Financial resilience and economic earthquakes
Speech given by
Alex Brazier, Executive Director for Financial Stability Strategy and Risk, Bank of England
Member of the Financial Policy Committee
University of Warwick
13 June 2019
I am grateful to Kiman Bassi, Jon Bridges, Jeremy Franklin, Andrew Gimber, Shahzad Gitay,
Nick Jackson, Ben King, Philip King, Miriam Kurtosiova, Cian O'Neill, Rupal Patel, Simon
Pittaway,
Matt Roberts-Sklar, Jamie Semark, Sagar Shah, Nick Vause and Danny Walker for their assistance in
preparing these remarks.
In the aftermath of the financial crisis, a new buzz phrase emerged in economic policymaking:
macroprudential policy. It tells you something about economic policymakers that this phrase qualified as
buzz. But after a fragile financial system had sideswiped the economy, turning what could have been an
economic downturn into a disaster, it was difficult to disagree with the aim: to promote a financial system that
could serve households and businesses in bad times, as well as good. That means a financial system that is
resilient to the bad times, but not so resilient as to be inefficient the rest of the time.
In many respects, the idea of macroprudential policy was vintage wine in a new bottle. The term was used at
least as far back as 19791 and the approach was set out in some depth in 2000 by Andrew Crockett,
General Manager of the Bank for International Settlements and previously an Executive Director at the Bank
of England.2
The innovation after the crisis was to create a new independent committee in the Bank of England - the
-
Financial Policy Committee (FPC) to make the idea an operational reality. In just the six years of its official
existence, the FPC has: boosted the resilience of the banking system, dealt with threats from pockets of
credit growth, limited high loan-to-income mortgage lending, built greater resilience to cyber-attack, and
ensured the core of the UK financial system is resilient and prepared for Brexit, whatever form it takes.
You may be relieved to know that will be my final mention of Brexit today. We continue our work to ensure
the financial system is prepared, but today I want to look beyond, to the future for macroprudential policy.
Building on the strong foundation of its achievements so far, the job now is to ensure that standards of
resilience in the financial system move with the times. In that, we must be agile and disciplined.
So today, I'll look at two themes. The first is how we keep pace with a changing economy. We are using
cutting-edge research to monitor how developments in debt levels today affect the severity of economic
downturns in the future. Armed with this, we can consistently build resilience into the financial system well
ahead of when that resilience is needed.
The second theme is how we are keeping pace with a changing financial system. New research is enabling
us to simulate the effect of economic downturns on the growing non-bank financial system. It has highlighted
possible weak spots that need monitoring and some that need new standards of resilience.
Keeping up with the economy
Disciplined macroprudential policy builds resilience to economic shocks into the financial system well before
it's needed. You don't make cities near fault lines resilient to earthquakes by waiting until there are tremors
that signal a quake may be imminent. That would be not just ineffective; it would be counterproductive,
1
See Piet Clement, 'The term "macroprudential": origins and evolution',
BIS Quarterly Review, March 2010.
2
Andrew D Crockett, remarks before the Eleventh
'Marrying the micro- and macro-prudential dimensions of financial stability',
Conference of Banking Supervisors, Basel, September 2000.
leaving the city with buildings under re-construction and surrounded by scaffolding and cranes just as an
earthquake hit.
The right approach, for building resilience to earthquakes into structures, and for building resilience to
economic shocks into financial systems, is to focus not on tremors, but on the underlying vulnerability. By
- - if one occurred at any
underlying vulnerability I mean how serious a quake real or economic could be
point. Whether a quake seems likely to occur soon has no bearing on this.
For resilience in structures, the best indicator of underlying vulnerability is how close the city is to the fault
Apple's new California HQ uses new earthquake resilient technology.3
line or plate boundary. On that basis,
For resilience in the financial system, it is how much debt there is in the economy (or economies) to which
it's exposed. That's why, when we come to decide how big the banking system's buffers of loss-absorbing
capital should be, we don't focus on any economic We don't insist on tougher
tremors we may feel.
standards just because trade tensions threaten to slow the world economy or changes in sentiment hit
financial markets, or because uncertainty is weighing on the domestic economy.
