GAO Report Finds that Leveraged Lending Has Not Threatened Financial Stability

On Dec. 16, 2020, the U.S. Government Accountability Office (the GAO) issued a report to the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission, the Department of the Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission (the Regulatory Agencies) that examines:

• The extent to which financial institutions are exposed to leveraged lending activities
• Financial regulators’ and others’ assessments of the potential risks to financial stability stemming from leveraged lending activities both before and after the COVID-19 shock
• The extent to which the Financial Stability Oversight Council (the FSOC) has established approaches for identifying, monitoring and mitigating potential risks to financial stability arising from leveraged lending

In preparing its report, the GAO examined Regulatory Agency and private data on market size and investor exposure; reviewed Regulatory Agency, industry and international reports; and interviewed federal financial regulators and industry participants.

The GAO report reached the following conclusions:

• Based on regulators’ assessments, leveraged lending activities had not contributed significantly to the distress of any large financial entity whose failure could threaten financial stability. Large banks’ strong capital positions have allowed them to manage their leveraged lending exposures, and the exposure of insurers and other investors appeared manageable.
• Mutual funds experienced redemptions by investors during the COVID-19 shock but were able to meet them in part by selling leveraged loan holdings. While this may have put downward pressure on already-distressed loan prices, based on regulators’ assessments, distressed leveraged loan prices did not pose a potential threat to financial stability.
• Present-day collateralized loan obligation (CLO) securities appear to pose less of a risk to financial stability than did similar securities during the 2007 – 2009 financial crisis, according to regulators and market participants. For example, CLO securities have better investor protections, are more insulated from market swings and are not widely tied to other risky, complex instruments.

The GAO report nonetheless makes a number of recommendations to enhance the FSOC’s ability to respond to financial stability risks arising out of leveraged lending:

• Congress should consider expanding the FSOC’s ability to designate non-bank financial companies for enhanced prudential supervision by the Board of Governors of the Federal Reserve to an activities-based authority (from its current entity-specific authority).
• The FSOC should conduct regular scenario-based tabletop and other simulation exercises.

The full text of the GAO report can be found here.