US watchdogs drop post-crisis safeguard on risky lending

Stay informed with free updates

Simply sign up to the US financial regulation myFT Digest — delivered directly to your inbox.

US regulators have scrapped a critical safeguard put in place in the wake of the 2008 financial crisis, as the Trump administration seeks to pave the way for banks to underwrite riskier loans to the buyout industry.

The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation said in a statement they had rescinded the leveraged lending guidance introduced in 2013 because it was too restrictive and captured too many types of loans.

The watchdogs said the guidance had “resulted in a significant drop in leveraged lending market share by regulated banks and significant growth in leveraged lending market share by non-banks, pushing this type of lending outside of the regulatory perimeter”.

The guidelines stated that “generally” any leveraged loans with debt exceeding six times a company’s earnings “raises concerns for most industries”. They were not hard rules but were widely interpreted as binding on banks.

Leveraged loans are junk-rated debt usually used to back or refinance private equity takeovers of companies. Banks keep little of the risk on their own balance sheets and sell almost all of the loans on to other investors.

It can be a highly lucrative business, but banks have been dealt painful losses during market sell-offs when they offloaded the loans at deep discounts.

The guidance was put in place in the aftermath of the financial crisis, when banks struggled to offload some risky loans they had underwritten. Regulators in Washington feared that the buyout financing, which could heap unsustainable debt burdens on companies, could prove to be fertile ground for another crisis if banks were stuck financing the obligations themselves.

The removal of the guidance comes as investors warn that the collapse of car parts supplier First Brands and subprime lender Tricolor could be early signs of trouble among riskier US borrowers.

Defaults in the US junk bond and loan market hit a four-year high at the start of this year, according to credit rating agency Moody’s. At 5.3 per cent, the 12-month trailing corporate default rate remains above average over the past decade.

Analysts say the regulatory change will prompt banks to do more leveraged lending and could lead to higher defaults in the next downturn.

“Though we are supportive of less regulation, rescinding the guidance on leverage lending will initially lead to more rapid loan growth but eventually we expect it will also lead to higher credit losses in the next credit cycle,” RBC Capital Markets analysts said in a note to clients.

The shift is expected to provide banks more ammunition to compete with private credit funds, with giants such as Apollo Global Management, Blackstone and Ares Management now routinely financing leveraged buyouts that until recently would have been typically underwritten by regulated banks.

Those firms have been able to provide loans that are often in excess of the six-times threshold many saw as a red line. They have also offered debt with terms that banks have been unable to furnish — including allowing companies to make interest payments with more debt, instead of cash.

By scrapping the guidelines, the US could also prompt banks to push European regulators to water down their equivalent rules. The European Central Bank said in 2017 that leveraged lending by banks with total debt of more than six times earnings “should remain exceptional”.

The US regulators said banks should in future apply the same “general principles for prudent risk management” to leveraged lending as they do to other types of corporate lending.