Leveraged loan exposures may represent an under-appreciated risk for financial institutions, says Fitch Ratings.
In a new report, the rating agency said that financial firms’ leveraged loan and collateralized leveraged loan (CLO) exposures appear “manageable” relative to their capital positions, but that the risks “may rise sharply” in a stressed market.
Fitch estimated that large U.S. banks had leveraged loans equivalent to 29% of common equity Tier 1 capital, as of the end of 2018. For large European and large Japanese banks, it estimated that leveraged loans amount to 27% and 16% of capital, respectively.
“These exposures appear moderate at a sector level. However, some banks have significantly higher direct exposure and may have built concentrations or taken riskier positions,” it said.
Fitch estimated that the more active banks in the leveraged loan market have exposures that represent 30% to 40% of capital.
Additionally, it said that U.S. life insurers have CLO holdings that average about 20% of total adjusted capital, and that non-bank financial institutions are “increasingly active” in some of the more aggressive aspects of leveraged lending, such as buyouts and dividend recapitalizations.
“Non-bank financial institutions could be more at risk given their weaker funding profiles and less diversified business mix,” Fitch said, adding, “If banks or investment managers step in to support funds, contagion back to the banking sector may increase.”
And it warned about liquidity risk for investment funds.
“Open-ended funds that hold large amounts of less-liquid leveraged loans are exposed to liquidity risk, particularly if spikes in redemptions raise the prospect of fire sales,” Fitch said.