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Leveraged Lending a Growing but Manageable Risk for U.S. Banks, Fitch

March 01, 2021, 08:10 AM
Filed Under: Banking News

Credit risk for those U.S. banks and non-bank entities active in corporate lending is rising, as seen in the shared national credit (SNC) regulatory report released on Feb. 22, with “non-pass” loans increasing to 12.4% of SNC-reported commitments at 3Q20 from 6.9% a year before. However, while criticized loans increased as a result of the pandemic-induced economic fallout and lender exposure to affected industries, they remain well below the 2009 peak of 22%. Credit risks to U.S. banks appear manageable over the near to medium term, thanks in part to their primary focus on investment-grade lending exposure, as well as fiscal support measures and the corresponding and rapid growth of loan loss reserves, Fitch Ratings says.

The SNC report, which assesses the credit risk of syndicated loans greater than $100 million, showed that commitments categorized as special mention or classified rose to $5.1 trillion at 3Q20, up 5%, or $242 billion, during the year. U.S. banks and foreign-bank owned (FBO) institutions held the largest shares of SNCs, at 45% and 33%, respectively, with U.S. bank exposure primarily in investment-grade and, to a lesser extent, sub-investment-grade revolvers. The large increase in loan loss reserves in 2020 also mitigates some of the inherent credit risk. Due in part to the adoption of CECL, as well as large reserve builds related to the pandemic, the median level of reserves to loans for the largest U.S. banks increased to 2.2% of loans at year-end 2020 compared to 1.1% a year prior, according to company data.

Non-bank lenders, defined in the SNC report as primarily including collateralized loan obligations, loan funds, investment managers, insurance companies and pension funds, accounted for only 22% of SNCs but held the largest share of special mention/classified loans, at 55% of total non-pass loans. The vast majority, or 93%, of non-bank exposure, was to non-investment-grade term loans. Non-banks’ classified loan rate spiked to 33% during the year, versus around 7% for U.S. banks and FBOs.

Banks entered the pandemic with relatively lower SNC risk on balance sheet, as seen by the lower direct exposures to classified SNCs versus non-bank lenders. This reflects improved credit risk management practices and frameworks post-Global Financial Crisis, along with more robust regulation, all of which are viewed as supportive of bank credit profiles. However, banks may face downside risk over the longer term, as they will invariably have direct and indirect exposures to non-bank lenders carrying criticized debt not reflected in banks’ direct exposures to classified SNCs.

Non-bank lenders and, to a lesser extent, banks are seeking higher yields in the market amid persistently low interest rates through purchased credit exposure, according to the SNC report. However, banks’ share of non-pass credits is rising as well, up to 45% currently from 35% in 2019, largely due to downgrades in oil and gas and other Covid-19 impacted industries that have long-standing lending relationships with banks.

As expected, increased defaults and downgrades were driven by losses in industries most severely affected by the pandemic, including entertainment and recreation, oil and gas, real estate, retail and transportation services.

Total commitments to borrowers in industries significantly affected by Covid-19 were $1.1 trillion, or 21.6%, of total SNC commitments for the year ended 3Q20. Leverage lending accounted for a growing share of non-pass loans, increasing to 29.2% of loans to coronavirus-affected industries from 13.5% during the same period and 16.6% for non-impacted sectors. Non-pass leveraged loans to industries impacted by coronavirus doubled during the year to $127 billion, with other leveraged lending also increasing by 59% to $333 billion during the same period.

Meaningful upside to U.S. bank ratings is not expected in 2021, given the outlook for relatively depressed earnings, despite the anticipated economic recovery from the rollout of mass vaccinations and government stimulus. However, large U.S. banks' expected performance supports our stable sector outlook for the year and likely eases near-term pressure on ratings.

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