Credit Risk Evaluation

CLOs are Cracking: Welcome to the World of Unintended Consequences A big selloff of existing collateralized loan obligations (CLOs), which buy and pool buyout debt, has slowed the issuance of new CLOs. This makes sense - because the selloff pushed down the prices of existing CLOs, that's what investors will buy until issuers price new CLOs more attractively. This in turn has created a headache for banks looking to offload buyout debt they would have gotten off of their balance sheets by repackaging it into new CLOs. This is not a minor issue; CLOs are a ~$1.4 trillion market. Part of the pressure the market is under is by design. CLOs typically pay floating rates, so they yield less when rates look like they might fall faster than previously believed. And because they are backed by debt used to help finance leveraged buyouts, they also have exposure to credit risk. You're seeing the heightened market pressure show up in ETFs that own CLOs. The $20 BN Janus Henderson AAA CLO ETF (JAAA) recently saw nearly $600 MM of withdrawals, the biggest single-day outflow since the fund’s inception in 2020. This alone was enough to put pressure on valuations overall. ETF prices normally trade in line with net-asset values because specialized traders (aka, "authorized participants" / APs) will buy shares of the ETF whenever they drop below the NAV because they can then redeem the ETF with the issuer in exchange for the underlying assets, which they then sell. It's essentially a risk-free profit. But some CLO-focused ETFs are trading at discounts to the value of their portfolios wider than 4%. The fact that the APs are not stepping in to pick up what should be free money makes us wonder how accurate those NAVs are. As the macro environment continues to deteriorate, and at an accelerating rate, the banks looking to offload the loans they made via new CLOs must be going through the same grim math. Needless to say, when even the specialists hesitate to step in, buyer beware... For the full picture, read these very thorough articles by Carmen Arroyo Nieto, Scott Carpenter, and Katie Greifeld: https://lnkd.in/eWBV527F https://lnkd.in/eiFA73Bx #investing #stocks #bonds #CLOs #ETF #stockmarketcrash #tariffs #TradeWar

Basel III Endgame (Part 2): Private Credit lenders will raise substantial capital to fill the void that will result from Basel III Endgame. As the credit markets become increasingly larger, while banks respond to regulatory requirements, Private Credit fund managers become a more important factor to the ecosystem that enables the machinery of a strong and vibrant economy to operate. Asset-Based non-bank lenders will likely become the biggest beneficiary of Basel III Endgame since banks make up a huge percentage of the ABL pie. The Commercial Real Estate Lending void is the most immediate concern as banks reduce their exposure to this asset class. Banks typically use 5-10x balance sheet leverage in comparison to most Private Credit Fund managers who deploy 1x turn of leverage, and furthermore, Private Credit funds are not funded by government guaranteed deposits as GPs & LPs have alignment in assuming the risk. Fifteen years ago, the impact from the 2008 GFC was multitudes larger in size and scope vs. what occurred in March 2023, yet Treasury Secretary Janet Yellen stepped up to the plate and did something never previously done when the U.S. Treasury implicitly guaranteed 100% of deposits without officially raising the FDIC’s $250,000 limit on deposits. The Treasury along with the three oversight boards (Fed, OCC, FDIC) convened to discuss the necessary precedent required to safeguard banks, which is the basis for Basel III Endgame. This was floated just months ago, but the federal bank governing bodies have told the banks where the ball lands. Banks are currently developing transition plans to submit by June 30, 2025 (full compliance 3-years hence). Any bank with assets >$100 billion will be subject to Basel III Endgame. There are 30 banks in the U.S. with assets >$100 billion that must comply. The entire U.S. banking system accounts for approximately $30.2 trillion in assets (~$24 trillion in risk-weighted assets). The top 30 U.S. banks subject to Basel III Endgame comprise $16.3 Trillion in assets as seen below. This table lists the top 10 banks in the U.S., ranked by assets, RWA, Equity Capital and Deposits:

