Risk-reward, supply-demand – the simple equations that drive the economy – are leading to a boom in risky loans even as regulators dial back some of the restrictions imposed in the wake of the financial crisis.
Banks are profit-seeking institutions and loans to companies already carrying a great deal of debt – so-called leveraged loans – reap bigger fees and entail higher interest rates because of their increased risk. Banks collect their fees, package the loans, and sell them to investors as collateralized loan obligations (CLOs) to investors according to their own appetite for risk.
The issue proccupying policy-makers and regulators is determining the point at which the appetite for reward and profit at an institution accumulates across the financial sector to pose a risk to the stability of the entire system. The big lesson of the financial crisis was that regulators cannot focus solely on the judgement and soundness of an individual bank but need to look at excessive risk piling up across the entire financial system.
Now the rollback of some of the safeguards put in place after the crisis is raising concerns that systemic risk is growing again.
In 2011, with the crisis still top of the collective mind, US federal bank regulators – the Office of the Comptroller of the Currency, the Federal Reserve and the Federal Deposit Insurance Corp. – issued guidance designed to curb a growing tendency by banks to make higher-risk loans to compensate for their margins being squeezed in a low interest rate environment.
Such guidance plays an ambiguous role in the regulatory system. It is not legally binding in the same the way as rule or a law, but banks are reluctant to antagonize regulators, who enjoy wide discretion in the application of many rules. The volume of leveraged loans fell from $607 billion in 2013 to $423 billion in 2015.
When President Donald Trump took office, however, he was keen to fuel growth with credit and encouraged regulators to ignore the guidance. The Republican majorities in both houses of Congress over the administration’s first two years in general frowned on regulation as interference with the efficient functioning of markets. With this hurdle at least lowered, leveraged lending soared 40% between 2015-16 and 2017-18, to $1.27 trillion.
Banks argued that with an estimated 50%-60% of leveraged loans being sold on to investors in the form of CLOs, much of the risk was not retained in the banking system. But as with the subprime mortgage marketOpens a new window , when loans to risky borrowers are packaged into collateralized debt obligations (CDOs), the accumulated risk can nonetheless threaten the entire financial system because of the interconnectedness of institutions that finish holding the debt.
In addition to increasing volume, leverage loans are coming with progressively less protection for lenders in the form of covenants that set thresholds, for instance, requiring a borrowing company to hold back dividends or avoid taking on further debt.
The absence of these limits raises the risk that the borrower will default.
The relaxation of lending standards coupled with increasing loan volumes was one of the chief threats to the global financial system highlighted by Randal QuarlesOpens a new window , the Fed’s vice-chairman for bank supervision and chairman of the Financial Stability Board, in an April letter to G20 finance officials ahead of their semiannual gathering in Washington.
At the spring meeting of the International Monetary Fund the same week, Tobias Adrian, director of the monetary and capital markets department at the International Monetary Fund, warned that the high level of corporate borrowing posed a risk to global stability in the event of a serious downturn.
Fed chair Jerome Powell has testified to Congress that the high volume of leveraged loans could have an “amplification effect†in an economic downturn, while Jay Clayton, chairman of the Securities and Exchange Commission, is concerned that holdings of leverage loans in fund portfolios could hurt liquidity in that sector because of their long settlement cycle.
The default rate on leveraged loans did fall below 1% in MarchOpens a new window , to a seven-year low of 0.93%. But the concern is not about now, when rates remain low and the US economy is still ticking along, but when the economy slows down or slips into recession, with little room to lower rates further to assist a rebound.
The 2011 regulatory guidelines continue to have an occasional impact even if agencies have relaxed their enforcement. UBS has just fired a senior investment bankerOpens a new window for failing to disclose that the Swiss bank’s financial support for a leveraged buyout in the US was reclassified as a loan rather than a bond, because the disclosures required for a bond were too intrusive.
The banker, James Boland, failed to disclose the change to his superiors, who were monitoring compliance with the leveraged loan guidelines. There is no evidence the loan actually violated the guidelines, the relaxed enforcement policy aside.
But UBS, which has been fined by US authorities for a number of infractions from tax evasion to mis-selling of mortgage securities, didn’t want to take any chances.
Given the rapid growth in leverage loan volumes, however, it seems such qualms are the exception. With the Fed reversing course on raising interest rates and markets now expecting a rate cut by year-end, the incentives for further growth in leveraged lending remain strong.