-
Instead we focus on debt a key driver of how far up the Richter scale economic earthquakes tend to be.4
Think of a build-up of debt as being the economic equivalent of building close to a fault line. When a quake
hits, the impact is greater and more resilience is needed in the structures.
This focus means we can appear contrarian. Debt has a habit of increasing in calm periods, when those in
the financial system think it's safe to take more risks. So we can find ourselves demanding tougher
to be low. And we don't start demanding them when the tremors
standards when risks are thought by many
start, when risks are thought by many to suddenly be high. We aim to be countercyclical.
Our work shows three features of debt to be of particular importance.
3
Thomas Fuller, 'Inside Apple's
Earthquake-Ready Headquarters', New York Times, 4 June 2019.
4
This approach was exactly what Andrew Crockett outlined almost 20 years ago: "The received wisdom is that risk increases in
recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances
build up, and materialising in recessions... And because the timing of downswings is exceedingly hard to predict, the approach
implies
a focus on measuring the vulnerabilities that build up in the upswing and on the more recurrent features of cycles. We may not know
exactly when the rainy day will come, but we can be pretty sure that it will. It is not wise to decide on policies or business strategies on
the assumption that it will not, or that we can predict its timing with sufficient foresight."
Mortgage debt
Households with more mortgage debt tend to cut back more in downturns. People do everything they can to
pay the mortgage. During the financial crisis, the fall in consumption relative to income among UK
households with loan to income (LTI) ratios above four was around three times larger than the fall among
those households with LTI ratios between one and two. But the effect can be to prolong the economic pain
for everyone by reducing spending, and therefore amplifying the effect on incomes and output in the
economy. The evidence, across countries, recessions (and US states) is compelling: build-up of household
debt means an economy is exposed to more severe recessions (Chart 1).
Chart 1 Household debt growth in the boom and the economic severity of the subsequent bust: across US
states, countries and time for GDP and unemployment
Source: David Aikman, Jonathan Bridges, Anil Kashyap and Caspar Siegert, 'Would macroprudential regulation have prevented the last
crisis?', Bank of England Staff Working Paper No. 747, August 2018.
Notes: State level household debt statistics (left hand panel) from Federal Reserve Bank of New York; GDP data from Bureau of
Economic Analysis (BEA); unemployment data from Bureau of Labour Statistics. Change in household debt to GDP ratio from 2004 to
2007 on x-axis, economic performance from 2007 to 2010 on y-axis. International data (middle and right panels) uses Bridges et al.
dataset: household debt data from Bank of International Settlements "Long series on
(2017) total credit and domestic bank credit to the
private non-financial sector"; real GDP and unemployment data from the OECD, the Global Financial Database and national statistics
websites. Middle panel shows experience across 27 advanced economies in the Global Financial Crisis, using same dates as U.S. state
panel. Right hand panel is for recession episodes in G10 countries from 1960 to 2004 (i.e. Great Recession not included). A recession
is defined as two consecutive quarters of negative real GDP growth, with at least eight quarters between consecutive peaks or troughs.
Corporate debt
A similar picture is apparent across companies. In a recession, companies with more debt tend to cut back
on investment and employment by more than others. The evidence here is that companies with net debt
more than about four times their cashflow cut investment twice as sharply as others (Chart 2).
Financing from overseas
Public debt, in contrast, tends not to deepen recessions, at least in countries issuing the debt in their own
currency and within the bounds of sustainability. However, whether debt is raised by governments,
households or corporates, the source of it does matter. A reliance on inflows of foreign capital -- what
-
Governor Carney has called the 'kindness of strangers' can mean future recessions tend to be deeper.
The evidence is that those strangers tend to be more flighty when the economic ground shakes, ceasing to
fund new investments, raising the cost of finance in the economy and magnifying recessions.5 Other things
equal, countries running bigger current account deficits tend to have deeper recessions.