CLOs becoming a victim of their own success? 🥹 I used to be a big buyer of CLO tranches back in the 2000s. An asset class I am super familiar with and which I like to follow for the opportunity set that CLO equity funds represent. Bloomberg is highlighting an interesting, somewhat disconcerting trend in CLO land which warrants a closer look 👀 in my view: "The $1.3 trillion CLO market is about to become a victim of its own success because managers can’t create the bonds fast enough to meet demand and are running out of things to buy. A slowdown in M&A after borrowing costs rose is continuing to deprive the lenders of the leveraged loans that the industry was built on. About $311 billion of M&A deals have been announced and completed so far this year, roughly $1 trillion below the same level two years ago when interest rates began to rise. 💡That may soon end up impacting the equity arbitrage which may hurt new issuance in the coming months. It’s also sent more managers into the secondary market, where about 60% of loans now trade above par, making it that much harder to find bargains to put together a portfolio. 💼 'There’s too much demand for CLO bonds and too little loan supply. CLO managers can’t keep up much longer,' said Pratik Gupta, who leads CLO research at Bank of America. Demand for the safest CLO tranches soared this year after an influx of money into ETF. Banks have also been piling into the AAA bonds, and some Japanese 🇯🇵 institutions may scoop up more of the debt. On top of that, Bank of America estimates that about $64 billion of the debt has been paid back so far this year, including amortizations and called CLOs, meaning asset owners have more capital to put to work. 'If you’re an existing investor, you’re getting so much money in the door that’s creating demand in and of itself,' said Amir Vardi, an MD at UBS Asset Management. 'Forget about increasing the budget to get more,' he said on a panel. 'You’re just trying to keep what you have invested.' Demand is so strong that even an 86% increase so far this year in US sales of new issue CLO bonds from the same period in 2023 hasn’t been enough to sate investors’ appetite. As a result, spreads on the AAA debt have compressed by more than 100 basis points over the benchmark since late 2022. ⚠️ Lenders are also trying to circumvent the dearth of paper by increasing their holdings of corporate bonds — both investment-grade and junk — in an attempt to preserve arbitrage returns, Gupta said. The rise of private credit is also crimping opportunities for leveraged loan lenders by winning business from them. 'The supply and demand balance is out of whack, it’s become more difficult to find assets at attractive levels,' said Christina O’Hearn, PM for the leveraged loan and CLO business at Pretium Partners. 'We expect to see continued refi & reset activity but not as many new issue CLOs.'" (+++Opinions are my own. Not investment advice. Do your own research.+++)

Europe’s credit markets had a near-perfect setup. Cheap money, stable inflation, and resilient demand. That setup is now quietly breaking; and the trigger isn’t just geopolitics - it’s energy. When oil spikes, it doesn’t hit credit markets immediately. It seeps in through inflation, margins, and ultimately, refinancing risk. And that’s exactly where Europe’s leveraged finance market is starting to feel the strain. Three markets. Three different fault lines. 1) Syndicated loans: the refinancing trap is back A large chunk of today’s loan book was built in a near-zero rate world. Those same borrowers are now staring at materially higher borrowing costs—with yields back above ~7% on average (European Leveraged Loan Index). Two risks are converging: > Refinancing risk: Covid-era deals rolling into a harsher rate environment > Default risk: Persistent inflation squeezing already thin margins Sponsor support has helped delay the pain. But it doesn’t fix weak cash flows. 2) Private credit: opacity meets leverage This is where things get more uncomfortable. European direct lending portfolios tend to have: - Higher leverage - Limited transparency on stress and defaults - Heavy exposure to services sectors At first glance, services look insulated from energy shocks. But that’s misleading. Inflation doesn’t care about sector comforts. It shows up in wages, input costs, and demand compression. 3) High yield bonds: inflation hits harder here Unlike loans, this is largely a fixed-rate market. Which means rising inflation expectations directly pressure valuations and spreads. Now layer in the numbers: > €60 billion of maturities due between 2026–2028 > Issuance costs already up ~100 bps post-conflict > Fund outflows accelerating The common thread across all three markets - refinancing risk. 1. It never really disappeared, it was just masked by liquidity. 2. And with issuance slowing since the Middle East conflict, the window to refinance on favorable terms is narrowing. 3. Supply chains have been already disrupted due to the Iran war. - Inflation may re-accelerate - Rate cuts may reverse or at least be delayed - Liquidity is becoming selective - And importantly, sponsor capital is no longer patient. That’s when markets stop being forgiving; and start being selective. Krishank Parekh | LinkedIn

