Federal banking regulators said in a recent report that the credit risk associated with leveraged lending in the industry remains elevated.
The findings came in the Shared National Credit (SNC) Program Review issued by the Federal Reserve, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.
The review primarily reflected loans originated on or before June 30, 2019.
“Lenders have fewer protections and risks have increased in leveraged loan terms through the current long period of economic expansion since the last recession,” the agencies said in a release accompanying the report. “Most banks have adopted credit risk-management practices to monitor and control this evolving risk. However, some of these controls have not been tested in an economic downturn.”
The 2019 SNC portfolio included 5,474 borrowers, totaling $4.8 trillion, up from $4.4 trillion in 2018. U.S. banks held the greatest volume of SNC commitments at 44.4 percent of the portfolio, followed by foreign banking organizations and other investor entities such as securitization pools, hedge funds, insurance companies, and pension funds.
Loan commitments 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 of which are known as “classified.”
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.
“The SNC reviews found that many leveraged loan transactions possess weak structures,” the report stated. “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. Many of these credit risk factors are market driven and were not materially present in previous downturns.”
The report said the regulators were 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 focus has intensified as the volume of leveraged transactions with layered risks has “increased significantly” as strong investor demand has enabled 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 stated. “In addition, nonbank entities continue to participate in the leveraged lending market as these firms seek credit exposure via loan purchases. These nonbank entities hold a significant portion of non-pass leveraged SNC commitments and mostly non-investment grade2 equivalent SNC leveraged term loans.”
Bank risk management practices for leveraged loans has improved since 2013, the report stated, as banks are better equipped to assess repayment capacity and estimate enterprise valuations.
“Banks engaged in originating and participating in leveraged lending should ensure their risk management processes remain effective in changing market conditions,” the report cautioned. “Controls should ensure that financial analysis, completed during underwriting and to monitor performance, is based on appropriate revenue, growth, and cost savings assumptions and considers the impact of incremental facilities. All banks should ensure that portfolio management and stress testing processes consider that recovery rates may differ from historical experience.
“Banks also should consider how potential risks from a downturn in the leveraged lending market may affect other customers and borrowers. The agencies expect identified risks to be measured against their potential impact on earnings and capital.”