2020 Stress Tests to Emphasize Leveraged Lending Risks

Kramer Levin Naftalis & Frankel LLP

On Feb. 6, the Federal Reserve Board released the hypothetical scenarios for the 2020 stress test exercises, which ensure that large banks have adequate capital and processes to continue lending to households and businesses even during a severe recession. The harshest scenario includes a severe global recession with heightened stresses in corporate debt markets and commercial real estate, and for banks with large trading operations, additional pressure on leveraged loans. 

The Board’s stress test framework consists of the Comprehensive Capital Analysis and Review, also known as CCAR, and the Dodd-Frank Act stress tests. Both exercises have been a cornerstone of the Board’s post-crisis framework for large banks, and this year’s stress tests will evaluate 34 large banks with more than $100 billion in total assets. The stress tests include two hypothetical scenarios: baseline and severely adverse. The severely adverse scenario this year features a severe global recession in which the U.S. unemployment rate rises by 6.5 percentage points to 10%, with elevated stress in corporate debt markets and commercial real estate. Additionally, banks with large trading operations will be required to factor in a global market shock component as part of their scenarios. This year’s shock features, among other things, heightened stress to trading book exposures to leveraged loans. This year’s global market shock for the severely adverse scenario emphasizes a heightened stress to highly leveraged markets that causes collateralized loan obligations (CLOs) and private equity investments to experience larger market value declines relative to last year’s stress tests.

Under the severely adverse scenario, weaker obligors struggle to maintain their financial conditions due to material declines in earnings associated with the poor economic environment while rating agencies downgrade large portions of debt outstanding. The historically high levels of nonfinancial corporate debt to GDP amplify the losses resulting from the wave of corporate sector defaults. This dynamic creates feedback between the economy and the corporate sector. Spreads widen sharply for non-investment grade and low investment grade bonds as ratings-sensitive investors anticipate further downgrades and sell assets. Similarly, the leveraged loan market comes under considerable pressure. Open-ended mutual funds and exchange-traded funds (ETFs) that hold leveraged loans and high yield bonds face heavy redemptions. Due to liquidity mismatches, mutual fund and ETF managers sell their most liquid holdings, leading to more extensive declines in the prices of fixed income securities and other related assets. Price declines on leveraged loans flow through to the prices for CLOs. CLO prices suffer severe corrections associated with the devaluation of the underlying collateral and selling by concentrated holders desiring to reduce risk. The broad sell-off of corporate bonds and leveraged loans spills over into prices for other risky credit and private equity instruments. Credit spreads for emerging market corporate credit and sovereign bonds widen due to flight-to-safety considerations. Asset values for private equity experience sizable declines as leveraged firms face lower earnings and a weak economic outlook.

Banks are required to submit their capital plans and the results of their own stress tests to the Federal Reserve by April 6. The Board will announce the results of its supervisory stress tests by June 30.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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