Chart 2 Highly indebted companies cut investment Chart 3 UK current account balance as a
and employment more than unleveraged percentage of GDP since 1955
companies in the global financial crisis
Percentage
% of GDP
Investment Employment
change in
6
crisis
15
10 4
2
50-5
0
-10
-15
-2
-20
-25
-4
-30
-35
-6
-40
No leverage High leverage
-8
1955 65 75 85 95 05 15
Sources: S&P Global Market Intelligence and Bank Source: ONS
calculations.
Notes: Change in investment and employment in the financial
crisis for unleveraged companies and companies with high
leverage ratios. Percentage change reflects the average log
change in investment and employment between 2007 and
2009. High leverage companies are those with net
debt/EBITDA ratio higher than four in 2006.
5
See, for example, Olivier Blanchard and Gian Maria Milesi-Ferretti, '(Why) Should Current Account Balances Be Reduced?', IMF
April 2012 and Julián A. Caballero,
Economic Review, 'Do Surges in International Capital Inflows Influence the Likelihood of Banking
Crises?', Economic Journal, March 2016.
Recent developments
What, then, has been happening in the UK to these drivers of underlying economic vulnerability?
Developments are summarised in the 'heat map' below
(Chart 4). The colours represent how high each
indicator is relative to past outcomes. The deepest red, for example, means the indicator is beyond the 90th
percentile of its historic distribution.
Chart 4 Selected indicators of underlying vulnerabilities
Series and sources: 12-month mortgage credit growth (Bank of England); share of households with mortgage LTIs above 4.5 (UK
Finance); corporate debt growth (annual) - Bank staff measure (Bank of England, Association of British Insurers, Cass Commercial
Real Estate Lending Survey, Datastream from Refinitiv, Deals Business Intelligence from Refinitiv, Deloitte, LCD, an offering of S&P
Global Market Intelligence, London Stock Exchange, ONS, Preqin and Bank calculations); UK current account balance (% GDP) (ONS
and Bank calculations).
Notes: Each data series included in the heatmap has been rescaled into a percentile by using a kernel density estimate of its cumulative
distribution function using all available data back to 1987. The Bank staff estimate for corporate debt adjusts the official ONS measure
by adding sources of market-based finance not captured by the ONS and by removing other sources of market-based finance that have
been misallocated to corporate debt. The net effect of these adjustments is predominantly to decrease the level of debt pre-crisis.
Stocks of PNFC debt at 2018 Q3 split: 43% bank loans, 39% corporate bonds, with residual being money market instruments and other
forms of non-bank finance.
The temperature overall doesn't look map stems from the UK's
elevated. The only warm colour on this heat
-
continued reliance on the kindness of strangers its persistent current account deficit, running currently at
4.4% of annual GDP
(Chart 3).
Although banks have real appetite to lend, households don't have the appetite to borrow. Credit conditions
in the mortgage market are easy and mortgage pricing competitive. The share of new mortgage lending at
loan-to-value ratios above 90% is approaching pre-crisis highs as the price of such lending falls relative to
that on lower LTV mortgage lending (Chart 5). And yet, mortgage debt is growing no faster than the
economy as a whole (Chart 6).
Of course, the level of household debt is high But the share of households with very high debt
(Chart 7).
burdens is in fact very low. In a low mortgage interest rate environment, only around 1% of households face
debt servicing costs of more than 40% of their pre-tax income. It would take a large and sudden rise in
- -
interest rates of up to 300bp to take that fraction of households to around it historic average (Chart 8).
Chart 5 Quoted spreads over risk-free rates on Chart 6 Annual growth rates for mortgage
two-year fixed-rate mortgages lending and nominal GDP
75% LTV Per cent
Percentage points Mortgages
20
90% LTV 6
Nominal GDP
95% LTV
5
15
4
10
3
2
5
1
0
0
-1 -5
2004 06 08 10 12 14 16 18 1994 97 00 03 06 09 12 15 18
Sources: Bank of England, FCA Product Sales Database Sources: Bank of England and ONS.
and Bank calculations.
