Two federal agencies announced they had rescinded existing interagency guidelines on leveraged loans, key steps in easing the stricter bank lending standards that helped fuel the growth of private credit. The Federal Reserve, a party to the guidelines established more than a decade ago, has so far not indicated whether it would similarly rescind the guidance.
Some market watchers said the change could spur lending by banks to the riskiest corporate borrowers. Others doubted that the guideline change would impact private credit’s market share. Notably, regulators had already cast doubt on their ability to enforce the existing guidelines, having never been reviewed by Congress.
The edict came on Dec. 5, when the Office of the Comptroller of the Currency (OCC) and the FDIC rescinded the Interagency Guidance on Leveraged Lending passed in 2013, as well as a 2014 note addressing frequently asked questions.
The rescinded 2013 guidance instructed banks that total debt-to-EBITDA leverage of greater than 6x “raises concern for most industries.” The agencies clarified in the 2014 FAQ, which was also rescinded, that while the threshold was not a “bright line,” loans with leverage above 6x may receive additional scrutiny.
The 2013 guidance had also set standards for repayment capacity, suggesting that borrowers should have the ability to amortize at least half of their total debt over a five- to seven-year period.
According to the OCC and FDIC, existing rules “were overly restrictive and impeded banks’ application to leveraged lending of the risk management principles that guide their other business decisions,” the agencies said in a joint statement.
“This resulted in a significant drop in leveraged lending market share by regulated banks and significant growth in leveraged lending market share by nonbanks, pushing this type of lending outside of the regulatory perimeter,” the OCC and FDIC added. “In addition, the guidance was overly broad and captured certain types of loans that were not intended to be covered, including loans to investment-grade companies.”
Open the floodgates?
So far, private credit market participants say the threat to their market share is slim, particularly among deals in the core middle market and below. They say that among deals that conform to the existing lending standards, direct lenders currently hold a commanding market share relative to banks.
Among larger issuers, market participants indicated that banks may end up shying away from the higher-levered borrowers that were covered by these guidelines anyway, whether or not the rules are enforced. Many of those deals have historically ended up in the private credit market, where loans are typically unrated and lenders are more open to borrowers with “complicated” stories and business plans.
Already, market participants have claimed that the standards were not reliably enforced. In 2018, OCC head Joseph Otting announced to a conference crowd in Las Vegas that banks no longer needed to adhere to the guidance, despite the rule being in effect, according to a report by the law firm Ropes & Gray. (Observers at the time called the remarks “bold and a bit surprising.”)
The comment by Otting followed a 2017 report from the US Government Accountability Office which found that the guidance needed to be submitted to Congress for review. In the joint statement announcing their withdrawal, the OCC and FDIC said that the agencies had ultimately never submitted the guidance to Congress after the 2017 notice.
Several market watchers, including analysts from accounting firm PWC and from JPMorgan, have forecast that the Federal Reserve would follow suit in reversing the guidance. In a Dec. 8 note, a JPMorgan analyst said the bank expects that the Fed will ultimately approve the change, given the “overall tone” in Washington, D.C.
In contrast with some views in the private credit market, the JPMorgan analyst called the move a “significant step that could accelerate [commercial and industrial] loan growth, potentially sharply at some banks.”
Richard Olson, a managing director at the consulting firm Alvarez & Marsal, said removing the interagency guidelines would drive increased competition for leveraged loans.
“Increased competition will inevitably lead to lower margins and potentially to lower borrower standards, and, therefore, higher default risks,” Olson said.
Safe and sound
In place of the existing guidelines, the agencies instructed banks to consider some “general principles for safe and sound lending,” and invited each bank to come up with its own definition of “leveraged loan.”
The principles include establishing a clearly defined risk appetite, consistently applying underwriting criteria, conducting analyses of borrower performance and monitoring refinancing risk.
“Examiners will examine banks’ underwriting, review risk ratings, and monitor the adequacy of loan loss reserves in accordance with general principles of safe and sound lending in a manner tailored to the size, complexity, and risk of leveraged lending activities,” the OCC and FDIC said.
In their joint statement on Friday, the agencies said they would “consider issuing additional guidance related to leveraged lending as appropriate,” and committed to following a notice and comment process.
Alongside the change on leveraged lending guidance, the OCC simultaneously updated guidance on venture loans, rescinding a 2023 bulletin and specifying that it was “not discouraging banks from engaging in prudent venture lending activities,” according to a separate OCC statement also issued Dec. 5.
Feature image by Neal McNeil/Getty Images
Learn about our editorial standards.
