6 policy responses to leveraged lending fears

By Hannah Lang, Neil Haggerty, Joe Adler

June 6, 2019 9:00 PM

WASHINGTON — As policymakers debate the nature of the risk presented by leveraged loans, some have been quick to recommend policy prescriptions to safeguard the financial system.

In its May Financial Stability Report, the Federal Reserve concluded that corporate debt has increased since the end of the financial crisis and that the least creditworthy borrowers account for most of that growth.

Regulators are keeping an increasingly close watch on leveraged lending, said Fed Chair Jerome Powell in a speech last month. But with the heightened risk mostly attributed to nonbank entities, it is unclear which agency would be responsible for crafting a policy response. Last year, Comptroller of the Currency Joseph Otting said banks “really kind of stayed on the rails” with leveraged lending.

The Financial Stability Oversight Council met last week in a closed-door session and reviewed a presentation about leveraged lending, according to a readout of the meeting.

House Democrats sounded the alarm at a House Financial Services subcommittee hearing Tuesday, in which Rep. Gregory Meeks of New York, the chairman of the subcommittee on consumer protection and financial institutions, urged his colleagues to “consider the possibility” that leveraged loans are a systemic problem.

In a speech the same day at the Economic Club of New York, Bank of America CEO Brian Moynihan argued that the weakening of standards that has contributed to the high concentration of leveraged loans is something “we should worry about.”

“We don't see anything yet because the economy's good, the companies are making money," he said. "The issue that's there is in the leveraged finance."
In a downturn, Moynihan said, "It'll be ugly for those companies if the economy slows down and they can't carry the debt and then restructure it, and then the usual carnage goes on."

Yet House Republicans sided with the Trump administration-appointed regulators, arguing that the risk is overstated and that banks have built sufficient capital cushions to combat any threat to the economy.

Regulators and lawmakers have some options already at their disposal to enable defenses, or Congress could attempt to provide new tools. But it remains to be seem if officials want to deploy any new protective measures.

Here are six routes they could take:

Congress addresses leveraged lending risks with new legislation

Tulips grow in front of the U.S. Capitol Building in Washington, D.C., U.S., on Thursday, April 18, 2019. Attorney General William Barr said Special Counsel Robert Mueller recounted 10 episodes of potential obstruction by President Donald Trump. But Barr said he and Deputy Attorney General Rod Rosenstein disagreed with some of Mueller's theories on possible obstruction. Photographer: Alex Edelman/Bloomberg

Alex Edelman/Bloomberg

At least three bill proposals have been floated by the House Financial Services Committee to address the potential risks in the leveraged loan market.

One of the bills would require that the Office of Financial Research assess the risks posed by leveraged lending and collateralized loan obligations to the economy and report on those risks every six months for a two-year period. It would also give the director of OFR the authority to subpoena information on leveraged lending.

But the Trump administration has sought to weaken OFR through layoffs, so an additional bill being considered by the committee would set a minimum funding level for the agency no lower than the funding levels set in fiscal year 2017.

A third bill would require the Federal Financial Institutions Examinations Council to establish uniform examinations procedures for firms that conduct leveraged lending activities, as well as minimum expectations. The FFIEC would have to report to Congress on a quarterly basis an analysis of leveraged lending activities by financial institutions, including general risk management and compliance with the minimum expectations.

But some are skeptical that any legislation will move forward in the leveraged lending space, given the divided Congress.

“It’s hard enough to get anything through Congress these days,” said Ian Katz, a policy analyst at Capital Alpha Partners. “They certainly bring [leveraged lending] up a lot, certainly the Democrats in hearings.”

FSOC seeks new rules for shadow banks and leveraged loans

FSOC council meeting in December 2018 with Treasury Secretary Steven Mnuchin

Steven Mnuchin, U.S. Treasury secretary, center, speaks during a Financial Stability Oversight Council (FSOC) meeting at the U.S. Treasury in Washington, D.C., U.S., on Wednesday, Dec. 19, 2018. When Mnuchin fingered high-frequency trading and the Volcker Rule as factors behind recent misery in the stock market he left out some other possibilities that might be contributing. Namely, the White Houses's ongoing trade conflict with China and President Donald Trump's threat last week to shut down the government. Photographer: Al Drago/Bloomberg

Al Drago/Bloomberg

The federal banking agencies only supervise depository institutions and their holding companies in the “regulated” banking industry. So, the Dodd-Frank Act established the Financial Stability Oversight Council to monitor the system for threats posed by nonbanks. That makes the FSOC a logical focus for dealing with systemic risks from corporate credit instruments in the shadow banking sector.

Yet FSOC itself is in flux. Under a March proposal, the council would revise its process for designating “systemically important” nonbanks for special Federal Reserve supervision, and shift FSOC’s approach to focus more on activities-based regulation of nonbanks. FSOC would flag activities deemed a threat and then coordinate with relevant prudential regulators on writing new rules.

