26 April 2018

Financial Times: Trump administration picks the wrong time to ease up on banks

If any American bank lent money to companies with high leverage — defined as six times more debt than earnings before interest, tax, depreciation and amortisation — then regulators at the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve would crack down. So, too, if banks funded companies that might struggle to pay back all their senior creditors within the next five to seven years, based on expected cash flows.

Joseph Otting, Donald Trump’s appointee to head the OCC, told bankers two months ago they have “the right to do what you want [with leveraged lending] as long as it does not impair safety and soundness”. And this week he offered another green light for loans, noting that “the outlook is very positive” for banking since “for the most part, the aggressive lending has stayed outside the banking industry”.

In some senses, Mr Otting’s observation is correct: banks today are much better capitalised than before, and much of the risky lending is now occurring in the non-bank world, namely by hedge funds, private equity groups and mutual funds.

But that is not a reason to relax. On the contrary, Mr Otting’s timing seems peculiar. After all, the US economy is in its eighth year of an expansion and the Fed is now raising interest rates.

Just a few days ago the IMF warned about the risks of overheating in risky loan and bonds markets. “Signs of late cycle credit dynamics are already emerging in the leveraged loan market,” the IMF Global Financial Stability Report observes, noting that “in some cases, [this is] reminiscent of past episodes of investor excesses”.

Now, the good news is that some banks have heeded the IMF’s warning, never mind what Mr Otting says: executives at big banks such as JPMorgan Chase and Morgan Stanley are now quietly telling staff to avoid the craziest deals. But the bad news is that non-banks are jumping into the gap. Indeed, non-bank entities were the lead investors on almost 25 per cent of all highly leveraged loan transactions in 2017, up from almost nothing a decade ago.

Some financiers think that this shifting investor base will make it easier for the system to absorb losses if — or when — the credit cycle turns; after all, getting non-banks involved means that any future pain will be widely dispersed, rather than just sitting with banks. Perhaps so. But it is also possible — and highly probable — that these non-banks are taking bigger risks, since they have less historical expertise than banks, and thinner capital buffers. And if the non-banks suffer losses when defaults rise, it is also possible that this will spark severe capital markets contagion, hurting banks and non-banks alike.

Full article on Financial Times (subscription required)

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