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Feds Increase Scrutiny of Leveraged Loans

The leveraged loan industry has experienced significant growth over the years and reached a record high of $450 billion in 2013. ((Off. Comptroller Currency Semiannual Risk Perspective Rep.  at 29 (Spring 2014).)) ((See also Gillian Tan and Ryan Tracy, Credit Suisse Loans Draw Fed Scrutiny, Wall St. J., Sept. 16, 2014, As the popularity of these loans increase, so too has the interest in government regulation. ((See Lee A. Meyerson et. al., Federal Banking Agencies Revamp Guidance on Leveraged Lending, 130 Banking L.J. 387, 388 (2013).)) In March 2013, the Federal Reserve (“Fed”), the Office of the Comptroller of the Currency (“OCC”), and the Federal Deposit Insurance Corporation (“FDIC”) issued revised guidance relating to financial institutions’ leveraged lending activities. ((Interagency Guidance on Leveraged Lending, 78 FR 17766-01 (proposed Mar. 22, 2013).)) This guidance provided the “minimum expectations” of financial institutions and focused on underwriting and valuation standards, exposure measurements, deal sponsor evaluations, and identification of risk. ((Meyerson, supra note 3, at 388.)) Recently, Washington indicated its seriousness in addressing risky leveraged loan practices when the Fed pointed out Credit Suisse’s failure to adhere to the guidance and demanded that they address problems with its leveraged loan practices. ((See Tan and Tracy, supra note 2.)) In addition, the Fed decided to tie leveraged lending to banks’ stress tests. ((Tracy Alloway and Gina Chon, Banks Face Fresh Curbs On Leveraged Loans, Fin. Times, Sept. 23, 2014, This increased oversight begets the question – is this an issue of legitimate concern by the federal government? Or is this an overly cautious move by the government resulting in unnecessary and substantial restraint of valuable financial investments?

In recent reports, the Fed and the OCC addressed concerns regarding the increase in risk-taking associated with leveraged loans. ((See Fed. Res. Sys. Monetary Pol’y Rep. at 22 (July15, 2014)(“Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened.”).)) ((See also Off. Comptroller Currency, supra note 1, at 5 (“The combination of higher leverage, lower yields, tighter credit spreads, and weaker covenant protections provides ample evidence of increasing credit risk in the leveraged loan market.”).)) Contributing to this concern is the fact that so far in 2014, almost 50% of leveraged buyout deals have involved debt greater than six times EBITDA, the bar set by regulators.  ((Tan and Tracy, supra note 2.)) The Fed highlights the interconnectivity of the financial system as a reason to maintain increased scrutiny of lending practices, ((Fed. Res. Sys. Monetary Pol’y Rep., supra note 8, at 23.)) and failure to adequately monitor banks leading up to the subprime-lending crisis could explain the government’s proactive concern with increased risk-taking. In addition, the report noted, “While stronger capital and liquidity positions in the banking sector should help reduce the consequences of this structural vulnerability, the Federal Reserve . . . continues to encourage firms to better manage their exposures to large counterparties.” ((Id.)) Although it is reassuring to see the government take a more proactive stance against potentially risky behavior by banks, one must question whether this is the best allocation of resources.

According to banks, it is not. Banks insist that the risks associated with these loans are not as high as the government contends, and that strong underwriting standards are being adhered to.  ((Tan and Tracy, supra note 2.)) Many of these loans are associated with private equity deals and, according to Moody’s Investors Service, have not resulted in disproportionately high default rates. ((Id.)) As regulators play a more proactive role in the leveraged loan market, it will be interesting to see what effects this may have on the industry. Will the market look to alternative, possibly unregulated, forms of funding? How much will banks change their behavior? Or will a new problem present itself and stymie government regulators leveraged loan concerns?


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Katherine O’Koniewski

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