Worth the Risk? The Performance of Banks Reliant on CLO Funding

Abstract

We study the effect of bank reliance on CLO funding on bank risk. We document that an exogenous increase in CLO funding significantly decreases bank expected default frequency, with a 1.6% reduction one quarter from the shock for the average bank in response to a standard funding shock. Changes in asset composition and income origination help explain this result. Upon an expansion in CLO funding, banks increase the origination of institutional business loans, fostering origination fees and net noninterest income. Banks also market a large share of the loans they participate in, decreasing the proportion of loans they hold on their balance sheets despite the rise in origination. The performance of the loans they retain on their balance sheets also improves, further strengthening bank conditions. Our results contribute to the literature in bank risk management and the increasing role the shadow banking system plays in funding banks and business lending, carrying relevant implications for the bank regulatory process.

Keywords: CLOs, institutional loans, institutional investors, bank risk, bank performance.

JEL Classification: G21, G23, G32