The Bank for International Settlements (BIS) - the central banker's central bank - has released its 2019 annual report, which is always a good read. Against a backdrop of downward pressure on global economic growth, catalysed by politically induced trade tensions, it paints a comparatively rosy picture of the world's economy. Ten years on from the Global Financial Crisis (GFC), supported by low and stable inflation, the banking system is better capitalised and holds much more liquidity than it did pre-GFC.

The report however also raised a warning sign about the growth of the leveraged loan market, which now amounts to some $3 trillion - a significant amount, but still only one per cent of the stock of global financial assets.  

Leveraged loans are typically loans made to non-investment grade borrowers that are highly indebted, or that are owned by a private equity sponsor. Most leveraged loans are taken out by US, and to a lesser extent, UK borrowers but are sold on by the originating bank to non-bank investors or banks in other parts of the world. Sometimes these leveraged loans are bundled up into collateralised loan obligations (CLOs) which are tranched, enabling different slices of risk to be sold to investors with different risk appetites, with institutional investors taking the riskier pieces of the deal and international banks - often in Asia - taking the least risky tranche. More recently, investor appetite for increased yield has driven growth in leveraged lending as structurers seek loans that they can collateralise.

Leveraged borrowers have inevitably responded to this increased investor appetite by negotiating weaker, so-called ?covenant-lite? loan agreements, cheaper pricing, and higher levels of leverage, which have increased from about four times the borrower's earnings to six times, with a quarter of all new leveraged loans having debt to earnings ratios in excess of six.

The BIS report observes that the stock of leveraged loans in 2018 was almost comparable to the stock of US subprime mortgages before the onset of the financial crisis, if measured relative to the size of the relevant credit market.   It could also be argued that the rate of growth and deterioration in lending standards echoes similar trends in the US subprime market before the GFC.

Comparisons have been drawn between the sub-prime securitisation market ahead of the GFC and leveraged loans. Central bankers are right to raise the risks that the rapid rise in leveraged loans brings, given the enormous impacts that the subprime-induced GFC had on citizens? wealth, bank capital, and economic activity. In the event of another economic downturn, with attendant credit deterioration of leveraged loan borrowers, there could be knock-on effects into the wider economy as prices deteriorate and wholesale funding costs increase - as with subprime mortgages before.

In my view, the regulatory reforms introduced since the GFC, including retention by the originator of some of the riskier tranches in securitisations structures like CLOs, greater transparency about the underlying risks and increased risk weightings mean that leveraged loan market structures are now more robust. On top of that there is less reliance by CLO investors on short term funding and banks are no longer providing backstop liquidity facilities exposing them, by the back door, to the risk in securitisation structures.

The Bank of England's 2018 stress test looked at the impact of a severe economic downturn on UK banks? holdings of leverage loans and found that they had relatively low levels of lower risk to CLO exposures, but that does not mean that banks in other parts of the world are immune to a leveraged loan stress.

One of the jobs of central bankers is to look forward and identify potential threats to future financial stability, but we all must keep our eye on the leveraged loan ball, particularly if economic conditions start to deteriorate.