Wall Street’s Leveraged Loan Risk Is a Focus in Fed Stress Tests

(Bloomberg) -- Wall Street’s biggest banks will have to show they can weather severe turbulence in the leveraged-lending market in the next round of the Federal Reserve’s annual stress tests, the agency said Thursday.

The growing market that’s drawn fresh scrutiny from regulators as underwriting standards decline will be a special focus of this year’s exercise, the Fed said as it released hypothetical scenarios the banks will have to measure themselves against. The lenders will also have to show they can stay in business through a major global recession in which corporate debt and commercial real estate are slammed.

The Fed tailors new scenarios each year, though recent efforts have dialed back their scope and given banks more information on how the tests work. Still, because they always assume a 10% unemployment level, the tests tend to get steadily harder as the current jobless rate declines.

Key Details

  • Specific traumas the Fed is seeking to test at the biggest banks will include a “wave of corporate sector defaults” and heavy redemptions at funds that invest in leveraged lending in which “price declines on leveraged loans flow through to the prices for collateralized loan obligations.”
  • A selloff in corporate bonds and leveraged loans would spill over into “other risky credit and private equity instruments,” according to the Fed’s scenario.
  • “This year’s stress test will help us evaluate how large banks perform during a severe recession, and give us increased information on how leveraged loans and collateralized loan obligations may respond,” Randal Quarles, the Fed’s vice chairman for supervision, said in the agency’s statement.
  • Banking giants such as Goldman Sachs Group Inc., Citigroup Inc. and JPMorgan Chase & Co. will have to test for additional “market shocks” that the smaller, regional lenders won’t have to address, according to the Fed.
  • The banks will have to submit their plans by April 6, and the results will be announced by June 30, the Fed said.
  • The Fed has moved toward taking some of the drama out of this process by no longer publicly revealing a pass-fail result in a “qualitative” assessment of banks’ readiness that had previously risked significant market responses for the affected institutions.

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