trending Market Intelligence /marketintelligence/en/news-insights/trending/Fk_96R585lsgZfl4Q_1Vlw2 content esgSubNav
In This List

CLOs could pose systemic risk if economy goes bad, FSB says


Banking Essentials Newsletter May 29th Edition


Managed Services Insights: The client lifecycle management solution


Technology & Automation Insights: Elevating KYC and onboarding efficiency


Banking Essentials Newsletter: May 15th Edition

CLOs could pose systemic risk if economy goes bad, FSB says

Leveraged loan and collateralized loan obligation markets are more vulnerable to macroeconomic shocks than a decade ago, and could pose a systemic risk in a downturn, according to a report by the Financial Stability Board.

SNL Image

The rapid growth of the leveraged loan and CLO markets since the financial crisis of 2008 has concerned many institutions, with the lower credit quality of corporate debt more generally suggesting that the market may be impacted as economic growth slows, the FSB report said.

The securitization of leveraged loans through CLO issuance exceeded pre-crisis levels in 2014 and has grown subsequently, with the combined leveraged loan markets of the U.S. and EU reaching $1.4 trillion, according to LCD, a division of S&P Global Market Intelligence.

Comparisons with the collateralized debt obligations that contributed to the financial crisis has rung alarm bells for the FSB, which was created at the G-20 summit in London in 2009 to monitor risks in global market. An investigation into CLOs was launched in March.

Ready to act

FSB Chairman Randal Quarles has previously suggested it could act if the FSB see hazards in the market, such as a risk that investors would pull the rug out from under indebted institutions if the market turns.

Leveraged finance has hit the headlines as investors have looked to financing high-yield bonds and leveraged loans in a world where traditional financial assets are providing little yield.

Leveraged loans have been used to fuel a boom in mergers and acquisitions.

The FSB identified weaker documentation and the uptick of leverage as a key concern. Changes to loan documentation that have weakened creditor protection are not fully priced in, according to the FSB. "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."

'Complexity and opacity'

The growing role of non-banks such as insurance companies, pension funds and broker/dealers as creditors is also a concern. The FSB warns this may have "increased the complexity and opacity" of leveraged loan and CLO markets, potentially making them more vulnerable to macroeconomic shocks.

"Insurers represent the largest non-bank holders of CLOs, and their exposures include lower-rated tranches," the FSB said. "Stress episodes could therefore have negative implications for insurers, pension funds and other non-banks with CLO exposures."

The researchers identified the holders of around 79% of outstanding leveraged loans and 86% of CLOs, but there is little known about the direct exposures of some non-bank investors, especially to the lower-rated CLO tranches.

'Data gaps'

Banks retain the most concentrated exposure to the sectors but the FSB found the exposure of banks is concentrated among a small number of large, international banks, increasing the potential systemic risk.

"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."