06 March 2018

Financial Times: Beware threat of low-quality debt and opaque shadow banks

Remember, among the many things that lay behind the financial crisis of 2008-9 was the banks’ urge to game the Basel capital adequacy regime.

They shovelled real estate loans into collateralised debt obligations and shunted them off the balance sheet in order to economise on capital and take on more risk. Policymakers have since done their best to address such problems but sometimes with perverse results.

A notable case in point relates to covenant-lite leveraged loans. These are syndicated loans to subinvestment grade borrowers that are bought by investors who trade away their governance rights for higher expected returns.

Credit protections such as restrictions on the borrowers’ rights to dispose of assets, degrees of leverage and dividend payments are sacrificed in the manic search for yield. The biggest uses for such loans are the refinancing of existing debt together with funding for mergers and acquisitions.

Evidence suggesting an escalation of risk-taking in this area comes from the Institute of International Finance, a global financial services industry representative body.

The US authorities were not asleep at the wheel. In 2013, they invoked their new macro-prudential powers and issued guidance on lending volumes with a view to damping down the party.

In one sense, it worked. Big banks reduced their market share of leveraged loans. The snag was that non-banks promptly increased their market share by more than 50 per cent by number and more than 100 per cent by volume.

Here, then, is just the kind of regulatory arbitrage that is the stuff of regulators’ nightmares. Exceptionally low-quality credit has staged an evacuation into other corners of the financial system, courtesy of shadow banks that are partly funded by the conventional banking system. The sense of déjà vu is palpable.

Or is it? To the extent that these non-banks are not funded by short-term deposits, shadow banking is arguably a solution to the financial stability issue here rather than the problem.

Some of the buyers of CLOs are insurance companies and pension funds. Their funding base is more stable than that of banks.

But mutual funds are also searching for yield in this market and are less stable because they may be overwhelmed by redemptions. Their liquidity management has improved since the crisis. Yet they are an obvious potential source of contagious fire sales.

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