A recent study by the University of Bath uncovered troubling distortions in the U.S. leveraged loan market, raising concerns that a new financial crisis could be on the horizon. According to the research, loans with high levels of leverage are being systematically underpriced, particularly by non-bank lenders—often referred to as “shadow banks”—that operate outside the scope of traditional financial regulation. This mispricing, the authors argue, poses a systemic risk that may go undetected until it manifests in severe economic instability.
Leveraged loans, typically extended to borrowers with substantial debt burdens or subpar credit histories, have seen default rates soar to their highest levels in four years. Data from the Financial Times in December 2024 indicated that the U.S. leveraged loan default rate had climbed to 7.2%, marking its highest point since the end of 2020. Many indebted companies are turning to distressed debt exchanges as a last-ditch effort to avoid bankruptcy. These arrangements often erode investor recovery rates, underscoring the fragility and precariousness of this market segment.
Dr Ru Xie, Associate Professor of Finance at the University of Bath’s School of Management and lead author of the study titled Leveraged Loans: Is High Leverage Risk Priced In?, emphasised that the risk associated with leverage is not being adequately priced in—especially by non-bank financial institutions. Since 2014, the pricing of leverage risk has deteriorated markedly, with the sharpest decline evident among the riskiest borrowers. These are typically clients of shadow lenders who issue loans with minimal protective covenants and then package these loans into securities to be sold on secondary markets. The diminished risk premium, particularly for the most vulnerable segments, suggests a breakdown in how financial markets evaluate and compensate for credit risk.
The study portrays a market landscape reshaped by structural changes over the past decade. The rapid ascent of non-bank lenders, the explosive growth of collateralised loan obligations (CLOs), and the proliferation of covenant-lite loan structures have created a breeding ground for systemic vulnerability. Unlike traditional banks, non-bank lenders are not subject to the same rigorous oversight, yet they now originate a significant share of new leveraged loans. This decentralisation of credit risk, with weak documentation standards and limited transparency, leaves regulators in a difficult position—largely unable to see or address the full extent of risk accumulating within the system.
Professor David Newton, co-author of the report, warned that these risks should not be viewed solely through a credit lens. “With today’s heightened geopolitical tensions—from global trade disruptions to military conflicts—and continued market volatility, the mispricing of leverage risk takes on macroprudential significance,” he said. “Should a wave of distress emerge among leveraged borrowers—particularly those financed by shadow banks—we could witness a new credit or banking crisis that escapes regulatory detection until it is too late.” His remarks highlight the growing divide between the visible portions of the financial system and the opaque, complex web of lending arrangements that now operate primarily out of view.
The researchers identified two primary forces driving this decline in risk sensitivity. First, the growing use of covenant-lite loans, which lack the performance-based protections traditionally embedded in lending agreements, significantly increases information asymmetry. With fewer covenants, banks and other lenders have reduced incentives or capacity to monitor borrower behaviour, especially when loans are bundled into CLOs and sold off in tranches. Second, the increasing securitisation of these loans further weakens the alignment of interest between originators and investors. As the risk is passed downstream to third-party investors, the original lenders retain little incentive to uphold rigorous underwriting standards.
In light of these findings, the authors call for more robust regulatory scrutiny of non-bank lenders and the structures they employ. They argue that opaque securitisation practices, coupled with weak documentation and loose lending standards, have enabled a build-up of systemic risk that traditional oversight mechanisms are ill-equipped to address. Global financial authorities, including the European Central Bank and the Bank of England, have recently voiced similar concerns about shadow banking and the unchecked expansion of leveraged lending. The University of Bath study adds an urgent academic perspective to this growing chorus, underscoring the need for coordinated policy action before the next crisis takes root.
The research presents a sobering assessment of the leveraged loan market’s trajectory in the United States. It suggests that without meaningful reform, the current path of underpricing leverage risk—driven by shadow lending, weakened oversight, and a securitisation-fuelled boom—could culminate in a destabilising financial event. As policymakers, investors, and regulators grapple with mounting economic uncertainty and complex global risks, this study serves as both a warning and a call to pre-emptively address the structural vulnerabilities now embedded within modern credit markets.
More information: Ru Xie et al, Leveraged loans: is high leverage risk priced in?, Inderscience Online Journals. DOI: 10.1504/IJBAAF.2025.146550
Journal information: Inderscience Online Journals Provided by University of Bath