32 CGFS Private equity and leveraged finance markets 5 Risks and financial

32 cgfs private equity and leveraged finance markets

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32 CGFS – Private equity and leveraged finance markets 5. Risks and financial stability implications Until recently, the broadening of the investor base in leveraged finance markets and the growing commitments to private equity funds increased the availability of alternative sources of capital to businesses that have traditionally relied more heavily on bank financing. In this context, the growth in private equity and leveraged finance markets in recent years potentially enhanced the resilience of corporations to funding shocks. The ability of banks and other arrangers to hedge some of the leveraged loan exposures in the loan derivatives market also opened up opportunities to manage warehouse and pipeline risks associated with leveraged finance more efficiently. Rapid market growth occurred at a time when a search for yield and high risk tolerance prevailed among investors supported by favourable macroeconomic conditions. The major banks that arrange leveraged financings now generally retain a smaller share of the exposure than in previous cycles, which may have weakened their screening and monitoring activities. Market participants and supervisory authorities should be alert to the possibility that the time profile and severity of credit losses may change as a result. The changing nature, structure and characteristics of the leveraged finance markets have also exposed new risks, some of which have unfolded during the market turmoil since July 2007. This section discusses a number of these and other risks, and assesses to what extent the recent turmoil in financial markets has impaired the functioning of the leveraged finance market. It then draws attention to financial stability implications arising from these developments. 5.1 Near-term risks 5.1.1 Warehouse risk Banks continue to play an important role in the origination and distribution of leveraged loans. As investors have reappraised risks embedded within leveraged loans since July 2007 – indeed, within structured credit products in general – banks have been unable to distribute many of the large loans they had committed to fund, and the fee income banks have generated from this activity has declined considerably. Although the amount of undistributed loans and high-yield bonds has steadily declined from the levels seen in August 2007, private sector estimates indicate that about $160 billion of leveraged loans and $70 billion of high- yield bonds remained undistributed at end-2007. In one extreme scenario, all of these “warehoused” assets could remain on bank balance sheets. Such an outcome would not only increase bank funding costs and capital requirements, but might also crowd out new lending. Another scenario could be that banks distribute the warehoused loans at substantial discounts, incurring significant losses in the process. In March 2008, traded leveraged loan index prices were suggesting that such discounts could amount to 10% on average.
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