Principals at the Office of the Comptroller of the Currency (OCC) and the Federal Reserve Bank (FRB) both indicated recently that they consider the leveraged lending guidance that the pair issued, alongside the Federal Deposit Insurance Corporation (FDIC), in 2013 as voluntary and non-binding. They said it allows banks to conduct whatever leveraged lending they please regardless of the risk, as long as they take into account ‘safety and soundness’.
The market responded well, taking this as an indicator that the two regulators are fine with risk.
But Bryan Hubbard, director of public affairs at the OCC, reiterated to IFLR that the OCC is not saying that banks can ‘dial up risk’ in corporate loans absent prudent risk management practices.
"Lending to leveraged borrowers must be conducted in a safe and sound manner"
“Lending to leveraged borrowers must be conducted in a safe and sound manner. This includes maintaining appropriate policies, procedures, controls, and personnel competency commensurate with the level of risk presented by the bank’s leveraged lending activities,” he said. “It also means maintaining an appropriate level of credit loss reserves for that risk.”
The leveraged lending market is enjoying a period of particular strength and high liquidity after the two regulators suggested at industry conferences that they have no problem with banks taking risks.
- The OCC and the FRB both indicated recently that they consider the leveraged lending guidance issued in 2013 as voluntary and non-binding;
- The market responded well, taking this as an indicator that the two regulators are fine with risk.
- The OCC reiterated to IFLR that the agency is not saying that banks can ‘dial up risk’ in corporate loans absent prudent risk management practices, lending to leveraged borrowers must be conducted in a safe and sound manner;
- Allowing judgement from a safety and soundness perspective to be the standard can create tension. You don’t have the same degree of clarity and certainty with a 6.0x standard that you have with a standard that is premised on safety and soundness.
Hubbard went on to stress that examiners should continue to cite matters requiring attention for practices that do not appropriately identify, manage, or control risks presented by leveraged lending activity; should continue to assign risk ratings to leveraged lending based on the interagency regulatory risk-rating definitions and that the guidance does not establish bright lines that represent limits or conditions, nor was it ever intended to do that.
Finally, Hubbard said that the OCC does not want examiners to criticise policies and practices solely because they do not match items in the leveraged lending guidance. He added that they should however continue to criticise practices that are inconsistent with the principles in the leveraged lending guidance that present excessive or unwarranted safety and soundness risk.
Despite this additional information to complement the interpretation of the guidance, the fact still remains that the agencies are relaxing standards and allowing for greater risk. Regulators have to be careful with what they advise, said one US-based partner.
“No regulator wants to say ‘look we are easing the standard, we are going to allow for more risk and we understand that is the trade-off here’,” they said. “Flexibility basically means more risk, the challenge they face is coming up with a standard that has the integrity of being applied from a safe and soundness perspective that does not increase risk, but at the same time allows for some flexibility.”
Bursting the bubble
The change in tact does not come as much of a surprise given the Trump administration’s regulatory about turn. But it is an interesting contrast to previous years of concern amongst the industry that leveraged lending would be the cause of the next financial crisis.
According to Jerry Comizio, partner at Fried Frank, this move is important because there are some ratios in that guidance on leveraged lending that have been particular objected to by the industry.
“If you look at the Annual National Credit Report, between 2013 and 2016 they were really throwing back the alarm bells that leveraged lending was the next international bubble,” he said. “Only by 2016 did they begin to declare victory based on the leveraged lending guidelines being implemented.”
Perhaps even more overwhelmingly significant was the concern that there is this lack of clarity as far as a bright line standard that the industry can understand and adhere to. The industry ended up with six times the leverage standard that the regulated sector is now chasing at for being overly constrictive.
Allowing judgement from a safety and soundness perspective to be the standard, largely in response to this constrictive approach, creates a tension. Market participants don’t have the same degree of clarity and certainty with a six times standard that with a standard that is premised on safety and soundness, and more importantly the interpretation of bank examiners.
“There is a significant amount of judgement that is occurring,” suggested Kevin Petrasic, partner at White & Case. “You might get treatment with one team based on certain factors that they view as paramount and appropriate. A different set of examiners may have different experience with lending review, covered protections or other restrictions.”
He added: “It is constantly the struggle for predictability and uniformity versus flexibility and allowing for what everyone agrees should be the standard - safety and soundness.”
The Trump administration initially asked the Government Accounting Office to review the leveraged lending guidelines late in 2017, alleging that the agencies could not put out guidance unless they were deemed a rule. Using the Congressional Review Act - a statute passed during the Clinton administration that had previously never been used - the Trump administration was able to suggest that the leveraged guidelines were essentially in violation of the act because they had never been sent to Congress.