December 20, 2023 - In 2020, the Government Accountability Office (“GAO”) published an extensive report on Financial Stability and leveraged loans, noting that “[a]lthough regulators monitoring the effects of the pandemic remain cautious, as of September 2020, they had not found that leveraged lending presented significant threats to financial stability.” Notwithstanding the GAO’s findings and the leveraged loan default rate subsequently falling by half, questions continue to be raised as to whether BSL institutional loans and CLOs pose a systemic risk to the financial system. In a recent Systemic Risk White Paper, the LSTA analyzed the market to put such worries to bed. Below we recap the White Paper but encourage interested readers to review the whole piece.

What is systemic risk…and how do you measure it? In its 2017 “Methodology For Assessing Implementation of the IOSCO Objectives and Principles of Securities Regulation,” the International Organization of Securities Commissions (“IOSCO”) defined systemic risk as “the potential that an event, action, or series of events or actions could have a widespread adverse effect on the financial system and, in consequence, on the economy.”

In its “Analytic Framework for Financial Stability Risk Identification, Assessment, and Response”  (“the Framework”), the U.S. Financial Stability Oversight Council (“FSOC”) stated that “[f]inancial stability can be defined as the financial system being resilient to events or conditions that could impair its ability to support economic activity…Events or conditions that could substantially impair such ability would constitute a threat to financial stability. Adverse events, or shocks, can arise from within the financial system or from external sources. Vulnerabilities in the financial system can amplify the impact of a shock, potentially leading to substantial disruptions in the provision of financial services.” FSOC went on to identify potential risks to financial stability (including leverage, liquidity risk and maturity mismatch, interconnections, operational risks, and complexity and opacity) and transmission channels (including exposures, asset liquidation, critical function or service, and contagion) that can transmit these risks to the broader financial system.

In the White Paper, we use this Official Sector Framework to address whether BSL institutional loans and CLOs are – or, more pointedly, are not – systemically risky. We recap the analysis below.

Potential Risks

• Leverage: The Framework notes that leverage can amplify risks by reducing market participants’ ability to satisfy their obligations and by increasing the potential for sudden liquidity strains.” While leverage (in the form of bank lending to non-bank lenders) does exist in the BSL and CLO markets, a very small portion of it is “mark-to-market” leverage; rather, credit lines from banks typically are based on credit fundamentals. The other main users of leverage – CLOs – issue long-term bonds, have no mark-to-market pressures and are not subject to forced selling pressures.
• Liquidity Risk and Maturity Mismatch: The Framework notes that a shortfall of sufficient liquidity to satisfy short-term needs, or reliance on short-term liabilities to finance longer-term assets, can subject market participants to rollover or refinancing risk.  Due to the constituents of the lender base, there is very little liquidity risk or maturity mismatch in the institutional loan or CLO markets. CLOs – which are match funded – comprise roughly 70% of the leveraged loan lender base. SMAs and commingled funds typically have a notice period for redemptions and the ability to gate. Open-end loan funds, which do need to meet redemptions daily, comprise less than 10% of the lender base and, as discussed extensively in the LSTA’s Liquidity Risk Management Comment Letter, have many tools to meet redemptions.
• Interconnections: The Framework notes that direct or indirect financial interconnections, such as exposures of creditors, counterparties, investors, and borrowers, can increase the potential negative effect of dislocations or financial distress. There are some important interconnections in the loan market, most notably the connection between banks and institutional loans. However, banks’ exposure to institutional loans generally has limited credit risk. Bank lines that finance lenders’ investments in loans are collateralized, have covenants and remedies, and are largely investment grade exposures. Banks do invest in CLO notes, but almost exclusively in AAA-rated notes, which have never suffered a default or impairment in their 30-year history. In order for AAA notes to suffer losses, institutional loan default rates would have to be magnitudes higher than those seen in the Global Financial Crisis.
• Complexity or Opacity:The Framework notes that a risk may be exacerbated if a market, activity, or firm is complex or opaque, such as if financial transactions occur outside of regulated sectors. Institutional loans and CLOs offer a surfeit of information to their lenders and investors. Institutional loan transparency is buttressed by i) public ratings, ii) trade press reporting, iii) daily secondary market prices and iv) document subscription services like Covenant Review and Xtract. CLO transparency is buoyed by i) public ratings, ii) trade press and bank analyst reporting, iii) trustee reports, iv) subscription services that investors use to monitor their CLO investments.
• Inadequate Risk Management:The Framework states that a risk may be exacerbated if it is conducted without effective risk-management practices, including the absence of appropriate regulatory authority and guidance. Leveraged loans arranged by banks remain subject to the Leveraged Lending Guidance, which “describes expectations for the sound risk management of leveraged lending activities.” Meanwhile, CLOs are the largest single institutional loan lender category and their entire structure is governed by a matrix of tests to ensure the safety of the loan portfolio and CLO notes. These include interest coverage (“IC”) and overcollateralization (OC) tests, as well as collateral quality tests and portfolio limitations that measure (i) credit quality of the portfolio, (ii) weighted average spread of the portfolio, (iii) weighted average life, and (iv) diversification tests and concentration limitations, all of which are measured against defined covenants within a CLO’s governing documentation and reported in the monthly trustee reports.
• Concentration:The Framework notes that a risk may be amplified if financial exposures or important services are highly concentrated in a small number of entities. The institutional loan market does not have a high concentration ratio. LSEG LPC’s 2022 “Institutional Bookrunner” League tables has more than 100 entities that acted as bookrunners for institutional loans in 2022 with no entity having more than 6.4% market share; Pitchbook LCD identified more than 250 institutional loan groups that purchased loans in 2022.