Some have suggested that the proposal be withdrawn out of concern that reducing the focus on specific nonbank firms lets them off the hook.

“It can be important … for regulators to enlarge the perimeter of regulation for financial stability purposes,” said Gaurav Vasisht, the director of financial regulation initiatives at The Volcker Alliance, in prepared testimony to the House Financial Services subcommittee’s Tuesday hearing.

Yet others argue that activities-based regulation — when done in tandem with institution-based regulation — could actually be beneficial.
“It might address the risks of herd behavior in shadow banking and other financial markets that institution-based regulation alone cannot adequately address,” said Erik Gerding, a law professor at the University of Colorado Law School, in prepared testimony.

Sen. Sherrod Brown, D-Ohio, the ranking member of the Senate Banking Committee, called on FSOC in April to take action to address the growing risk of leveraged loans.

“FSOC must consider whether this additional risk to the banking system serves as a public benefit to the real economy,” Brown wrote in a letter to Treasury Secretary Steven Mnuchin, who chairs the council. “For example, leveraged loans are often used to fund risky private equity transactions, many of which struggle and fail under unsustainable debt loads, causing harm to local and regional economies.”

Turn the bank regulators’ 2013 guidance into a rule

Senator Patrick Toomey, a Republican from Pennsylvania, speaks during a Bloomberg Television interview in New York, U.S., on Friday, Nov. 10, 2017. Toomey said an alternative Republican could win the Alabama Senate race where Roy Moore is under fire after he reportedly made inappropriate sexual advances toward underage girls four decades ago. Photographer: Christopher Goodney/Bloomberg

Christopher Goodney/Bloomberg

The bank regulators in 2013 issued guidance directing banks to improve risk management and underwriting standards for leveraged loans.

But the guidance was effectively nullified after the Government Accountability Office ruled in 2017 that the guidance should have been treated as a rule under the Congressional Review Act. The GAO, which studied the issue after a request by Sen. Pat Toomey, said the guidance amounts to formal policy that should have been submitted to Congress, which then has 60 days to consider blocking it. The regulators could have resubmitted the guidance, but they did not take that road. Last year, the Office of the Comptroller of the Currency said it would not enforce the guidance.

To address the current buildup of leveraged lending risk, the regulators could issue the same guidance as an interagency proposed rule, which Vasisht pushed for during the hearing. However, that would only affect leveraged loans on banks’ balance sheets.

“I propose that regulators reinstate the substance of their 2013 leveraged lending guidance, which helped improve banks’ risk management and curtailed the dollar volume of such loans,” he said.

But in the short term, it isn’t likely that the regulators issue a rule resembling the earlier guidance. The agencies have largely downplayed the threat posed to banks, noting that the heightened growth of risky borrowing was occurring at nonbanks instead of those they regulate.

“That market has evolved really significantly since before the crisis,” Powell said at a September press conference. “The banks take much less risk than they used to.”

Fed raises countercyclical capital buffer

Federal Reserve Board Gov. Lael Brainard

Lael Brainard, governor of the U.S. Federal Reserve, speaks during the Monetary Policy Strategy, Tools, and Communication Practices Conference in Chicago, Illinois, U.S., on Tuesday, June 4, 2019. The conference includes overviews by academic experts of themes that are central to the Federal Open Market Committee (FOMC) 2019 review. Photographer: Taylor Glascock/Bloomberg

Taylor Glascock/Bloomberg

There are tools at the Federal Reserve’s disposal for dealing with financial stability concerns. In particular, the Fed now has a rule on its books making the largest and most complex financial institutions subject to an additional capital buffer to confront building risk in the financial system. The countercyclical buffer is designed to boost capital reserves during a healthy economic environment to soften the impact of a market shock.

Lael Brainard, a governor on the Fed board, has championed the idea of deploying the countercyclical buffer now to address the buildup of risk. In a 2018 speech, she highlighted the buffer as a defense against corporate credit risk. However, the buffer would only shield the banking system from the effects of losses, not shadow banking entities.

“The appetite for risk among financial market participants rose notably over 2017 and much of 2018, and corporate borrowing has reached new heights amid rapid growth and deteriorating underwriting standards in riskier segments, such as leveraged lending,” Brainard said.

“The mutual funds that have built up exposure to some of this risky debt have liquidity mismatches that could contribute to market dislocations in stressed conditions. ... At a time when cyclical pressures have been building and bank profitability has been strong, it might be prudent to ask large banking organizations to fortify their capital buffers, which could subsequently be released if conditions warrant."

Yet so far, Brainard is the only Fed governor to support deploying the buffer. In March, the central bank’s board voted to keep the extra capital buffer at 0%; Brainard was the lone voice in support of raising it.