Notes: Spreads are taken relative to the risk-free rate of the Notes: Mortgage lending defined as twelve-month growth
same maturity. Dashed line is an estimate of historical 90% rate of total sterling net secured lending to individuals
LTV spreads, which uses rates reported on new mortgages seasonally adjusted. Nominal GDP is gross domestic
in the FCA Product Sales Database. product at current prices seasonally adjusted.
Chart 7 UK household debt to income ratio Chart 8 Percentage of households with mortgage
DSRs of 40% or greater
Other
BHPS / Understanding
Per cent of
Percentages
Consumer credit
Society Survey
disposable
of households
Mortgages income
NMG Survey
3.00
Total (ex. student loans) 160
2.50
140
120
2.00
100
1.50
80
60
1.00
40
0.50
20
0
0.00
1994 97 00 03 06 09 12 15 18
91 93 95 97 99 01 03 05 07 09 11 13 15 17
Sources: Bank of England, ONS and Bank calculations. Sources: British Household Panel Survey/Understanding Society
(BHPS/US), NMG Consulting survey and Bank calculations.
There has been a substantial reduction in corporate debt since the crisis as commercial real estate
companies have repaired their balance sheets after over-extending them before the crisis (Chart 9). Banks
and investors have had strong appetite for corporate lending but corporate debt has only just outpaced the
growth of the economy (Chart 10).
Chart 9 Corporate debt, % of GDP Chart 10 Corporate debt growth versus nominal
GDP growth
Non CRE CRE
growth rate
Corporate debt growth
% of GDP
Corporate debt
80
GDP growth
20%
70
15%
60
50
10%
40
5%
30
0%
20
90 95 00 05 10 15
10
-5%
0
1998 00 02 04 06 08 10 12 14 16 18
-10%
Sources: Association of British Insurers, Bank of England, Cass Commercial Real Estate Lending survey, Datastream from Refinitiv,
Deals Business Intelligence from Refinitiv, Deloitte, LCD, an offering of S&P Global Market Intelligence, London Stock Exchange,
ONS, Preqin and Bank calculations.
Adding it all up
The challenge for us is to put developments across the heatmap into a common currency; to prioritise them;
ask whether one outweighs another; and consider what they mean all together for how damaging any future
economic earthquake could be.
In this we are drawing on cutting edge research in the Bank.6 That work, sometimes referred to as
calculating 'GDP at risk', seeks to translate developments in each metric into its typical effect on the depth of
recessions.7
Without unusual developments in debt, the distribution of GDP growth over the next three years is shown by
the blue distribution in A typical economic earthquake - the sort that tends to occur every twenty
Chart 11.
-
years or so results in a recession and subsequent recovery that leaves economic output after three years
just 0.3% below where it was when the shock hit.
6
David Aikman, Jonathan Bridges, Sinem Hacioglu Hoke, Cian O'Neill and Akash Raja, 'How do financial vulnerabilities and bank
macroeconomic tail risk?', Bank of England Staff Working Paper, forthcoming.
resilience affect medium-term
7
This work builds on research at the IMF, with whom we have collaborated closely. Governor Carney used the same analytical
approach to consider 'Capital flows at risk' - see speech given at the
'Pull, push, pipes: sustainable capital flows for a new world order',
2019 Institute of International Finance Spring Membership Meeting, Tokyo, June 2019.
When debt builds up, the distribution of future growth outturns shifts. It skews towards weaker growth. The
red line shows how this distribution shifts in response to elevated levels of credit and a wider current account
deficit. A 1-in-20 earthquake tends to be more damaging.
Chart 11 Distributions of cumulative 3-year GDP growth under typical conditions and with elevated
debt and a wide current account deficit
Probability density
Distribution with typical conditions
0.12
Distribution with elevated debt and wide current account deficit
0.10
0.08
0.06
0.04
-0.3%
0.02
0.00
-8 -6 -4 -2 0 2 4 6 8 10 12 14
Cumulative GDP growth over 3 years (%)
Notes: Chart shows the predicted distribution of the cumulative GDP growth rate over 3 years. The blue line is the predicted distribution
when the change in household credit-to-GDP, the change in corporate credit-to-GDP and the current account deficit are at their
historical average in the UK. The red line shows how this distribution shifts when household and corporate credit have increased by
10pp relative to GDP, and the current account deficit has widened by 2pp.
