On June 13, the U.S. Department of the Treasury released its report to President Donald J. Trump in response to Executive Order 13772 issued on Feb. 3, which set forth the "core principles" of the Trump administration regarding financial regulation. This report, titled "A Financial System That Creates Economic Opportunities – Banks and Credit Unions," is the first of four reports setting forth specific policy recommendations for financial regulation. (The other three will address capital markets, asset management and insurance and nonbank financial institutions.)
In discussing the leveraged lending guidance, the report notes that both experts and market participants have provided mixed feedback on the 2013 leveraged lending guidance, with one of the primary concerns being the level of ambiguity in the definition of leveraged lending. For example, while the guidance specifically expressed concern with loans exceeding six times (6x) leverage (defined as the ratio of total debt to EBITDA), the regulators simultaneously said the 6x limit is not a "bright line" so long as other "compensating factors" make up for the amount of leverage. This ambiguity left banks unsure how to satisfy regulatory demands and subject to ex post facto regulatory review to get clarity on whether a leveraged loan would pass or fail supervisory review.
In addition, the report notes that:
"[B]ecause the guidance lacked specificity, it led to uncertainty in the leveraged lending market, and ultimately, resulted in fewer leveraged loans by banks. However, the reduction in leveraged lending by banks did not necessarily lead to a reduction in risk in the financial system. Instead, a recent Federal Reserve staff paper found that leveraged lending migrated to less regulated nonbanks – a dynamic which makes it far less clear that the guidance actually diminished risks to financial stability, since nonbank lenders often originate leveraged loans using more aggressive and riskier credit structures. What is clear, however, is that the reduction in leveraged loans available from banks reduced access to credit by businesses."
In its "Findings and Recommendations" section, the report set forth the administration recommendations regarding the regulation of leveraged lending. Specifically, Treasury recommends that:
- The 2013 leveraged lending guidance should be reissued for public comment. Following the public comment process, the guidance should be refined with the objective of reducing ambiguity in the definition of leveraged lending and achieving consistency in supervision, examination and enforcement.
- Banks should be encouraged to incorporate a clear but robust set of metrics when underwriting a leveraged loan, instead of solely relying on a 6x leverage ratio discussed in the 2013 leveraged lending guidance. Encouraging banks to do so will help maximize the role that leveraged lending plays in the provision of capital to business.
These Treasury recommendations (and the recent Federal Reserve Bank of New York staff paper) come as the market awaits the decision by the Government Accountability Office as to whether the leveraged lending guidance was properly adopted in 2013, or whether the "guidance" was in fact a rule that should have afforded Congress the opportunity to vote to reject it. Regardless of the outcome of the GAO decision, it now appears that revising the leveraged lending guidance to liberalized lending by regulated banks is a priority item for the Trump administration.
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