains on liquidity in these markets to date, their exposures could nonetheless add to the risk of procyclical behavior in times of stress. Insurers represent the largest non-bank holders of CLOs, and their exposures include lower-rated tranches. Stress episodes could therefore have negative implications for insurers, pension funds and other non-banks with CLO exposures.
- A comprehensive assessment of the system-wide implications of the exposures of financial institutions to leveraged loans and CLOs is challenging. First, there remain important data gaps. Using supervisory and market data, the direct holders of roughly 79% of leveraged loans and 86% of CLOs were identified in the Report. Little is known, in particular, about the direct exposures of certain non-bank investors to these markets, including their holdings of lower-rated CLO tranches. Moreover, limited information on indirect linkages between banks and non-banks makes it difficult to assess possible risks from spillovers and interconnectedness, and their systemic implications. Second, the propagation of adverse developments across the financial sector would depend on the behavior of the holders of leveraged loans and CLOs in stressed scenarios. This behavior, in turn, depends on factors such as sources of funding, investment horizons and risk management practices, some of which may encourage shedding of exposures under stressed market conditions that potentially amplify strains. At the same time, more resilient CLO structures might act as a mitigating factor. The magnitude of the stress itself would depend on macroeconomic conditions, and could be compounded during an economic downturn when alternative sources of credit are limited.
- More work is needed to close remaining data gaps and assess in a comprehensive manner the possible financial stability implications associated with leveraged loans and CLOs. Supervisory authorities across all jurisdictions in scope have put banks’ leveraged lending activity under increased scrutiny and have launched a series of data collections. The closing of data gaps, particularly for the highly heterogeneous non-banking sector, as well as information sharing and cooperation between supervisors and market authorities on a cross-border basis, is needed to assess exposures and possible transmission channels of shocks associated with leveraged loans and CLOs. The FSB will consider whether there is scope to close data gaps, will continue to analyze the financial stability risks and will discuss the regulatory and supervisory implications associated with leveraged loans and CLOs.
The full report can be found here.