Federal banking regulators want banks to tighten up the underwriting of leveraged loans, which are often used by private-equity firms in buyout transactions. They are recommending more-frequent stress-testing of such loans and want banks to delve deeper into whether the financial sponsors would inject capital into the borrowing company if it underperforms.
The regulators — the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency — issued the proposed guidance in March. While the guidance isn’t law, it is a good indication of the information that examiners will regularly request from banks.
The guidance is intended to prevent a repeat of 2006–2007, when aggressive underwriting led to “covenant-lite” loans that left banks with little recourse when the recession hit and companies defaulted. Considering many borrowers’ risk profiles at the time, the capital structures and repayment prospects for transactions were too aggressive, according to the regulators.
Now, “banks will have to establish an overall strategic level or ‘appetite’ for this kind of financing,” says James Defrantz, senior consultant at CCG Catalyst, a bank consultancy. “They better have a strategic plan, a plan for constant monitoring, and an exit plan.”
Companies and private-equity firms, meanwhile, may find it harder to get a bank to back their deals, as regulators want highly leveraged deals underwritten with an eye toward the borrower’s ability to fully pay back the debt or pare back its total debt in five to seven years.
One of the biggest changes in the guidance centers on suggestions for how banks should account for the financial condition of the buyout firm in their internal risk ratings. Banks usually analyze a loan based on the borrower’s stand-alone financials, but they have been able to also consider a PE firm’s ability to “provide financial support” to an ailing investment.
The new guidance doesn’t change that, but it provides much more detail on how banks should evaluate that potential support. It suggests a periodic review of the buyout firm’s financial statements, liquidity, and past practices with regard to dividends and capital contributions.
An IT Challenge
A big question for banks will be whether their IT systems can handle the additional reporting and analytics that bank examiners may request on leveraged-loan portfolios. Many bank systems are not sophisticated enough to do even simple things like aggregate risk exposure across product lines, says Christine Pratt, a senior analyst at Aite Group. “If a construction firm has multiple commercial real estate and development loans with a bank and has a small-business loan as well, many systems can’t tie that information together,” she says.
Banks have until June 8 to comment on the guidance. They are expected to say that any clampdown on leveraged-loan underwriting will hamper their ability to finance mergers and acquisitions and impose undue regulatory burdens on the industry. But such guidance, especially that related to stress-testing, can protect banks, says Kimberly Songer, director of risk products at Harland Financial Solutions.
“The idea is not to approve fewer loans,” wrote Songer in a recent blog post. “A more effective portfolio analysis enables lenders to take action long before liquidation — requesting additional guarantees, business-loan agreements, or collateral adjustments.”
Firms issued $18 billion of highly leveraged debt in February, an eight-month high, according to S&P Leveraged Commentary and Data.