Regulators 'Tighten the Screws' on Leveraged Lending

WASHINGTON — Regulators' patience is running thin for banks that continue to overindulge in leveraged loans despite repeated warnings from the agencies over the past two years.

Regulators said Friday they are going to ramp up reviews on leveraged loans after a report found such credits are still the vast majority of criticized assets among large commercial loans shared by lenders.

They pointed to the 2014 Shared National Credit report issued Friday that found that leverage loans made up more than 80% of all the "doubtful loans" and nonaccrual loans, among other criticized categories. The exam assesses banks over a period that runs from the end of December to March.

Agency officials said on a conference call with reporters that time was up for some banks that have not fully complied with new guidance on the subject issued in March 2013. They also released answers to frequently asked questions on the guidance and an additional supplemental study Friday.

"The agencies recognize that leveraged lending is an important type of financing for the U.S. and global economies, and that the U.S. banking system plays a key role in making credit available by syndicating credit to investors. However, banks must not heighten risk by originating and distributing poorly underwritten and low quality loans," the Federal Reserve Board, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency said in the supplement study. "Institutions that participate in this lending activity, without implementing strong risk management processes consistent with the 2013 guidance, will be subject to criticism by the appropriate agency. As a result of the recent SNC leveraged lending findings, supervisors will increase the frequency of reviews around this business line to ensure risks are well understood and well controlled."

Agency officials acknowledged that some banks made improvements in line with the guidance but they still had concerns about the underwriting, borrower repayment capacity and valuations in leverage loans, among other problems. As a result, they are currently reviewing shared credit portfolios more frequently than just for the annual report and are scrutinizing leveraged lending beyond shared loans. Risk management was the top concern across the board, officials said.

"In addition, examiners noted risk-management weaknesses at several institutions engaged in leveraged lending including lack of adequate support for enterprise valuations and reliance on dated valuations, weaknesses in credit analysis, and overreliance on sponsor's projections," agencies said in the press release.

Leveraged loans made up 23% of the shared national credit portfolio in 2014, which totaled nearly $3.4 trillion in commitments. It also represented nearly 75% of the $341 billion of total criticized assets. Regulators said they found "material weaknesses in the underwriting and risk management" of leveraged loans. Roughly 33% of the $767 billion leverage loan portfolio were criticized by the agencies. That compares with a mere 3% of non-leverage loans that were criticized.

"Overall, the SNC review showed gaps between industry practices and the expectations for safe- and- sound banking articulated in the guidance," regulators said in the supplement report. "Thirty-one percent of leveraged transactions originated within the past year exhibited structures that were cited as weak, mainly because of a combination of high leverage and the absence of financial covenants. Other weak characteristics observed included nominal equity and minimal de-leveraging capacity."

Industry observers said they understood regulatory concerns on overleveraging and poor underwriting after the mortgage meltdown. However, observers were concerned that borrowers who tend to be more leveraged are moving outside of the banking system and turning to nonbank lenders to seek financing.

"This is a move on the regulators' part to try to prevent excessive risk taking by large banks that these zero-interest rates have really encouraged," said Jeff Davis, managing director of the financial institutions group at Mercer Capital. "It will push more of this leveraged lending outside the traditional banking system into the shadow banking market."

Jaret Seiberg, a senior policy analyst at Guggenheim Securities, said in a note that the regulatory crack-down on leveraged lending is a "negative" for mega banks that do such lending and issue collateralized loan obligations.

It is "offering opportunities for nonbanks such as insurers and business development companies to fill the breach," Seiberg said.

Industry reports have indicated that leveraged loan portfolios are shrinking from last year. Leverage loan issuance dropped by 15% to $807 billion through October compared to a year earlier, according to Thomson Reuters LPC.

"We appreciate the banking agencies' focus on the quality of bank underwriting and are making every effort to work within the Leveraged Lending Guidance issued by the banking agencies to ensure U.S. companies continue to have access to affordable loans," said Bram Smith, executive director of the Loans Syndications & Trading Association, in an emailed statement. "Non-investment grade U.S. companies have unique characteristics and financing needs. Recognizing the uniqueness of these borrowers, we encourage the agencies to continue to evaluate leveraged loans on nuanced basis, balancing the importance of a safe system, while ensuring that credit-worthy companies are still able to access the financing they need."

Overall, credit quality on large commercial loans remained stagnant in 2014 after seeing improvements in the three years prior to 2013, according to regulators. The report looked at corporate loans exceeding $20 million that are shared by three or more lenders. Overall, criticized assets were at $340.8 billion, up from $302 billion a year before. Criticized assets were more than 10% of total commitments, about the same percentage as the 2013 findings, which are double that of pre-crisis levels, regulators said.

Analysts said it will likely be another year before the effect of the leverage loan guidance and regulatory crackdown is seen in the report.

The regulators, "to their credit, they tried to be flexible in terms of its guidance in not trying to be too hard and fast" but "they started to tighten up mid-year," Davis said. "So next year, you will see a more pronounced impact of their regulatory tightening of the screws."