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'The risk isn't in the banks': Fed's Powell on leveraged lending

WASHINGTON — Federal Reserve Chairman Jerome Powell said Wednesday that the agency is "very carefully" monitoring bank exposure to leveraged lending risks, but that the greatest risks posed by high corporate debt is outside the banking system.

Speaking during a press conference for the Federal Open Market Committee, Powell said that banks have a clear understanding of the Fed’s supervisory expectations for leveraged lending — relatively high-interest loans made to companies that already have large debt loads.

"The issue isn't that the banks don't understand what the rules are,” Powell said. “The issue is that the risk isn't in the banks. It's out in those market-based vehicles.”

Leveraged lending has been an increasing source of concern, particularly among congressional Democrats, who held a hearing earlier this month to examine the risks posed by the large and growing business. Bank of America CEO Brian Moynihan said at an appearance in New York this month that leveraged lending could create “carnage” among firms with large exposures to leveraged loans and indebted companies if the economy took a sudden downturn.

Powell said that he thought the state of the leveraged loan market was “in a good place,” but noted that other advisory and regulatory bodies with a broader jurisdiction than the Fed — such as the Basel, Switzerland-based Financial Stability Board and the Treasury-led Financial Stability Oversight Council — are examining the potential risks that leveraged lending might pose to the financial system, particularly cross-border risks.

“We now have a good sense domestically of where that paper is. Internationally, not as much, and the Financial Stability Board is looking more carefully at that,” Powell said. “And we monitor those vehicles pretty carefully to see where they are. And they're actually pretty stably funded in the sense that there's no run risk, but there are still macroeconomic risk. This is something we take very seriously and the FSOC, the Financial Stability Oversight Council, is looking at.”

Powell’s comments suggested that the Fed and other regulators are not considering a revision to their 2013 guidance document aimed at clarifying the agencies’ supervisory expectations for leveraged lending.

The Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. issued a joint guidance document in 2013 aimed at setting supervisory expectations for banks when they originate or syndicate leveraged loans.

Sen. Patrick Toomey, R-Pa., sent a letter to the Government Accountability Office in March 2017 asking the agency to examine the leveraged lending guidance and consider whether it qualified as a rule for the purposes of the Congressional Review Act. Under that law, agencies must send rules to Congress to give the legislature a chance to consider whether it will overturn it before it takes effect.

In October 2017, the GAO replied that the guidance was effectively a rule, and as such could not be enforced on banks because it had not been sent to Congress pursuant to the agencies’ obligations under the congressional review law.

The ruling put the guidance in a state of legal limbo, though the regulators said after the publication of its latest Shared National Credit Survey in January that risks were building in the sector, and urged banks to “update credit risk management practices as the risk profile of borrowers and the industry changes.”

Banking industry groups have argued that any risks posed by leveraged lending are unlikely to come home to roost in the banking sector’s coop. Banks originate syndicated loans — which account for a majority of the leveraged loan market — but those loans are generally bought and held by collateralized loan obligations, or CLOs, which for the most part are maintained by asset management companies and institutional investors.

Powell said in a speech in May that, while losses in CLOs would certainly hurt investors, they are unlikely to “lead to broad harm to households and businesses, should conditions deteriorate.” He reiterated as much on Wednesday, saying "we do understand what risks the banks are running. And really the question is how concerned should we be about large holdings by market-based vehicles that I mentioned? We are very carefully assessing that."

During the press conference, Powell was also asked about the threat posed by new digital currencies — such as Libra, a cryptocurrency unveiled this week by Facebook — and whether they could one day disrupt central banks' abilities to manage currencies.

“We’re a long way from that,” Powell said. “Digital currencies are in their infancy, so I’m not too concerned about central banks’ ability to carry out monetary policy because of cryptocurrencies or digital currencies.”

Powell added that the Fed had met with Facebook representatives ahead of their announcement and discussed their plans, and noted that the central bank meets with a variety of financial technology firms “all the time.” But he warned that the Fed will be highly attuned to the potential risk of widely circulated cryptocurrency and would regulate such a currency rigorously.

“There are potential benefits here, there are also potential risks,” Powell said. “A currency could potentially have a large application, so I would echo what [Bank of England Gov. Mark] Carney said, which is that we will wind up having quite high expectations from a safety and soundness and regulatory standpoint if they decide to go forward with this.”

Powell also responded to reports that President Trump explored the possibility of demoting Powell as Fed chair, saying that he had no intention to leave and that he believed there was no legal basis for the president to remove him as chairman.

“I think the law is clear that I have a four-year term, and I fully intend to serve it,” Powell said.

Trump has lobbed repeated criticisms of the Fed’s monetary policy and Powell’s leadership over the past several months, calling him and other members of the Fed’s Board of Governors — all but one of whom he appointed — as “not my people.”

Powell himself said in January that he would not resign if the president asked him to, and has maintained in several public appearances since that the Fed conducts its monetary policy independently of political considerations.

Powell’s comments came as FOMC members exhibited an uncommon bifurcation in their 2019 interest rate projections. Eight of the 17 members expected no interest rate changes for the rest of the year, while another seven members said they expected two rate cuts by the end of 2019. One member expected a single rate cut, while another expected a single 25-basis-point rate hike.

It is typical for FOMC members to express a range of views on interest rate projections, but it is far less typical for the committee to fall almost completely into two factions. Powell noted that even members who had projected a flat interest rate through the end of the year, many agreed that “the case for more accommodative policy has strengthened.”

The committee’s revised economic projections suggested a conflict in the FOMC’s indicators: the agency revised its projections for unemployment downward, from an already ultra-low 3.7% to 3.6%, suggesting the labor market could be tightening and interest rates might need to rise to combat inflation.

But the committee also revised its inflation projections sharply downward, expecting 1.5% inflation on personal consumer expenditures in 2019 instead of the 1.8% it projected in March, suggesting that lowering interest rates may be necessary to reach the FOMC’s 2% inflation target.

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