The leveraged loan market is to be investigated by the Financial Stability Board in case it poses a systemic risk to the global financial system. This is likely to lead to even greater scrutiny of the shadow banking sector. Justin Pugsley reports.
What is happening?
Randal Quarles, chair of the Financial Stability Board (FSB), recently told the Financial Times that his organisation is to investigate the $1400bn leveraged loan market in case systemic risks are lurking there.
Mr Quarles said the FSB needs to better understand this market from a systemic risk point of view and it will be studying whether there is a need for a cross-border or cross-cutting supervisory or regulatory response to mitigate potential risks. In other words, more regulation could be in store for highly leveraged loans and their associated derivatives markets.
Regulators have become much more twitchy about anything resembling a catalyst for a financial meltdown, after being collectively caught asleep at the wheel when the global financial crisis struck with such devastating force.
Lately, a lot of regulatory attention has focused on lending to highly leveraged corporates with feeble balance sheets. In turn, many of these loans have been bundled into collateralised debt obligations and sold on – the very type of derivative instruments (at that time using very dodgy mortgages as collateral) that wrought so much carnage on the financial system during the crisis.
Indeed, there seems to be good cause for concern. S&P Global issued a report warning that global debt levels are now “higher and riskier” than a decade ago, suggesting that another credit downturn may now be inevitable. However, it does not expect it to be as bad as the last one.
The rating agency said debt is 50% higher than in 2008, though that is mainly down to borrowing by developed countries and Chinese corporates leaving debt-to-gross domestic product ratios at 231%, compared with 208% a decade ago.
In a study of nearly 12,000 corporates, S&P Global found 61% “having aggressive or highly leveraged financial risk”. And though defaults have a remained low in recent years, this could all change during a recession, especially as there are many speculative grade corporate borrowers loaded with debt.
Also, the absolute level of debt in the BBB category (the lowest investment grade rating) has ballooned by 170% since 2008.
And it gets worse. S&P found that 80% of leveraged loans outstanding were done on ‘cov-lite’ contracts, meaning that the loan imposes fewer restrictions on the borrower and provides less investor protection. Many cov-lite loans have been made to highly leveraged large corporates.
Why is it happening?
Just like last time, it is all about investors chasing yield while riding the tailwind of a relatively benign economic environment. Meanwhile, corporates have taken advantage of cheap money, often to fund share buy-backs and bumper dividend payouts to shareholders and sometimes takeovers.
What do bankers say?
While some of the numbers being bandied about look alarming, bankers point out that there are some important caveats. Among them is that this debt is largely being accumulated by asset managers rather than banks, which often have to shun it because of high capital requirements associated with holding it. Banks are also far better capitalised with lower leverage and are more much closely supervised.
In terms of collateralised loan obligation (CLO) structures, these are said to be more conservative now, with lower rated loans taking the brunt of any defaults first. Many of these are floating rate, meaning that if a recession struck, central banks are likely to slash interest rates and even restart quantitative easing, thereby taking some pressure off borrowers.
Also, many borrowers have managed to refinance at lower rates and on extended maturities, which reduces rollover risks for them. Many have sufficient cashflows to service their loans – though this could change in a recession when business falls away and customers take longer to pay (think cyclicals such as construction and airlines).
Will it provide the incentives?
The FSB wants to know who is buying all these loans and CLOs and how they would react in the event of a downturn. As banks do not hold much of them these days, it is very likely the FSB will discover the so-called $50,000bn ‘shadow banking’ sector is deeply intertwined in these activities. There will be a particular emphasis on how some of these vehicles, such as some mutual funds or exchange-traded funds, cope with investor redemptions. The International Organization of Securities Commissions has already done work in that particular area.
If the FSB does uncover some nasty gremlins lurking in the shadows, then asset managers, insurance companies and other non-bank finance providers could find themselves the target of much greater scrutiny and regulation – though in some jurisdictions, banks could be told to raise their counter-cyclical capital buffers to guard against possible contagion risks.