Our work finds that if the economic earthquake comes after a 10% increase in household debt relative to
incomes, the cumulative loss of output over the 3 years after the quake is 1.5%. If it comes after a 10%
increase in corporate debt, the cumulative loss of output is 1%. And for every 1% of current account deficit
before the quake, a further 0.5% of output is lost after the quake (Chart 12).
9
All speeches are available online at www.bankofengland.co.uk/news/speeches
Chart 12 Impact of debt vulnerabilities on depth of economic earthquakes
Cumulative impact on 5th percentile of GDP growth
0.5
over next three years (pp)
0.0
-0.5
-1.0
-1.5
Impact of 1pp widening in the current
Impact of 10pp increase in credit to GDP
account deficit (as % of GDP)
ratio over past 3 years
-2.0
Household Corporate (PNFC) External
credit credit imbalance
Notes: Figure based on Aikman et al. (forthcoming). It shows the impact of an increase in each vulnerability indicator at time t on the 5th
percentile of real GDP growth over the next three years. The cumulative three-year impact on the left-hand tail of GDP growth is shown.
For household and corporate credit in turn, the impact of a 10pp increase in the credit to GDP ratio over the subsequent three years is
shown. For the current account, the impact of a 1pp (relative to GDP) widening in the deficit is shown. For reference, for the UK
19802018, a one standard deviation increase in three-year credit growth was 5.9pp (household) and 8.1pp (corporate) and for the current
account was 1.7pp.
Using these estimates we can add up the different developments in debt to see what they might mean for the
overall degree of underlying economic vulnerability. Chart 13 shows their sum total over time.
Two points stand out from this chart. First, the sum of recent developments isn't elevated. The UK's current
account position creates some additional vulnerability, but recent developments in overall corporate debt are
I'll come on to explain), and household
neutral (though with a caveat developments slightly offsetting.
Rather, the underlying level of economic vulnerability has returned to a standard level after a long period in
the aftermath of the financial crisis in which it was subdued as debt levels fell back. That's consistent with
the Financial Policy Committee's judgement that the degree of underlying economic vulnerability is at a
standard level. That judgement drives our assessment of how resilient the financial system needs to be, in
particular how large should be the buffers of capital banks run with.
'Adding up' the impact of debt vulnerabilities on
Chart 13 the possible damage caused by a 1-in-20
economic earthquake
The black line 'adds up' the combined impact of each vulnerability indicator at time t
Notes: Figure based on Aikman et al. (forthcoming).
on the 5th percentile of real GDP growth cumulatively over the next three years. For example, the point labelled 2005q1 shows the
estimated impact of these vulnerabilities on the left tail of GDP growth over the period 2005q1-2008q1. The decomposition uses full
sample coefficient estimates (based on 16 advanced economies 1980-2017), applied to the UK data. Each indicator enters relative to its
UK historical average, so that if credit growth and the current account deficit were at their average levels, the bars would be zero. The
chart shows a subset of a larger model, which also includes equity volatility, house prices, bank capital and macroeconomic control
variables.
The second standout from the chart is that developments in debt prior to the 2008 financial crisis would have
been sufficient to make an economic earthquake 2% more damaging. As it was, almost 4% of output was
lost in the three years between 2008 and 2010. Why did output fall so much more than might have been
expected? Was it bad luck? Was the economic earthquake off the Richter scale?
Our research concludes that the 2008 recession was not the result of an unusually severe earthquake. The
UK's current account deficit and debt
run-up prior to the crisis meant we were closer to the fault line. As
important was the fact that the banking system did not have the strength to reflect that. As a result, it
collapsed, tightening financial conditions for the economy and adding to the damage.
Once we account for these factors, the depth of the 2008 recession is consistent with a 1-in-20 economic
It wasn't that we were hit by a seismic event of unprecedented scale.
earthquake (Charts 14 and 15). The
scale of the economic damage was avoidable.
