Guidance on leverage lending issued by the federal banking agencies has received a lot of attention: originally, because banks complained that they were constrained from originating sound loans; more recently, because a GAO opinion found that the guidance was procedurally unsound and therefore legally ineffective. But longer term, the most important thing to understand about the guidance is that it was the first major post-crisis attempt by the banking agencies at so-called “macroprudential policy.” In other words, the restrictions on bank leveraged lending were never primarily intended to have a safety and soundness purpose – that is, were not supposed to protect banks from loss – but rather were intended to serve as a financial stability tool, working in conjunction with the Fed’s monetary policy. Therefore, whether that attempt succeeded or failed is important not just in assessing the wisdom of that particular guidance, but also the broader concept behind it.
Below, we describe how radical a notion the leveraged lending guidance was, how it apparently failed (but continued apace), and why it should serve as a cautionary tale to policymakers considering a similar adventure in the future.
The Logic Behind the Leveraged Lending Guidance
Because almost every report on the GAO opinion wrongly casts the goal and effect of leveraged guidance as protecting bank safety and soundness, some background facts are probably necessary to demonstrate that the guidance never had that goal and never had that effect. That conclusion is evident from the stated purpose and actual scope of the guidance, as well as its clearly articulated role in the Fed’s broader monetary policy approach of 2013-14.
Purpose. Through guidance in 2013 and more specific FAQs in 2014, the federal banking agencies (Federal Reserve, OCC, FDIC) restricted the ability of banks to originate, arrange or hold leveraged loans – that is, loans to corporate borrowers with high leverage levels, usually for the purpose of financing a merger, acquisition, or expansion. Growing companies are particularly in need of such financing, as they do not have credit ratings or an established earnings history; once financed, they are also a potent source of economic growth.
The 2013 guidance described its “Purpose” as follows:
Leveraged lending is an important type of financing for national and global economies, and the U.S. financial industry plays an integral role in making credit available and syndicating that credit to investors. In particular, financial institutions should ensure they do not unnecessarily heighten risks by originating poorly underwritten loans. For example, a poorly underwritten leveraged loan that is pooled with other loans or is participated with other institutions may generate risks for the financial system.
Notably, the risks to “the financial system” at which the guidance aimed arise regardless of whether a bank ends up holding the loan. Presumably as a result, there is no reference to potential overlap with bank capital standards and reserving practices, whose explicit purpose is to cushion banks against all types of losses, including losses from leveraged lending. Rather, the guidance serves a different purpose.
Scope. The macroprudential purpose of the guidance was consistent with the scope of its application: the guidance applied on equal terms regardless of whether a bank served as the lender – and therefore was exposed to credit risk from the borrower – or only as an arranger or underwriter – bearing no credit risk at all. Such an approach would have been irrational for a policy with a safety and soundness goal – e.g. a capital rule. But here, through the leveraged lending guidance, the banking agencies were pursuing a different aim: to regulate indirectly that which they could not regulate directly – the global leveraged credit market at large.
Context. The goal of the guidance is plain not just from its stated purpose and scope, but also how the Fed explicitly described it in macroeconomic terms at the time, and consistently after its issuance.
In 2013, to counter continued weakness in the economy, the Federal Reserve was maintaining interest rates near zero and expanding its holding of longer-term securities aggressively through its flow-based asset-purchase program. At the same time, some FOMC participants were expressing concerns about financial imbalances and suggesting that monetary policy should be tightened, or at least that easing should slow or stop, to counter those imbalances. Leveraged lending was identified as a source of such imbalances: for example, the minutes to the April 29-30, 2014 FOMC meeting state:
In their discussion of financial stability, participants generally did not see imbalances that posed significant near-term risks to the financial system and the broader economy, but they nevertheless reviewed some financial developments that pointed to potential future risks. A couple of participants noted that conditions in the leveraged loan market had become stretched, although equity cushions on new deals remained above levels seen prior to the financial crisis. Two others saw declining credit spreads, particularly on speculative-grade corporate bonds, as consistent with an increase in investors’ appetite for risk. In addition, several participants noted that the low level of expected volatility implied by some financial market prices might also signal an increase in risk appetite. Some stated that it would be helpful to continue to explore the appropriate regulatory, supervisory, and monetary policy responses to potential risks to financial stability.
