Credit quality associated with large loans originated by multiple banks improved last year, but that result does not fully reflect the impact on borrowers of rising interest rates and softening economic conditions in the second half of 2022 that could lead to reduced credit quality this year, according to a report issued Friday by the federal banking agencies.
The Federal Deposit Insurance Corp. (FDIC), Federal Reserve, and Office of the Comptroller of the Currency (OCC) said in their 2022 Shared National Credit (SNC) report that credit risks for the large loans (known as syndicated loans) were moderate at the end June 30 of last year (the end of the period of loan commitments primarily covered by the report). However, by the end of the third quarter – the last period covered in the report – financial and economic conditions were changing, the report indicates, leading to challenges for the year ahead.
“The magnitude and direction of risk in 2023 will be impacted by borrowers’ ability to manage through a period of softer economic conditions including supply chain imbalances, labor challenges, geopolitical tension, inflation, and vulnerability to rising interest rates,” the report states. “These macroeconomic conditions could negatively impact the financial performance and repayment capacity of borrowers in a wide variety of industries, especially highly leveraged borrowers that often lack the financial flexibility to respond to external challenges.”
The report states that credit risk associated with leveraged lending remains high despite moderate overall risk. It also indicates that the leveraged loans can be fragile.
“Leveraged loans comprise half of total SNC commitments but represent a disproportionately high level of the total special mention and classified exposures,” the report states. “SNC reviews have found that many leveraged loans continue to have weak structures. These structures often reflect layered risks that include some combination of high leverage, aggressive repayment assumptions, weak covenants, or terms that allow borrowers to increase debt, including draws on incremental facilities.”
The report warns that, over the coming year, portfolio management and stress testing processes should consider “that loss and recovery rates may differ from historical levels, and risks identified in stress tests should be measured against their potential impact on capital and earnings.”
The report, the agencies said, was based on $5.9 trillion in commitments, which “increased significantly” in 2022 by $718 billion, or 13.9% year-over-year, with an increase of $533 billion in loans reported as investment grade by the agent bank.
Outstanding balances increased by 22.1% due to strong commitment growth and increased utilization of revolving credit facilities. The number of borrowers and credit facilities increased again in 2022, the agencies said.
The program reviews borrowers with minimum aggregate loan commitments totaling $100 million or more that were shared by three or more regulated banks.