11
All speeches are available online at www.bankofengland.co.uk/news/speeches
Chart 14 Financial conditions index (UK) Chart 15 GDP fall during the crisis compared to tail
risks flagged by high debt vulnerabilities and low
bank capital resilience
Three-year cumulative
Difference from
GDP growth
average since 1995
6
1 in 20 forecast
2007Q42010Q4 (%)
(number of standard
(as of 2007 Q4)
deviations)
5
0
4
-1
3
2
-2
1
-3
0
-4
-1
Household Credit Corporate Credit
-2
-5
Current Account Low Bank Capital
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
Other Total
Actual
Sources: Bloomberg Finance L.P., Eikon by Refinitiv and Notes: Figure based on Aikman et al. (forthcoming). The chart
Bank calculations. compares the actual cumulative three-year fall in UK GDP during
2008-2010 to the 5th percentile of real GDP growth forecasted
Notes: Financial conditions index (FCI) estimated using
for the same period as of end-2007. This estimate is
principal component analysis. The FCI summarises
decomposed in the same way as described in the note to Chart
information from the following financial series: term spreads,
13 and additionally shows the estimated impact of low bank
interbank spreads, corporate spreads, sovereign spreads,
capital resilience.
long-term interest rates, equity price returns, equity return
volatility and relative financial market capitalisation. An
increase in the index indicates a tightening in conditions.
The job the FPC has been given in the aftermath is to avoid another avoidable disaster. And real progress
has been made. Through new capital requirements the banking system now has the resilience to absorb
even a repeat of the 2008 recession, without causing serious economic damage.
And with the help of this work, we can stay agile as debt evolves so we can ensure the resilience of the
system keeps pace with the underlying vulnerability in the economy.
That's not to say we will be slaves to any
particular approach. No single model can capture everything. The
point is that we have a benchmark for our assessment, ensuring continuity and discipline in our approach.
To that benchmark, we can apply judgements.
A pocket of risk
In that regard, we're watching closely what's happening in corporate debt. Although, as we've seen, the
aggregate picture looks fairly benign, a more concerning development hides underneath. We have just been
through a period of rapid growth of one type of corporate lending: leveraged lending. That is, lending to
companies who have high levels of debt.8
Chart 16 The flow of gross issuance of leveraged lending to UK companies has declined from
post-crisis highs and there is a tail of highly indebted firms
Annual flow (£bn)
% of total debt
60
40
Net debt to EBITDA >4x
35
50
30
40
25
30
20
15
20
10
10
5
0
0
01 03 05 07 09 11 13 15 17 19
00 02 04 06 08 10 12 14 16 18
Source: S&P Global Market Intelligence.
Notes: Gross issuance of leveraged loans by UK companies on a 12 month rolling basis. Net debt to EBITDA ratios of the top
500 largest non-financial corporates by revenue outside of real estate and oil & gas weighted by debt.
That rapid growth has now eased right off. But it has left a legacy on the balance sheets of some companies
and on the balance sheets of those who have lent to them. The legacy on the balance sheets of companies
is that more than a third of corporate debt is now in companies that have debt more than four times their
cash flow (Chart 16).
That can raise the underlying level of economic vulnerability. As we saw earlier, high-debt corporates are
-
likely to cut back more sharply in downturns. The effect overall is unlikely to be large a few tenths of one
per cent on the depth of an economic earthquake. But this, for me, particularly when coupled with the clear
appetite of lenders and creditors to lend, means the vulnerability level needs to be watched closely.
8
Leveraged loans are typically loans to corporate borrowers that are highly indebted (for example with net debt to EBITDA ratios greater
than 4x) or that are owned by a private equity sponsor. However, there is no widely-accepted definition.
The legacy effect on the balance sheets of lenders and investors could potentially be of more significance.
There is a real risk of loss to those exposed to these loans. In the financial crisis, we estimate that 8% of
these loans soured, twice the loss rate on loans to businesses overall.9 The shift to riskier lending matters.
