LONDON, Nov 27 (Reuters) – Relaxing or repealing US Leveraged Lending Guidelines could offer banks the opportunity to take back market share lost to shadow banks and direct lenders and open the door to more multi-billion dollar buyout loans, bankers and investors said.
The guidelines, which were implemented in 2013 to curb systemic risk in the banking sector by restricting banks’ ability to underwrite highly leveraged loans, have not reduced overall volume or dented robust investor appetite, but have changed the composition of the lender base.
Relaxing the regulations could shift underwriting volume back to the investment banks from less regulated entities, potentially leading to more jumbo M&A loans suited to large banks’ powerful balance sheets.
“I think it will change the banks’ financing deals and you could start to see larger high-leverage deals get done,” a banker said.
Rolling back LLG will not, however, cool aggressive market conditions. Ratings agency Moody’s described the US leveraged loan market as overheated in a report last week and said that removing the regulatory guidance would not materially worsen lending conditions.
Moody’s has been increasingly vocal about toppy market conditions, which it expects to persist into 2018 as investor demand continues to outweigh supply, and continues to warn about the prevalence of covenant-lite loans, which it says could result in significantly higher default rates and lower recoveries in the next default cycle.
“When the market’s this overheated, saying that rule is not a rule will not really change anything,” said Christina Padgett, Moody’s head of leveraged finance. “What we’re seeing today is as aggressive an environment as we’ve ever seen.”
A similar report from Fitch, also published in November, said that it did not expect changes to the guidelines to boost new-money issuance.
Leveraged lending guidelines were introduced in March 2013 by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation to reduce banking sector risk by curbing banks’ ability to underwrite risky loans that they may not be able to sell.
Rolling back the US guidelines contrasts starkly with a tougher approach in Europe. The European Central Bank’s final guidance on leveraged transactions was implemented on November 16, and is modelled on the US guidelines – but contains some differences.
The US guidelines, which view leverage over six times as problematic and also focus on a borrower’s ability to pay off debt within a specific time frame, did not restrict leveraged loan volume, which at US993m at the end of the third quarter of 2017 is on track to break the US$1.1trn record of 2013, according to Thomson Reuters LPC data.
But it did force regulated banks to pass on underwriting highly leveraged loans to avoid having criticised loans in their portfolio, while less regulated lenders including Jefferies, Macquarie and Nomura benefited.
“The LLG has constrained bank leveraged lending,” said J. Paul Forrester, a partner at Mayer Brown in Chicago.
Lending from non-bank financial institutions reached 20.8% of total US loan commitments at 1Q17, up from 15.9% in 2007, according to the OCC, Fed and FDIC’s shared national credit review, as Business Development Companies, private credit funds and direct lenders also benefited from banks’ restraints.
“The guidelines did reshape the industry. Maybe the banks now feel that they can push on a couple of deals they didn’t push on before,” Padgett said.
Although banks could be more comfortable underwriting sizeable deals, big buyouts are currently more constrained by valuations than regulation and making acquisition multiples work is more of an issue than raising finance, sources said.
RELAXED NOT REMOVED?
Although the LLG may be relaxed or repealed, regulators are still expected to conduct loan reviews and banks will remain sensitive to criticised assets, which may lead to an ongoing form of self-censorship, investors and bankers said.
“There may be less regulation but there’s still going to be a loan review by the regulators and banks will remain sensitive to that as an issue,” Padgett said.
The discussion around the future of the Guidance emerged in the backdrop of the Government Accountability Office’s decision that the Guidance is a “rule” subject to the Congressional Review Act.
It remains to be seen if the regulators will submit the rule for Congressional review, submit a revised rule, or not act.
Bankers are continuing to underwrite deals as though they are in place until they hear officially from regulators and are keeping an eye on other banks for signs of looser underwriting, but have not seen enough new deals yet to see a pattern. With the Trump administration preoccupied by tax reform, some market participants see relaxation as more likely than a repeal, which could be politically unpalatable and open the door to tighter terms, if not necessarily to higher leverage.
“It would make it seem that Congress is pro-leverage or pro-debt. Imagine Congress being unable to fix healthcare but able to pass legislation to increase debt levels,” a loan and high-yield investor said.
Acting Comptroller of the Currency Keith Noreika told Reuters on November 20 that the regulator had been working to ensure that examiners on the ground have a lighter touch with institutions they scrutinise, but change will take more time.
While some lenders remain concerned that additional risk could enter the market if the LLG is relaxed, most market participants expect some form of regulatory oversight to continue, even if investors are still willing to buy racier deals.
“Credit availability and terms of financing for corporate borrowers are determined by investor demand for credit risk,” said Brit Stickney, portfolio manager of Allianz Global Investors’ income and growth fund team, which manages US$39.5bn in assets.