Newsletter on credit risk: real estate and leveraged lending

• The Covid-19 pandemic and the recent inflation have heightened credit risk concerns, with the Committee focusing on risks in real estate and leveraged loan markets.

• It is important for banks to maintain prudent risk management practices on real estate and leveraged loans, as supervisors have observed higher risk lending and deficient practices in some areas.

• Supervisory authorities have responded to increased risks through heightened supervision, deep-dive reviews and the use of certain macroprudential tools, and will continue to use a combination of supervisory activities to ensure the effective management of credit risk by banks. 

Credit risk continues to be a key area of focus for the Basel Committee on Banking Supervision, following the onset of the Covid-19 pandemic and more recent inflationary pressures. The Committee had previously highlighted specific credit risk topics that it intended to focus on in greater detail during 2022, including particular asset classes that are generating supervisory concerns in specific regions.¹

The Committee recently held supervisory workshops with private sector participants and bank supervisors on real estate and leveraged loan markets. The workshops focused on risks and vulnerabilities, and supervisory perspectives and practices across various jurisdictions. The workshops highlighted that: 

• The Covid-19 pandemic has exacerbated credit risk. Many jurisdictions have seen an increase in house prices and household and corporate indebtedness. Structural transformations in terms of how individuals work and consume products have also impacted businesses and demand for certain types of residential and commercial real estate.
• Both real estate and leveraged loans are vulnerable to higher inflation and interest rates, which are likely to impede debt servicing capacity and may also reduce broader consumption and spending.
• Banks' risk management practices in financing real estate and leveraged loans are generally considered adequate, but there is significant diversity both across and within jurisdictions, and banks should be alert to evolving risks. For leveraged loans, supervisors have observed weaker structures and deficiencies regarding banks' management of risks associated with the underwriting pipeline, stress metrics, loss-given-default estimates and risk appetite frameworks.
• Supervisory authorities have responded to increased risks through heightened supervision, deep-dive reviews, and the use of certain macroprudential tools, and will continue to use a combination of supervisory activities to ensure the effective management of credit risk by banks.

The Committee will continue to monitor banks' risk management practices and exposures to real estate and leveraged loans/collateralised loan obligations.

More detailed observations from the workshops are set out below.

Real estate

• Many jurisdictions have experienced a significant increase in house prices over recent years. High house prices and low interest rates have contributed to high levels of household debt. Rising inflation and interest rates may curb house price growth but are also likely to stretch the debt servicing capacity of some borrowers and lead to adverse wealth effects. While banks do not appear to have significantly loosened their underwriting standards, some relaxation has been observed (eg longer loan maturities and shorter employment history for income verification). Across jurisdictions, a variety of innovative financing structures have been observed (eg home equity lines of credit, reverse mortgages, shared equity mortgages) that may present unique challenges in a downturn. Increased offering of non-amortising products, such as interest-only loans, may make it more difficult to assess borrowers' ability to repay, and also raises questions around whether risks can be appropriately modelled.
• Risks in certain subsectors of commercial real estate (CRE) – including retail, office and hotels – remain elevated due to pandemic-related effects. CRE may also be affected by inflation, as higher development costs are likely to erode yields and reduce new development. Interest-only and non-recourse lending remain the primary forms of CRE finance, with the use of mezzanine financing also increasing. There is some concern that complexity in financing structures may be disguising leverage.
• Supervisors are focused on ensuring banks maintain strong credit underwriting standards for both residential and commercial real estate financing. The use of various macroprudential tools (eg capital buffers and borrower-based limits) also complements microprudential supervision. Over the medium term, supervisors will focus on the impact of structural adjustments across the real estate sector driven by changes in how individuals work and consume products, and by ESG and climate-related trends.

Leveraged loans and collateralised loan obligations

• Leveraged loan and CLO markets were buoyant leading into the pandemic, with the low interest rate environment and search for yield by investors contributing to higher leverage, tighter yields, higher valuations and looser documentation. The pandemic exacerbated risks, due to increased leverage and structural adjustments across certain industries and sectors. In the current environment, there is an increasing bifurcation between stronger and weaker credits, with the latter likely to struggle to service debt or refinance given higher interest rates and wider credit spreads.
• Private debt markets have also expanded, which has allowed borrowers to access a wider range of financing options. However, this greater involvement of private funds may also increase the channels of potential risks between banks and non-bank financial institutions.
• Risk management practices at some banks are considered adequate, while others have exhibited deficiencies in their management of risks related to the underwriting pipeline, stress metrics, loss-given-default estimates, and risk appetite frameworks.
• Supervisory authorities have adopted different approaches to supervising banks' exposures to leveraged loans. These approaches, which are both supervision and regulation-focused, also reflect the diversity of leveraged finance transactions, including leveraged buyouts, highly leveraged corporates, collateralised debt and unsecured exposures. Considering the global nature of the market, continuous information-sharing and risk assessment by supervisors remains a priority.

¹  See the Committee's Newsletter on Covid-19 related credit risk issues (2 March 2022).