Since the financial crisis, underwriting standards on leveraged lending have deteriorated. Lenders have real
appetite for risk, reducing the price of these loans while also shunning covenants on borrowers. Ten years
ago all leveraged loans imposed some restrictions on borrowers. Now only one third have them. And
companies are increasingly making use of earnings add-backs, which involves assuming future earnings
improvements, to flatter their leverage at issuance. With this deterioration in standards, loss rates are
probably now more sensitive to economic conditions than they were a decade ago.
This is why we're working to ensure that the period of rapid growth we've been through hasn't compromised
banks' resilience to economic downturns. UK banks have £60bn of exposures to non-investment grade UK
Through rigorous stress tests, we're ensuring that banks have the capital to withstand
and US corporates.
loss rates on their loans greater than those seen in the financial crisis. Consistent with our overall approach,
those loss rates reflect not the recent good performance of these loans, but the not-so-good underwriting
standards applied as they were originated.
However, even then our work to ensure the resilience of the system keeps pace will not be done. The
leveraged loan market is one illustration of a broader development in finance over the past decade: the
growth of finance provided by institutions other than banks.
The leveraged loan market is global. The UK has not been alone in experiencing rapid growth in leveraged
lending. The United States and Europe have seen it too and, unlike the UK, they still have it. Globally, we
estimate that 45% of the finance comes ultimately from non-banks. Sometimes they hold the loan exposure
-
directly. And sometimes they hold tranches of securitised packages of leveraged loans collateralised loan
obligations (CLOs). Some 25% of loans have been securitised. And the holders of the equity slice of CLOs
- -
the slice that takes the losses on the loans in the package before the other investors are at real risk. If
leveraged loans experienced loss rates in line with the financial crisis, the equity tranches of CLOs would
lose all their principal.
Before everyone takes fright at the 's' word, some important context is needed.
These securitisations are
very different beasts to their ancestors of 2008. CLOs now have much less embedded leverage than they
And they are not held in 'shadow banks' like
did before the crisis, with equity tranches around 25% thicker.
investment vehicles that turn out really to be a part of banks. They are held properly outside the banking
system, on the balance sheets of non-banks like hedge funds and open-ended funds. Chart 17 shows our
map of who holds the loans and in what form.
9
These are estimated five-year loss rates based on observed default rates during the global financial crisis on the S&P leveraged loan
indices for the US and Europe and Moody's data for all corporates. We assume a recovery rate in line with the average on
first lien
loans.
Chart 17 Map of who holds leveraged loans and in what form
Indicative estimated global stock of leveraged Indicative estimated holdings of leveraged loans by
loans by product type global investors
Sources: BarclayHedge, Bloomberg Finance L.P., FCA Alternative Investment Fund Managers Directive (AIFMD), Firm public
disclosures, LCD, an offering of S&P Global Market Intelligence, Morningstar, National Association of Insurance Commissioners,
Securities Industry and Financial Markets Association, Solvency II submissions and Bank calculations.
Notes:
the total stock are based on Bloomberg's definition of leveraged loans. Given the lack of a consistent definition of
(a) Estimates of
leveraged lending, there is uncertainty over the total stock of outstanding leveraged loans.
and CLOs, allocation across investors is based on estimates of
(b) For loans that are distributed to non-bank investors 'bottom-up'
holdings from a range of sources. Hence, there is a significant proportion of institutional loans that are unallocated.
(c) For hedge fund holdings of leveraged loans and CLOs we scale up holdings reported to UK authorities by non-EEA managed
AIFs to reflect the size of the global hedge fund universe. This means these estimates are particularly uncertain.
(d) Revolving credit facilities and amortising term loans are allocated to banks given that they are typically the holders of these
facilities.
This picture is consistent with wider developments in corporate credit. Non-banks account now for 56% of
the stock of UK corporate debt. Market-based debt has accounted for all of the growth in the stock of debt to
UK businesses since end-2007.
Overall, that shift is positive for the resilience and stability of the system. Other things equal, £1 of loss
incurred in the non-bank financial system is almost certainly less disruptive to the wider economy than £1 of
loss incurred in the banking system. But without the right resilience, could the non-bank system also result in
some damage to the economy in an economic earthquake? How should financial building standards adapt
to the changing nature of the buildings in our economic city?
Keeping up with a changing financial system
system'