According to Fitch Ratings, leveraged loan risks to the U.S. banking system are manageable in the near term. However, negative rating actions for banks would become more likely in the event of a significant market disruption for institutions with large on-balance sheet leveraged loan portfolios and considerable outstanding credit lines to nonbank leveraged loan market participants. Negative rating actions could be further exacerbated if the banks did not adjust capital management practices to reflect weakening market conditions.

U.S. banks are exposed to leveraged lending risk in four ways: as underwriters and distributors through the syndication process; as holders of these loans on balance sheets; as providers of financing to nonbank leveraged loan market participants active in this space; and as investors in collateralized loan obligations (CLOs).

Banks involved in loan syndication can be vulnerable to significant and sustained market dislocations, which could force them to keep the loans on balance sheet and potentially lead to increased losses and/or writedowns. However, balance sheet risk appears manageable, as Fitch estimates leveraged loans account for approximately 5% of banks’ loan portfolio exposure. That said, U.S. banks do not typically publicly disclose leveraged loan holdings on their books, and the definition of leveraged loans varies across individual financial institutions.

The institutional leveraged loan market increased to $1.29 trillion as of September 2018 from $799 billion in 2007, according to Fitch’s U.S. Leveraged Loan Default Index, driven by increased M&A and leveraged buyout activity and institutional/mutual fund investors seeking floating-rate instruments. As leveraged loans are variable rate and often pegged to LIBOR, they provide increasing returns in a rising rate environment.

Given the late stage of the credit cycle, the combination of elevated borrower leverage and rising rates increases the debt service burden for borrowers and the likelihood of underperformance and higher defaults.. However, this risk can be partially offset if rates are rising as a result of sustainable economic growth, which could benefit corporate revenues and EBITDA. The institutional leveraged loan default rate was 1.8% through the trailing 12 months ended November 2018. Fitch currently forecasts a 2019 default rate at 1.5%, which would be the lowest since 2011.

Banks also face indirect leveraged loan exposure by providing warehouse financing or other forms of lending to nonbank leveraged loan market participants, such as direct commercial lenders, business development companies (BDCs), and CLOs. While this exposure is not routinely publicly disclosed, it is included in a relatively new regulatory call report category, loans to nondepository financial institutions, which has grown significantly (up approximately 22% on CAGR basis compared to slightly less than 6% for all loans) since it first began being reported in 2010.

Many banks have exposures to CLOs in their investment portfolios, but Fitch-rated U.S. banks typically invest in the senior CLO tranches, and credit risk appears manageable. Still, Fitch notes that market conditions can change and contribute to unrealized losses, which can impact capital. Further, some banks with large CLO books may have concentration and/or credit quality risk, such as smaller, community banks.