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    US Agencies Find Risk Associated with Leveraged Lending to be High

    January 31, 2020

    US agencies (FDIC, FED, and OCC) published a report that assesses credit risks in context of the loans originated on or before June 30, 2019 by the supervised banks. This review is part of the Shared National Credit (SNC) Program, which assesses credit risk and trends as well as risk management practices associated with the largest and most complex credits shared by multiple regulated financial institutions. The report finds that credit risk associated with leveraged lending remains elevated. Also, the share and amount of loan commitments with the lowest supervisory ratings (special mention and classified) rose slightly between 2018 and 2019.

    Based on the definitions in the agencies’ uniform loan classification standards and examination manuals, classified risk ratings include commitments rated substandard, doubtful, and loss.  Loans that are special mention and classified are considered non-pass loans. The report finds that the total special mention and classified commitment levels remain elevated compared with lows reached during previous periods of strong economic performance. A significant portion of special mention and classified commitments are concentrated in transactions that agent banks identified and reported as leveraged loans. There has been accumulation of risk in bank-identified leveraged loan structures through the long period of economic expansion. In response, most banks have adopted credit risk management practices to monitor and control this evolving risk. Some of these controls, however, have not been tested in an economic downturn. 

    Overall, the agent banks’ risk management practices for leveraged loan commitments have improved since 2013. They are better equipped to assess borrower repayment capacity and estimate enterprise valuations while having improved other risk management practices. The agencies expect that banks engaged in originating and participating in leveraged lending should ensure their risk management processes remain effective in changing market conditions. Controls should ensure that financial analysis, completed during underwriting and to monitor performance, is based on appropriate revenue, growth, and cost savings assumptions and considers the impact of incremental facilities. All banks should ensure that portfolio management and stress testing processes consider that recovery rates may differ from historical experience. Banks also should consider how potential risks from a downturn in the leveraged lending market may affect other customers and borrowers. The agencies expect identified risks to be measured against their potential impact on earnings and capital.

    The SNC Program is governed by an interagency agreement, with the agencies conducting SNC reviews in the first and third calendar quarters with some banks receiving two reviews and others receiving a single review each year. The 2019 SNC portfolio included 5,474 borrowers, totaling USD 4.8 trillion, up from USD 4.4 trillion in 2018. U.S. banks held the greatest volume of SNC commitments at 44.4% of the portfolio, followed by foreign banking organizations and other investor entities such as securitization pools, hedge funds, insurance companies, and pension funds. Total commitments increased by USD 396 billion, or 8.9%, from third quarter of 2018 to the third quarter of 2019. The next report will be published following the third quarter 2020 SNC examination.

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    Keywords: Americas, US, Banking, Credit Risk, Leveraged Lending, Loan Origination, SNC Loans, US Agencies

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