WASHINGTON — When a government watchdog's decision effectively scrapped federal regulators' guidance on leveraged lending, it was the culmination of a yearslong effort to roll back an action that the industry had long reviled.

But the move also left the future uncertain about what, if anything, regulators will devise to replace it and bankers on their own in determining how to treat such lending.

It leaves things kind of in limbo,” said Kevin Petrasic, a partner at White & Case and former Treasury and Office of Thrift Supervision official. “It doesn’t negate the fact that the agencies have safety and soundness authority. [Banks] just don’t have the comfort, if you will, in terms of clearly delineated guidance that was set out in the rule.”

Sen. Pat Toomey, R-Pa.
"This is an important reminder that agencies have a responsibility to live up to their obligations under the Congressional Review Act," said Sen. Patrick Toomey, R-Pa. Bloomberg News

On Oct. 19, the Government Accountability Office said in a letter to Sen. Patrick Toomey, R-Pa., that 2013 guidance issued by the banking regulators was a rule, and as such was subject to the requirements of the Congressional Review Act. The decision meant that the regulators should have formally notified Congress of the guidance four years ago. Because they didn't, regulators must resent the guidance to Congress, which then has a window to review and reject it.

"This is an important reminder that agencies have a responsibility to live up to their obligations under the Congressional Review Act," Toomey said. "When they don't, Congress should hold them accountable. I will explore steps to do so."

The decision means regulators must now decide whether to reissue the guidance, revise it or let it drop entirely.

The guidance was developed jointly by the banking regulators to address risks posed by leveraged loans — loans made to already-indebted borrowers that are often shared by multiple institutions for large amounts. They include financing for mergers and acquisitions. The regulators issued the guidance after noticing a sharp increase in leveraged loans since the previous guidance on the subject in 2001, and after identifying lax underwriting for leveraged loans following the financial crisis.

Since it was designed as a guidance, is was only intended to give banks uniform expectations about what the regulators’ attitudes would be for leveraged loans. But Mike Alix, financial services advisory risk leader at PricewaterhouseCoopers, said that banks bristled at the guidance, fearing that nonbanks would just swoop in and steal the business and with no risk management benefit.

“This was a direct intervention in a particular business where the balance sheet risks to the institutions weren’t really present,” Alix said. “So it was a lucrative business for the banks, and the competitive forces in the market were such that there was worry about entities that weren’t subject to the guidance being able to fill the void.”

Because the guidance is now considered a rule for Congressional Review Act purposes and was never sent to Congress for review, the guidance cannot now be technically enforced.

Each of the regulators said that they are reviewing GAO’s report and have not decided what to do next, but they have a few options. They could send the existing guidance to Congress for review, thereby either codifying it if Congress lets a 60-day legislative window pass without acting. But if regulators resend it, Congress could reject it.

Petrasic said that striking down the guidance via Congressional Review Act might complicate whatever future moves the agencies might want to pursue since under the law, regulators could not issue a guidance — or a rule similarly designed — to replace it.

“At that point, what is spelled out in the statute is that it … effectively strikes down any similar iterations that could be sent back up,” Petrasic said. “That means the regulators would have to take a somewhat different approach, and it couldn’t be substantively too close to the [old rule].”

Alix said that may not be ideal, since banks aren’t opposed to everything in the guidance and have spent a long time adapting to it. Having to change to an entirely new regime — and one that by definition can’t resemble the old — might be more disruptive than helpful, he said.

“I don’t know what the great benefit is of unwinding all those things,” Alix said. “They have some more freedom perhaps, but they’ve done the hard work to adapt to the guidance. The guidance has been out there for years.”

Another option would be to develop a new guidance — or even a formal rule — that would embody the aspects of the old rule that banks accept and whittle down the sharp edges that bothered them.

The Treasury Department already indicated that leveraged lending was a top priority in its June report on banking regulatory reform, saying the 2013 guidance should be reissued for public comment and “refined with the objective of reducing ambiguity in the definition of leveraged lending and achieving consistency in supervision.”

Wayne Abernathy, vice president of for financial institutions policy and regulatory affairs at the American Bankers Association, said the likely immediate effect of the GAO report is to move that recommendation up the list of concerns by regulators.

“There are a hundred-some recommendations in the [June] report, and another hundred or so recommendations in the October report, and the question is where they go in the priority list,” Abernathy said. “This decision maybe moves it up.”

In the meantime, the agencies could also do nothing, since the guidance is already unenforceable and there are greater risks associated with moving too quickly. But that leaves banks without any bright lines on what might be an acceptable leveraged loan.

Alix said that one of the biggest problems with the guidance was the effect that it had on banks’ ability to know their own risk, since the definition of a leveraged loan under the guidance was often more expansive. That makes models less precise, and often overestimates the firm’s risk exposure. But the guidance’s de facto rescission isn’t likely to result in a bonanza of new leveraged loans.

“The best outcome for the industry is probably the freedom to make their risk underwriting decisions according to their own risk tolerance, rather than having to adhere to prescribed distinctions by the regulators,” Alix said. “But the industry will still probably be wary of going too far down the risk curve.”

Abernathy agreed, saying that while the guidance may be gone, banks are unlikely to use this opportunity to move forward with loans they wouldn’t have pursued otherwise — at least not without asking your regulator first.

“Banks are by nature cautious enterprises,” Abernathy said. “I would doubt that they would want to go forward with some kind of leveraged lending that is clearly in violation of the existing guidance. But it maybe creates an opportunity to have a conversation with your regulator.”

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