Regulators Sound Warning on Leveraged Loans

Large leveraged loans remain a significant risk to banks in 2023, despite overall credit risk for larger loans declining since the pandemic, according to federal regulators.

In a report on the Shared National Credit System, overseen by the Office of the Comptroller of the Currency, the Federal Reserve, and the Federal Deposit Insurance Corporation — the agencies warned that leveraged syndicated loans often suffered from issues that could pose problems during periods of economic weakness.

“The magnitude and direction of risk in 2023 will be impacted by borrowers’ ability to manage through a period of softer economic conditions including supply chain imbalances, labor challenges, geopolitical tension, inflation, and vulnerability to rising interest rates,” the report stated.

“These macroeconomic conditions could negatively impact the financial performance and repayment capacity of borrowers in a wide variety of industries, especially highly leveraged borrowers that often lack the financial flexibility to respond to external challenges.”

Overall, credit quality for large syndicated bank loans — those originated by two or more banks — improved last year. However, the agencies warned that “the results do not fully reflect increasing interest rates and softening economic conditions that began to impact borrowers in the second half of 2022”.

In addition, many companies in sectors that were particularly affected by the Covid-19 pandemic are still struggling in terms of credit quality, including in areas such as entertainment, recreation, and transportation services. These represented approximately one fifth of loans covered by the report.

According to the report, non-bank entities hold the largest share of “special mention and classified loans” — those deemed to be riskiest. However, overall credit quality has increased even for these types of loans, the report indicated.

The report covered 6,214 borrowers and loans totalling $5.9 trillion — up by 13.9% from 2021.