National bank examiners were told Monday to turn a keener eye on leveraged lending-an exploding segment of the loan market.
The Office of the Comptroller of the Currency's 10-page letter to examiners and national bank executives describes leveraged lending and the more complex risk management it requires.
Unlike earlier warnings aimed at the largest banks financing hedge funds, this advisory targets the average bank.
"Leveraged borrowers are everywhere in the system," said David D. Gibbons, deputy comptroller for credit risk. "Leverage lending is becoming a bigger portion of the lending market, which presumes it is a bigger part of banks' balance sheets."
The trend is particularly troubling because it coincides with a gradual easing of credit standards, he said in an interview. "It's not just the leverage," he said, "it's the combination of leverage with instances of weak underwriting."
The Comptroller's Office has no simple definition of a leveraged loan. In fact, the agency does not specifically gather data on borrowers with high debt-to-equity ratios. However, using Loan Pricing Corp. data, Mr. Gibbons said, leveraged loans made up 31%, or $273 billion, of the syndicated loan market at yearend 1998. That's up from 7.5%, or $28 billion, in 1993.
But the advisory also cites "strong anecdotal evidence of increased leveraged lending activity in the middle market."
"This is about plain, old-fashioned bank lending," Mr. Gibbons said.
The guts of the advisory letter outline collateral and repayment problems examiners should look for in leveraged loans and notes that some of these loans may have to be downgraded.
For instance, the OCC warned against deferring repayment or giving borrowers too much time to repay principal. "Where repayment terms are overly liberal or structural protections are weak, the loan will warrant increased scrutiny and may warrant special mention or classification," the advisory states.
In the interview, Mr. Gibbons said he is most concerned about bankers not recognizing links between primary and secondary sources of collateral.
Often one source of collateral, say the sale value of a company, depends on a second source, say cash flow. Mr. Gibbons said if a borrower's cash flow does not meet projections, then its value is also reduced, hurting both sources of collateral.
"It's too easy to take comfort in the fact that you're collateralized," he said. The advisory recommends bankers and examiners "analyze the extent to which primary and secondary sources of repayment are related."
The advisory is full of hard-to-define words like "significant" and "reasonable." Mr. Gibbons said that was intentional.
"With lending you have to use your judgment and we could give some more definition ... but then you get dangerously close to setting federal lending standards," he said.
The OCC's advisory is one among many regulatory warnings related to the general topic of leverage. In January the agency zeroed in on risk management of financial derivatives and bank trading activities. Last week the President's Working Group on Financial Markets issued a study that among other things recommended added disclosures and higher capital requirements for bank loans to hedge funds.
Sen. Robert Bennett, chairman of Senate Banking's financial institutions subcommittee, has scheduled a hearing for Wednesday on the working group's study.
House Banking Committee Chairman Jim Leach has scheduled a similar hearing for Thursday. Lawmakers plan to quiz Gary S. Gensler, the Treasury Department's under secretary for domestic finance, and other regulators about the recommendations.
Prompted by the September crash of Long-Term Capital Management, the study concluded that hedge funds should be forced to disclose more financial data but rejected calls for direct regulation.