Understanding the Imperative: Basel III and Post-Crisis Reforms The financial crisis of 2008 was a stark reminder of the interconnectedness and vulnerabilities within the international financial system. The crisis exposed significant weaknesses in the global regulatory framework, particularly under Basel II, necessitating a more robust and resilient banking system. Understanding why Basel III and other post-crisis reforms were introduced is crucial for banking professionals who are navigating these regulatory environments. Although Basel II was a significant advancement over its predecessor, it became apparent during the financial crisis that it did not go far enough in preventing the build-up of systemic risk. Basel II was heavily reliant on internal risk assessments by banks, which proved to be overly optimistic and insufficient in the face of financial distress. The framework also lacked stringent requirements for liquidity and leverage, allowing banks to operate with high leverage while maintaining insufficient liquid assets. Basel III was developed to address these shortcomings and to significantly strengthen the global capital framework. Key enhancements introduced by Basel III include: 1. Higher Capital Requirements: stricter capital requirements, increasing both the quantity and quality of capital banks must hold. This includes a higher ratio of equity to risk-weighted assets, ensuring that banks have enough capital to absorb losses during periods of financial stress. 2. Countercyclical Buffers: To prevent excessive credit growth that can lead to asset bubbles, Basel III introduced countercyclical capital buffers, requiring banks to hold additional capital during periods of high credit growth, which can be reduced when conditions worsen. 3. Leverage Ratio: Unlike Basel II, Basel III introduced a non-risk-based leverage ratio to serve as a safeguard against excessive leverage on banks' balance sheets. This measure helps ensure that banks' expansion is matched by solid capital support. 4. Liquidity Requirements: Basel III established two key liquidity ratios - the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These ensure that financial institutions maintain sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario and promote more stable funding structures. The implementation of Basel III and its ongoing updates reflect an ongoing commitment to fortifying the global banking system against future crises. These reforms have led to a more conservative banking environment where institutions must operate with higher levels of capital and stronger risk management practices. Understanding the rationale and requirements of Basel III is not just about regulation, but about appreciating the role of these reforms in fostering a more stable banking system. As the landscape continues to evolve, the insights gained from these reforms will be essential in guiding future regulatory changes.

At Rich Data Co we saw a gap in the market for banks to better utilise their customers’ transaction data to understand the financial health of their business and commercial customers. AI plays a key role in predicting the cashflow health of businesses. This enables bankers to understand their customer’s past, present and most importantly, their future. With these capabilities, bankers are able to do 3 things:    1️⃣ Seeing warning signs in real time: RDC applies AI to transaction data to identify cashflow deterioration. Cashflow is a leading indicator for early warning, while many other factors are lagging behind business operation problems. Many banks rely on risk rating changes to identify early warnings. This could be triggered by a review of financial statements (often 18 months old), behaviour data changes or banker judgement. While all these factors are important, they are likely to be too late given it is backward looking. This is like comparing driving a car looking out the front window vs. looking at the rear view mirror.  2️⃣ Identify lending opportunities: A businesses cash flow position goes through ups and downs, especially seasonal businesses such as retailers. The prediction of cashflow health allows bankers to look into the future and provide lending to customers when they need it the most. This also allows banks to assess loan suitability to lend responsibly. Banks need to assess how the business can pay the loan back with the cashflow it generates, i.e. the primary source of repayment. Lending to businesses with a strong cashflow will be less risky for banks and provide affordable loans for the business to grow. 3️⃣ Improving efficiency in the customer review: Continued assessment of customer risk enables banks to drive efficiency in their customer review obligation required by the regulators.   This is a paradigm change in how banks manage their business and commercial lending portfolio. We have seen enlightened banks embracing and leveraging AI to realise significant benefits for both the bank and their customers. This paradigm change moves banks from assessing credit risk only a few times, to ongoing. This is like comparing banks taking a static picture of their customers’ financial health vs. making a movie by ongoing observation of their customers. Static picture vs. a movie of a customer's financial health, which one do you think would be more accurate and timely?     The difficulty in applying AI in this domain is how to achieve cashflow prediction accuracy to a banks lending standard. If you'd like to hear more details, RDC is always open to chat.   https://lnkd.in/gjshBwbb   #FutureOfCredit #MachineLearning #ArtificialIntelligence  

