The US leveraged loan market is facing growing systemic risks, according to a recent study from the University of Bath, which warns of the potential for another financial crisis. The study, published on June 25, 2025, identifies several concerning trends, including the underpricing of highly leveraged loans, the increasing role of less-regulated non-bank lenders, and a decline in loan standards. These factors collectively contribute to a fragile market environment where the risk of widespread financial instability is heightened.
Leveraged loans, which are extended to companies with high levels of debt or weaker credit histories, have seen default rates surge to a four-year high of 7.2% in December 2024. Many borrowers are engaging in 'distressed exchanges' to avoid bankruptcy, a practice that further erodes investor confidence and market stability. The study points to a significant weakening in the pricing of leverage risk since 2014, with the risk premium for the most vulnerable borrowers declining sharply, reflecting underlying structural weaknesses in the market.
The rise of non-bank lenders, or 'shadow lenders,' has been a key development in the leveraged loan market. These entities operate with less regulatory oversight than traditional banks, raising concerns about risk-taking and transparency. Despite some state-level licensing requirements, the absence of a comprehensive federal regulatory framework for non-bank lenders leaves a gap in oversight that could exacerbate systemic risks.
Another critical factor is the surge in Collateralized Loan Obligation (CLO) issuance, which now accounts for approximately 70% of the US leveraged loan market. CLOs package leveraged loans into securities sold to investors, transferring risk away from original lenders but creating complex structures that may obscure the true risk to investors. Additionally, the widespread adoption of 'covenant-lite' loans, which offer fewer protections for lenders, has further weakened the market's resilience to financial distress.
Regulators are increasingly concerned about the rapid growth and interconnectedness of the private credit market, which includes non-bank lenders and their leveraged loan activities. The size and complexity of this market mean that any significant disruption could have far-reaching implications for financial stability. While previous assessments, such as a 2020 GAO report, downplayed the immediate threat of leveraged lending to financial stability, the current environment of underpriced risk and diminished oversight presents new challenges.
The study's findings underscore the urgent need for enhanced regulatory oversight and risk management practices in the leveraged loan market to prevent a potential crisis. The combination of underpriced risk, the proliferation of non-bank lenders, and relaxed lending standards poses a significant threat to the financial system, highlighting the importance of addressing these issues proactively.
