United States: Federal Reserve Bank Report Examines The Effects Of US Leveraged Lending Guidance On The Banking Industry

Following the global financial crisis of 2007-2009, the Board of Governors of the Federal Reserve System (the "Board"), the Federal Deposit Insurance Corporation (the "FDIC") and the Office of the Comptroller of the Currency (the "OCC") issued in 2013 the Interagency Guidance on Leveraged Lending (the "Initial Guidance"), providing guidance to regulated entities (i.e. banks) on the appropriate origination of leveraged lending. The Initial Guidance acknowledged the important role of leveraged lending in the U.S. financial industry, while also recognizing the risk presented by origination of poorly underwritten loans, and outlined "expectations for the sound risk management of leveraged lending activities." In response to follow-up inquiries about the interpretation and implementation of the Initial Guidance, the Board, FDIC and OCC issued responses to "frequently asked questions" later that year (the "FAQ" and, together with the Initial Guidance, the "Guidance").  

In May 2017, the Federal Reserve Bank of New York issued a Staff Report  (the "Report") that examined the impact of the Guidance to determine (1) whether the Guidance caused risk to migrate out of the U.S. banking system, and (2) whether that risk found its way back to banks through different channels. The Report found the following:

• Only the largest, and most scrutinized, banks cut their leveraged lending activity significantly and did so only after the release of the FAQ.
• The Guidance did not reduce the risk in the banking sector overall, because some of the leveraged lending risk migrated to non-banks that in turn used banks to raise funds for these activities.
• Non-banks took advantage of the Guidance by significantly increasing their market share in the leveraged lending business, with the volume of non-bank leveraged lending nearly doubling that of pre-Guidance years.
• Following the Guidance, non-banks made more (but not larger) leveraged loans, suggesting that non-banks have a capacity limit and highlighting non-banks' limited ability to substitute for banks.

The Report concluded that it is necessary to consider the stability of the entire financial system, not just the federally regulated banking system, when creating macroprudential policies.

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