Wall Street banks are facing renewed pressure from federal regulators on their lending standards for risky corporate loans just as credit markets roar back, according to people with knowledge of the matter.
Bankers who generally retreated from the riskiest corner of the leveraged lending market since new guidelines were issued three years ago are now being queried on their plans for loans that just sneak in as acceptable under the measures, the people said. Regulators are questioning how such loans would perform under adverse conditions, one of the people said, asking not to be identified as the information isn’t public.
“While regulators are satisfied that most deals are in compliance, they are concerned that many of the ‘pass deals’ are on the line,” said Richard Farley, chairman of the leveraged finance group at law firm Kramer Levin Naftalis & Frankel LLP. Farley advises banks on leveraged finance deals.
“They want to understand the game plan that banks have in place to address these credits in a rising interest rate or recessionary scenario," he said. “They want clarification on the procedure for monitoring these deals."
This is the latest push by banking regulators who’ve been trying for three years to curb excessive risk-taking by Wall Street’s biggest lenders. The aim is to limit banks’ exposure to loans made to heavily indebted companies. While the guidelines have achieved that to a degree, regulators want to make sure banks are better appraised of the risks for deals that are on the edge. The move comes after the Federal Reserve, Office of Comptroller of the Currency and the Federal Deposit Insurance Corp. already intensified scrutiny of the banks by carrying out the so-called shared national credit review process twice instead of once.
Banks have been focusing on designing policies and guidelines for leveraged credits and presenting their plans to regulators, the people said. It comes as the market for high-yield bonds is on track to post its best returns since 2009, buoyed by easy-money policies from global central banks that are pushing investors into risky assets in search for income.
Representatives for the Fed, FDIC and OCC declined to comment.
There’s also fresh concern from regulators that banks’ withdrawal from the market hasn’t actually killed risky deals, as companies turn to less regulated entities such as private equity firms and direct lenders for loans. The Federal Reserve Bank of Dallas on Thursday said that links between these firms and traditional banks may create risks for the economy, according to a report by Alex Musatov and Michael Perez.
“Players in this spectrum operate largely beyond the numerous safeguards placed on the traditional banking system," they wrote in the report. Their connections with the banks, which they rely on for funding, “engender fear” that a collapse of one of these firms “would most likely spread into the banking sector, affecting availability of credit to the real economy.”
The leveraged-lending guidelines were first published in 2013 and regulators spent the better part of 2014 pushing banks to fall in line with the new measures. Last year, they expressed satisfaction with compliance levels, acknowledging that the banks were broadly following the guidelines even as it decided to step up scrutiny of the loans.