This statement was no fluke: leveraged lending was mentioned in the minutes of 14 of the 16 FOMC meetings in 2013 and 2014.
During this period, Chair Yellen was of course working hard to maintain the support of the Committee for continuing asset purchases and then, when the purchases ended in October 2014, maintaining a large portfolio. In July 2014, in a speech on monetary policy and financial stability, she argued that supervisory tools, not monetary policy, should be the first line of defense against financial stability risks. If FOMC participants were stating that there should be a monetary policy response to eased terms on leveraged loans – e.g., fewer asset purchases or higher interest rates — then, judging by her speech, Chair Yellen’s counterargument presumably would have been “No, the appropriate first response is supervision.” Indeed, that is precisely what she said in her speech:
Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach…[T]erms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a “reach for yield” in the face of persistently low interest rates. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures. But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.
Again, it is worth noting that these remarks did not focus primarily on a risk of loss to banks but rather on “risk-taking across the financial system” and the risk of nonfinancial borrowers “taking on excess debt.”
This history also explains why by all accounts, the agencies began in 2014 to enforce the leveraged guidance as if it were a binding regulation. When banks failed to respond to the initial guidance in 2013 – treating it as simply guidance – the agencies issued a series of FAQs mandating rigid compliance and began a “no exceptions” approach to deviations from the guidance.
Impact of the Leveraged Lending Guidance
With the stakes more clear, two questions seem important. Was the guidance a good idea? And did it have its intended effect?
First, at the time the guidance was issued, the Fed (and the other agencies) provided no evidence that there was a risk to financial stability posed by leveraged loans. That is perhaps not surprising because there was (and is) no such evidence. It is broadly recognized that investments in risky assets, even if those assets prove to be overvalued, do not present a material financial stability risk so long as the investments are not funded with short-term debt. For example, the popping of the massive bubble in high-tech stocks in 2000 did not give rise to financial instability, just losses for those who invested in the stocks. As described in the Office of Financial Research’s 2013 annual report on financial stability, leveraged loans issued in 2013 and 2014 were primarily purchased by mutual funds that specialize in such loans, or bundled into collateralized loan obligations (CLOs). Investments in loan mutual funds are generally not funded with leverage and so do not present a financial stability risk. And the OFR report concludes that the CLOs backed by the leveraged loans did not entail financial stability risk because they were funded either by commercial banks, which held only senior tranches, or by long-term investors that did not finance their holdings using short-term debt.
Second, even if there had been systemic risk associated with leveraged lending in 2013 and 2014, two separate Fed working papers (one published in 2016 by the Board and one published in 2017 by the New York Fed) independently concluded that the leveraged lending guidance was an ineffective tool for addressing that risk. Both papers found that the guidance had the effect of shifting leveraged lending origination activity away from large banks and towards less regulated market participants, with no meaningful reduction in any systemic risks posed. The finding is well summarized by a New York Fed blog post:
The effect of the guidance on [the largest] banks’ leveraged lending business was meaningful. Compared to the pre-guidance period, the market share of these institutions in the post clarification period declined by 11.0 and 5.4 percentage points depending on whether it is measured by the number or volume of leveraged loans, respectively. This decline is meaningful, particularly if one takes into account that it happened over about one year (November 2014 – December 2015). Nonbank lenders appear to have been the main beneficiaries of this response, as their market share based on the number of loans increased by more than 50 percent while their market share based on the volume of lending more than doubled over that period of time.
[W]hile the guidance achieved its goal of reducing banks’ leveraged lending business, the migration of leveraged loans to nonbanks makes it less clear that the guidance accomplished its broader goal of reducing the risk that these loans pose for the stability of the financial system.
