Risky Business: Leveraged Lending

Leveraged lending offers credit to commercial businesses with high levels of debt, helps companies obtain funding for leveraged buyouts, mergers and acquisitions, and recapitalizing businesses. While many commercial businesses see success from these loans and are able to repay them, the high levels of debt and lower liquidity can reduce a business’ ability to respond to unexpected changes in economic conditions. We’ve been in a season of economic expansion and lower interest rates, which has resulted in more businesses receiving leveraged loans over the past decade.

The FDIC has recognized the importance of leveraged lending and the role it plays in global market economy. With the heightened risk of leveraged lending, underwriting and bank risk-management practices are expected to be of utmost importance and soundness. Strongly underwritten loans benefit everyone in the leveraged-lending market, according to the FDIC.

Leveraged lending has no specific, universal definition. Generally, criteria for consideration includes overall borrower risk, loan pricing, and measure of leverage (debt to income). Credit rating agencies generally define leveraged lending as “loans rated below investment grade level” and “loans to non-rated companies that have higher interest rates than typical loan interest rates.”¹

Both banks and non-bank entities participate in leveraged debt financing, approximately 63 percent by banks and 37 percent by non-banks.¹ After looking at statistics and observations from FDIC-supervised insured depository institutions (IDIs) and Shared National Credit Program (SNC), the FDIC released it’s Supervisory Insights Report for Fall 2019 that looks at exposure in the banking sector. Leveraged lending is tracked by the SNC based on information reported by IDIs. Based on these reports, bank-reported leveraged credits in 2018 totaled approximately $2.1 trillion, $700 billion being investment grade. Rating agencies consider this market size average.

What’s the risk? In terms of dollar volume and loan structures, heightened demand for leveraged credit alongside non-bank preferences have resulted in weak credit structures. The 2018 SNC review found that “many leveraged loan transactions possess weakened transaction structures and increased reliance upon revenue growth or anticipated cost savings and synergies to support borrower repayment capacity.” The FDIC urges IDIs to ensure the ability to properly measure, monitor, and control leveraged loans-- awareness of the risks involved is the best measure that can be taken.

There are $295 billion in Special Mention and adversely classified loans out of the $4.4 trillion SNC portfolio. Leveraged loans total 73 percent of special mention commitments, 87 percent of substandard, 45 percent doubtful, and 76 percent of non-accrual loans.¹ The FDIC has standards in place in the Interagency Guidelines Establishing Standards for Safety and Soundness to ensure steps are taken to prevent concerns before they threaten the Deposit Insurance Fund. The Guidelines outline appropriate risk management based on the size of the institution and the nature, scope, and risk of its activities. A few guidelines suggested are internal controls and information systems, periodic asset-quality reviews to identify problem assets, and loan documentation processes that enable informed lending decisions, to name a few.

The FDIC believes this trend of more leveraged loans and weaker loan structures is caused in part by more competition for these loans and increased fees for generating them. Data trends show that some IDIs have created loans without proper risk assessment or appropriate policies and procedure. Sound underwriting procedures are essential, as these already risky loans cam cause losses for IDIs. The FDIC writes, “IDIs are expected to develop policies and procedures that identify and measure risk, monitor leveraged credit, and implement sound underwriting and risk management practices” to protect against losses.

The FDIC sums up that “leveraged lending presents heightened risk for IDIs if internal risk management programs are not established and effectively managed. Leveraged lending volumes, held by banks and non-banks, have continued to increase. As a result, regulatory scrutiny of this sector will continue.” Check out the entire Supervisory Insights Report here.

Source:

1. https://www.fdic.gov/regulations/examinations/supervisory/insights/sifall19/si-fall-2019.pdf