Transmission Channels

• Exposures: The Framework notes that direct and indirect exposures of creditors, counterparties, investors and other market participants can result in losses in the event of a default or decreases in asset valuations. The potential risk will generally be greater if exposures are larger. At $1.4 trillion and $1 trillion, respectively, institutional loans and CLOs are a small portion of the $50 trillion fixed income market tracked by SIFMA. Banks do have exposure to the institutional loan and CLO markets, but primarily in the form of investment-grade quality lines of credit to lenders and AAA-rated CLO notes. Neither carry significant credit risk.
• Asset Liquidation: The Framework notes that a rapid liquidation of financial assets can pose a risk to U.S. financial stability when it causes a significant fall in asset prices that disrupts trading or funding in key markets or causes losses or funding problems for market participants holding those or related assets. There are few forced sellers in the institutional loan market. Banks closely manage their underwritten pipeline of loans and “mark-to-market” leveraged financing by banks largely disappeared after the GFC. Open-end loan funds do face daily redemptions and do sell assets to meet redemptions. However, as the LSTA’s Liquidity Risk Management Comment Letter and – more importantly – the natural experiment of Covid-driven redemptions during March 2020 demonstrated, these funds have a set of effective tools to manage redemption risk.
• Critical Function or Service: The Framework notes that a risk to financial stability can arise if there could be a disruption of a critical function or service that is relied upon by market participants and for which there are no ready substitutes (substitutability). There is no obvious service that loan market participants rely upon whose interruption could transmit a systemic risk through the financial system. Functionally, institutional loans are important sources of financing to U.S. companies. However, companies have turned to substitutes such as high yield bonds and private credit when BSL institutional loans have not been available.
• Contagion: The Framework notes that even without direct or indirect exposures, contagion can arise from the perception of common vulnerabilities of exposures, such as business models or asset holdings that are similar or highly correlated. It is not obvious how a contagion transmission channel would be expressed in the institutional loan market. Market participants know that there is credit, pricing and downgrade risk – and this is built into their risk management frameworks. While a small segment of the institutional loan lender base is subject to redemption risk, open-end loan funds have demonstrated an ability to endure a black swan event in March 2020. CLOs are the single largest holders of institutional loans and even if CLO issuance ceased, there is no mechanism to force existing CLOs to liquidate their holdings. Banks do have exposure to institutional loans, but in safe, generally not mark-to-market forms.

Ultimately, when we analyze BSL leveraged loans and CLOs in the Official sector’s own framework, it is difficult to see a manner in which they pose a systemic risk.