Fed's Warning on Leveraged Loans Seconded by U.S. Bank Regulator

(Bloomberg) -- A key regulator of Wall Street banks has joined the Federal Reserve in warning about risky corporate borrowing that has reached record levels as lender protections are eroded.

The Office of the Comptroller of the Currency cautioned in its Semiannual Risk Perspective released Monday that it’s looking at “transactions with increasing leverage, weaker capital structures, and looser credit agreements.” The report includes a special section highlighting emerging risks in corporate bonds and lending, after the preceding version released in May didn’t address this high-risk debt.

“The OCC remains attentive to the heightened risks in the corporate bond and loan markets, and in particular, the leveraged lending market,” the agency said, noting “near-record issuance” of such loans in the first half of this year, with the average leverage of large corporate loans at a record high.

But the agency -- which along with the Fed represent the main regulators of banks’ participation in the market -- said the economy is still in good shape and the leveraged loans still have “generally satisfactory credit quality.”

The report comes less than two months after OCC chief Joseph Otting started praising banks for having “really kind of stayed on the rails” in leveraged lending, remaining within “relatively healthy” measures. He made similar remarks on Monday, saying, “We haven’t seen significant defaults. The banks, generally we feel comfortable with their underwriting.”

When asked whether it might be time for the Financial Stability Oversight Council to look into the market as a potential systemic risk, Otting said that he doesn’t see it “at levels that are systemic at this point.” He said the multi-agency council’s risk committee has discussed the issue, and those talks will continue.

The Fed had recently fired a warning shot over corporate debt markets, with Chairman Jerome Powell, Vice Chairman Randal Quarles and a report on U.S. financial stability all expressing unease about the rapid growth in lending and erosion of lender safeguards. Fed officials have also said that banks don’t seem to be in direct risk from the debt -- often used to finance mergers and acquisitions of highly indebted companies.

Quarles said earlier Monday the reason leveraged loans aren’t threatening banks is that “they’re selling them off to other investors.” Instead of keeping the loans on their books, lenders package the debt into securities known as collateralized loan obligations, or CLOs, which are often sold to investors such as pension funds and insurance companies. CLOs haven’t been threatened by investor runs in the past, but Quarles said the Fed is watching for signs that could change.

Even if the OCC and Fed wanted to force Wall Street to dial back on risky corporate lending, the agencies’ tools are limited. While the regulators still favor standards they outlined in 2013 guidance to bankers, a Government Accountability Office decision last year accused the agencies of overstepping their authority. Officials of the OCC and Fed have responded by publicly promising they won’t hold lenders to the standard.

The banking industry has enjoyed record profits in recent quarters, but the OCC’s risk report said banks have faced increasing competitive pressure from each other and -- more than ever -- from other types of financial firms. That has contributed to what Otting said had been years “of incremental easing in underwriting.”

The report also said cyber threats are a major danger to the industry, as is the risk posed by rising interest rates.

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