The blog post concluded:
This evidence highlights an important challenge of macroprudential policies. Since those policies reach beyond individual banks and target risk in the entire banking system, they are more likely to trigger significant responses that may have unintended consequences.
In sum, the guidance had the effect of moving the origination of leveraged loans out of the banking sector and into the nonbanking sector.
In sum, to reduce a risk that likely did not exist, and based on no empirical evidence that it did, the Fed (along with the OCC and FDIC) embarked on a remarkable and novel attempt to use bank supervision to achieve macroeconomic goals. By its own standard, the guidance demonstrably failed, yet continued apace, at least until issuance of the GAO opinion.
We should note that while the leveraged lending guidance therefore appears to have been a serious policy mistake, it would have been an even worse outcome if the Federal Reserve had used monetary policy to resolve its financial stability concern. Proponents of a monetary policy response often note, as did former Fed Governor Jeremy Stein, that higher interest rates “get in all the cracks,” reducing the chances that a tightening will simply result in circumvention into the unregulated sector. However, and for the same reason, a monetary policy response also has much higher collateral damage: while higher interest rates might help reduce financial imbalances, they certainly drive up unemployment and slow economic growth. As Lars Svensson has forcefully pointed out, any benefit in terms of somewhat lower chances of a future financial crisis is virtually never higher than the higher and certain cost of continuously higher unemployment, making monetary policy a poor financial stability tool.
A Post Script for our Legal Friends.
Because the leveraged lending guidance is not rooted in the statutory safety and soundness authority granted to the federal banking agencies, one can reasonably ask what authority they had to issue it. Section 165 of the Dodd-Frank Act grants the Federal Reserve the authority to issue prudential standards on large banks “[i]n order to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.” One could read “ongoing activities” to mean any activity of a large bank, including arranging or syndicating loans, but the reference to “interconnected financial institutions” would seem to imply a narrower view of financial stability. Furthermore, the statute authorizes the Fed to impose prudential standards that “are more stringent than the standards and requirements applicable to nonbanking financial companies and bank holding companies that do not present similar risks to the financial stability of the United States.” Here it is clear that section 165 was focused on risks posed by potential instability of the financial institution, not the secondary effects of its activities on the macroeconomy. And of course the leveraged lending guidance is not “more stringent” than other standards, as there are no standards imposed on other firms.
It is worth noting that a broader reading (and apparently the reading underlying the leveraged lending guidance) could take the Federal Reserve into some truly worrisome territory. On this reading, there would be nothing to stop the Fed from deciding to cool a stock market it viewed as irrationally exuberant by prohibiting large financial institutions from underwriting IPOs, or setting the prices at which they were issued. It could cool economic growth by limiting bond underwriting, say in the high-yield market. We sincerely doubt that this is what Congress had in mind in section 165. Rather, Congress traditionally has focused the banking agencies on the more narrow and achievable goal of preventing a failure of a bank at taxpayer loss. It has entrusted another regulator (the CFPB) with authority to enforce consumer protection laws.
Furthermore, redressing any macroprudential risk of the type purportedly presented by leverage lending as a market activity was a task that Congress specifically assigned to the Financial Stability Oversight Council, and not to the Federal Reserve alone, under section 120 of the Dodd-Frank Act:
The Council may provide for more stringent regulation of a financial activity by issuing recommendations to the primary financial regulatory agencies to apply new or heightened standards and safeguards, including standards enumerated in section 115, for a financial activity or practice conducted by bank holding companies or nonbank financial companies under their respective jurisdictions, if the Council determines that the conduct, scope, nature, size, scale, concentration, or interconnectedness of such activity or practice could create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies and nonbank financial companies, financial markets of the United States, or low-income, minority, or underserved communities.
Directing such a task to the collective wisdom of the FSOC makes eminent sense. If a financial system-wide macroprudential effort were ever warranted, presumably multiple agencies would need to be involved, not just banking agencies.
Finally, even if one presumes that the Fed’s authority here is practically limitless, the OCC and the FDIC are granted no such “financial stability” authority, by Dodd-Frank or any other statute.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.