In recent years, the participation of non-bank lenders such as insurance companies and pension funds in making loans to corporations and commercial real estate has skyrocketed. While securitizations of such loans have been around decades in the forms of CLOs (collateralized loan obligations) and CDOs (collateralized debt obligations), the vast increase in this area has created a “shadow banking” system that is largely driven by private equity firms, write Northfield Research’s Emilian Belev & Dan diBartolomeo for the Professional Risk Managers’ International Association (PRMIA) magazine, Intelligent Risk.
The rapid expansion of private credit as an investment asset class for institutions, particularly pensions and insurers, continues an accelerating trend. Quantitative methods for assessing risks in such investments are less well developed than for bonds, particularly with respect to default correlation, and so the perceived risk of securitizations and credit fund portfolios are downward biased.
Belev and diBartolomeo present multiple analytical approaches to estimating default probabilities in individual private loans. They assert that Merton-type methods offer the most sensible approach to default correlation and hence the risk of private credit funds and securitizations (CLOs and CDOs). An important nuance to understand is the implications of higher moments (skew and kurtosis) on real-world credit portfolios.
The implications of the expansion of a shadow banking system must be carefully monitored in terms of macroeconomic and systemic impacts nationally. It should be clear that a growing fraction of corporate lending is now occurring outside the traditional banking system. Stress testing and other techniques routinely used in banks will be much harder to impose on largely unregulated lenders.
The potential risks are no less serious than those that arose from credit default swaps which were a major contributor to the global financial crisis of 2007-2009.
“We highlight the concern of regulatory ‘jurisdiction shopping’ by US insurance companies wishing to participate more aggressively as lenders. To address this challenge, the authors suggest that private credit activities be required to report a central information center (e.g. Depository Trust Company) and require private credit activities to be subject to independent “mark to market’ assessments for insurers and participating defined benefit pension plans,” they write.
Other topics in the magazine issue include how the US Securities and Exchange Commission is targeting CDS “shenanigans”, operational risk capital and Fed interest rate decision analysis.