Concerned that underwriting standards have loosened since the financial crisis of 2007, federal regulators recently released new guidelines for leveraged lending intended to update and replace the last such guidance released in April 2001.
But it’s unclear right now how the new guidance could affect lending and borrowing in an economy that is, by most measures, still struggling to rebound in most parts of the country, though industry observers largely aren’t surprised by what they’ve seen so far in the Interagency Guidance on Leveraged Lending, released by the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System and Federal Deposit Insurance Corporation (FDIC).
“Right now it’s probably too early to tell,” remarked Bernard Mason, the regulatory relations liaison at the Risk Management Association, which represents about 2,500 banks and non-bank financial institutions. “It seems like among industry observers that I’ve read, that’s been the conclusion, that it’s just too early to tell whether this could have a chilling effect.”
“While leveraged lending declined during the crisis, volumes have since increased and prudent underwriting practices have deteriorated,” the agencies wrote in a press release accompanying the March 21 report.
According to Robert Burns, associate director of the FDIC’s Division of Risk Management Supervision, the guidance was a long time coming and wasn’t prompted by the recent financial crisis.
“There were major changes in the leveraged lending market prior to the last crisis. Leveraged lending became the replacement for high-yield bonds. [The 2001 guidance] was extremely appropriate for 2001,” Burns said.
The leveraged lending market began evolving in 2003, but largely froze up during the financial crisis, he added. And when the market started to rebound and leveraged lending ramped up in 2011, the agencies decided a refresher was necessary.
However, Burns clarified, that’s not because leveraged lending had anything to do with the recent financial crisis.
“The leveraged loans were impacted a little bit during the financial crisis, but in terms of the main drivers of the crisis, it was more in retail lending and structuring that was taking place in products. It wasn’t really as much leveraged lending that precipitated the crisis,” he said.
According to the guidance, “Since the issuance of the 2001 guidance, the agencies have observed periods of tremendous growth in the volume of leveraged credit and in the participation of unregulated investors. Additionally, debt agreements have frequently included features that provided relatively limited lender protection including, but not limited to, the absence of meaningful maintenance covenants in loan agreements or the inclusion of payment-in-kind (PIK)-toggle features in junior capital instruments.”
In the report, the three agencies zero in on several key areas of focus, including valuation standards, pipeline management, reporting and analytics, stress testing and underwriting standards. Additionally, regulators advised institutions to establish sound risk-management framework and in risk rating leveraged loans to consider “a borrower’s ability to de-lever to a sustainable level within a reasonable period of time.”
All In The Definition
As in 2001, the 2013 guidance also largely leaves it up to institutions to define on their own what exactly constitutes leveraged lending, though the agencies do lay down a few key benchmarks for banks and other institutions to cover when establishing their own definition.
“Back in 2001, they actually didn’t define leveraged lending. There was the assumption that you know it when you see it. So a definition is provided in the current guidance,” Burns said. But under the new guidance, for example, a loan to any borrower with a total debt to earnings before interest, taxes, depreciation and amortization (EBITDA) ratio of more than four to one would probably be considered a leveraged loan.
However, the guidance does not cover asset-based lending, which is often done with highly leveraged borrowers, nor does it exactly cover banks’ participations in leveraged lending, though it does advise those banks to “apply the same standards of prudence, credit assessment and approval criteria, and in-house limits that would be employed if the purchasing organization were originating the loan.”
The guidance also makes no exceptions for community banks and other financial institutions under $1 billion. But the agencies acknowledged community banks’ “limited involvement in leveraged lending” and anticipated the guidance would have very little effect on smaller banks, writing, “Community and smaller institutions that are involved in leveraged lending activities should discuss with their primary regulator the implementation of cost-effective controls appropriate for the complexity of their exposures and activities.”
Burns added, “The leveraged borrowers that this market captures are really big dollar borrowers. Community banks can’t originate the size of loans this is designed to capture.”
Email: lalix@thewarrengroup.com
