Amid tightening economic and financial conditions, global banking regulators are warning about elevated credit risks.
In a new report, the Bank for International Settlements (BIS) said that the lingering effects of the pandemic and soaring inflation has intensified credit risk concerns.
In particular, the real estate and leveraged loan markets are vulnerable to higher inflation and interest rates, as they “are likely to impede debt servicing capacity and may also reduce broader consumption and spending,” the BIS said.
To start, the pandemic elevated credit risk, as both housing prices and indebtedness rose, the BIS said. High house prices and low interest rates stoked the accumulation of household debt.
Additionally, shifts to remote working and changing consumer trends have altered the patterns of demand for both residential and commercial real estate, it said.
As a result, commercial real estate faces continued risks stemming from the pandemic, alongside the impact of high inflation on developers’ costs.
For households, “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,” it said.
Similarly, the low interest rate environment, and the intensified search for yield by investors, also stoked risks in the leveraged loan market, the report noted. Those risks include higher leverage, tighter yields, higher valuations and looser documentation.
The pandemic exacerbated these risks due to increased leverage and other structural adjustments.
“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,” it said.
Private debt markets have grown too. This may increase the transmission of potential risks between the traditional banking sector and shadow banks, the report warned.
In response to these concerns, bank regulators have stepped up oversight and are using other tools at their disposal (such as capital buffers and other prudential measures) to ensure that banks are effectively managing their credit risks, the BIS said.
Overall, regulators have found that banks’ risk management is adequate, but that “there is significant diversity both across and within jurisdictions, and banks should be alert to evolving risks.”
Indeed, the BIS noted that “supervisors have observed higher risk lending and deficient practices in some areas” — such as weaknesses in their “management of risks associated with the underwriting pipeline, stress metrics, loss-given-default estimates and risk appetite frameworks.”
Additionally, regulators said that the use of financing structures — such as reverse mortgages, shared equity mortgages, and home equity lines of credit — “may present unique challenges in a downturn.”