Almost daily, commentators now express concerns about leveraged loans as a source of macroeconomic risk, and perhaps a potential future crisis. Leaving aside whether that diagnosis is correct (and there are many reasons to believe it is not[1]), the prescriptions being offered appear wildly inappropriate for that diagnosis.
As the story goes, many American companies are overleveraged – that is, their debt levels exceed their net income by unhealthy amounts. As a result, the next recession will see more defaults than ordinary, with greater job losses and other economic effects. But if this is the problem, it is a borrowing problem, not a lending problem, and the most direct and effective response would be to limit the leverage of American companies, large and small – say, by prohibiting a company from borrowing more than some multiple of its earnings.
Such limits will not be forthcoming, however, as the notion of restricting the ability of businesses to borrow for growth would be highly unpopular, especially as many popular and successful businesses – think: Uber, American Airlines, Burger King – would be swept into the restriction.
Instead, the only policy prescriptions floated thus far seek to diminish the leverage of growing companies only indirectly — by restricting the types of loans that banks (and only banks) can make or imposing higher capital charges on the loans they hold. This approach is very difficult to understand, for five reasons.
First, banks hold a small percentage of leveraged loans. Thus, no macroeconomic or financial stability goal would be achieved by reducing or eliminating their holdings.
Second, today, business debt does not appear to present notable risks to financial stability. The debt-to-GDP ratio has moved up at a steady pace, in line with previous expansions and neither fueled by nor fueling an asset bubble. Moreover, banks and other financial institutions have sizable loss-absorbing buffers. The growth in business debt does not rely on short-term funding, and overall funding risk in the financial system is moderate.[2]
Third, none of the proposals would prohibit such companies from turning to the debt capital markets and issuing junk bonds.
Fourth, and most confoundingly, the policy tool some have suggested is use of the so-called countercyclical capital buffer, which would simply require all large banks to hold more capital – say, an additional 50 basis points. But this buffer, if imposed, would apply to every bank asset, not just the tiny minority of leveraged loans. Thus, this capital increase would not just increase the cost of leveraged loans, but also unleveraged loans, small business loans, home mortgages, lines of credit, etc.
Consider the perversity of this outcome: to prevent U.S. companies from taking on too much debt, the government would not limit their debt, but rather increase the cost of all forms of bank lending, even knowing that most leveraged corporate debt is not held by banks.
Lastly, large banks for which the CCyB applies are already subject to the Fed’s stress tests, which assume a stress scenario that is much more severe than the 2007-2009 financial crisis. Thus, banks’ own capital requirements already reflect the riskiness of the loans they hold under a very severe recession. None of the other holders of this risk are subject to those stress tests, or anything like them.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.
[1] https://libertystreeteconomics.newyorkfed.org/2019/05/is-there-too-much-business-debt.html
[2] https://www.federalreserve.gov/newsevents/speech/powell20190520a.htm