Rising Interest Rates & Credit Risk: What It Means for Expected Credit Loss (ECL) With interest rates climbing, the credit risk landscape is shifting. As borrowing costs rise, more businesses and consumers face financial strain, increasing the likelihood of defaults. That’s where Expected Credit Loss (ECL) analysis becomes even more critical: Expected Credit Loss = Probability of Default × Loss Given Default 🔹 Probability of Default (PD) → Higher interest rates can lead to increased defaults, especially for highly leveraged borrowers. 🔹 Loss Given Default (LGD) → Declining asset values (e.g., real estate or collateral) may reduce recovery rates, increasing potential losses. 💡 How Financial Institutions Are Adapting: ✅ Stress testing loan portfolios against rate hikes 📊 ✅ Adjusting risk models to reflect macroeconomic conditions 📉 ✅ Strengthening capital reserves to absorb potential losses 💰 The key to navigating this environment? A proactive credit risk analysis process that integrates real-time data and forward-looking risk models. As central banks continue adjusting policies, financial professionals must stay ahead of the curve. 📢 How is your organization managing credit risk in today’s high-rate environment? Let’s discuss in the comments! 👇 #CreditRisk #InterestRates #RiskManagement #Finance #CFO

If you don't I will - Private Credit Bank loans to the private credit sector are making headlines, with regulators warning of systemic risks if economic conditions deteriorate. But behind the headlines, a fundamental shift is underway: banks are retreating from lending to SMEs, and private credit is stepping in to fill the gap. Banks, constrained by tighter regulations and risk management policies, are increasingly focusing on large, well-established corporates, leaving many smaller businesses underserved. Private credit funds—backed by experienced institutional investors—are now a vital source of flexible, tailored financing for SMEs and mid-market companies. In the UK alone, private credit managers are supporting around 2,000 firms with an estimated £100 billion in funding. Private lenders often provide faster, more bespoke solutions than banks, helping growth companies access capital when they need it most. While private credit typically comes at a higher cost, the flexibility and speed are crucial for businesses unable to meet banks’ rigid criteria. This has enabled many SMEs to expand, innovate, and compete, driving broader economic growth. Due diligence and risk management are central to private credit. Leading funds conduct rigorous assessments of borrowers, monitor covenants closely, and diversify portfolios to manage risk. Despite the growth and complexity of the sector, default rates have remained relatively low—recent data puts US private credit defaults at around 5.7%, while European forecasts suggest a 4.25% default rate by late 2025, with expectations for further moderation as markets stabilize. Many experts expect defaults to remain below long-term averages, especially as interest rates ease. Importantly, capital for private credit typically comes from seasoned institutional investors—pension funds, insurance companies, and family offices—seeking attractive, risk-adjusted returns and willing to support SME lending through specialized funds. As the landscape evolves, policymakers are working to improve SME access to finance, with initiatives like the Bank Referral Scheme and enhanced data sharing to help level the playing field. But for now, private credit is proving to be a critical engine for SME growth—helping the companies that need it most, while banks don't help the real economy and only focus on the largest players. #PrivateCredit #SMEs #AlternativeLending #FinancialInnovation #RiskManagement #BusinessGrowth #Regulation #Investing #BankingTrends Banks’ links to private credit could pose systemic risk, says Boston Fed - https://on.ft.com/3FjOQns via @FT

Should every lending decision be AI-driven? Banks are experimenting with GenAI credit models. But here’s the nuance: 👉 Not all credit risk is a “prompt-and-predict” problem. My view: 🛑 Low-ticket, rule-driven loans (personal, auto) → Use scorecards + automation 🛑 SME working capital with stable patterns → Use predictive ML on transaction flows 🛑 Complex project finance, syndicated loans → Use structured analytics + expert committees ✔️ High-variance SME/retail mix, where qualitative signals matter (e.g., sector shifts, sentiment from contracts/emails) → GenAI adds real lift 💡 AI isn’t about “faster yes/no.” It’s about augmenting risk insight where rules fail and variance is high. What are your thoughts on the AI-driven decision making? #ArtificalIntelligence #AI #Banking #Lending #GenAI #AgenticAI #Finance #SME #RetailBanking