Meanwhile, Fed Chairman Powell has appeared to show little concern about the effects of leveraged lending on the system.

“The parallels to the mortgage boom that led to the Global Financial Crisis are not fully convincing. Most importantly, the financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages,” Powell said in a speech last month. “And there are other differences: Increases in business borrowing are not outsized for such a long expansion, in contrast to the mortgage boom; business credit is not fueled by a dramatic asset price bubble, as mortgage debt was; and CLO structures are much sounder than the structures that were in use during the mortgage credit bubble.”

Additional stress tests

The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S., on Monday, April 8, 2019. The Federal Reserve Board today is considering new rules governing the oversight of foreign banks. Chairman Jerome Powell said the Fed wants foreign lenders treated similarly to U.S. banks. Photographer: Andrew Harrer/Bloomberg

Andrew Harrer/Bloomberg

Since the crisis, stress tests have been a key tool to assess large banks’ capital adequacy in the face of hypothetical shocks to the system.

Brainard noted in her 2018 speech that the Fed’s annual stress test “scenarios have been designed to explore severe dislocations in corporate credit markets as a salient risk.” And the banking agencies, in the now-defunct 2013 interagency guidance on leveraged lending, recommended that “portfolio and pipeline stress tests to quantify the potential impact of economic and market conditions on the institution's asset quality, earnings, liquidity, and capital.”

But some have suggested that the Fed’s current stress testing approach has limitations. Brainard said it is hard to “introduce entirely new scenarios each year to target specific sectoral risks without introducing excessive complexity.” And the Fed’s stress testing regime is limited to banks.

In his testimony for Tuesday’s hearing, Gerding of the University of Colorado called on Congress to require the Fed to conduct stress tests of the shadow banking system.

“This would extend the approach of stress testing individual financial institutions to entire markets,” he said. “Stress testing should start with markets for CLOs and other complex asset-backed securities, as well as other important shadow banking markets (e.g., repos) which engage in credit intermediation, credit transformation, and liquidity/maturity transformation.”

Maintaining the status quo

Jerome Powell, chairman of the U.S. Federal Reserve, arrives to a Group of 20 (G-20) finance ministers and central bank governors meeting on the sidelines of the spring meetings of the International Monetary Fund (IMF) and World Bank in Washington, D.C., U.S., on Friday, April 12, 2019. The IMF cut its outlook for global growth to the lowest since the financial crisis amid a bleaker outlook in most major advanced economies and signs that higher tariffs are weighing on trade. Photographer: Andrew Harrer/Bloomberg

Andrew Harrer/Bloomberg

Despite the concerns raised by Democrats and market observers, the divisions in Congress and the relative lack of alarm from principals at the regulatory agencies suggest any policy response could be light, if there is a response at all.

Key officials such as Powell and Otting have emphasized banks' capital strength following the 2008 crisis and the separation between leveraged lending risks and the regulated financial sector.

“The members of Congress and some regulators are warning about leveraged lending because there is a view that if you warn about it and there ends up being a crisis, you get credit,” said Ed Mills, a policy analyst at Raymond James. “With the divided government, it’s extremely unlikely that Congress would step in and supersede the regulators.”

Some in the banking industry say leveraged lending does not pose macroeconomic risks.

"While regulators should continue to monitor certain risks associated with leveraged lending, such risks do not pose a systemic threat to the U.S. economy," the Financial Services Forum said Tuesday. A report issued by the group in April found that "risks of leveraged lending, though not immaterial, are not outsized relative to the U.S. economy."

Rep. Andy Barr, R-Ky., argued at the hearing that CLOs actually create more stability.

"They’re not subject to short-term redemptions or outflows, and in this regard, CLOs provide a vital source of liquidity in a downturn. This is exactly the type of structure that policymakers should want,” Barr said. “Overregulation of CLOs would be an impediment to financial stability.”

That assertion is in direct contrast to that of industry critics.

"There is very wide agreement that leveraged lending even at the levels it’s at now … is probably going to act to amplify the next recession,” said Marcus Stanley, policy director at Americans for Financial Reform. “It’s going to make the next recession more harmful for workers and communities.

“We’ve allowed nonfinancial institutions to accumulate a lot of debt. This debt has not really driven higher investment. … Instead a lot of this debt has been used for private equity investment and share buybacks.”

Mills added that if leveraged lending does become a systemic problem, it would likely put members of the Financial Stability Oversight Council in the hot seat.

“If it ends up being a problem, regulators have a lot of questions to answer,” Mills said. “It would be seen as a failure of the FSOC process, because if there is a problem it is more likely to exist in the nonbank space, and the whole reason why Congress created FSOC was to look at not only the regulated, but also the nonregulated markets.”