Global regulators launch inquiry into leveraged loans

Date published: 07 March 2019

Sam Fleming in Washington

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The Financial Stability Board, a top global rulemaker, has launched an examination of parts of the $1.4tn leveraged loan market, as officials intensify scrutiny into potential financial stability risks surrounding corporate debt.

Randal Quarles, the FSB’s chairman, told the Financial Times that regulators could act if their findings point to actual hazards in the market for leveraged loans — the increasingly popular practice of extending credit to lowly-rated, more indebted companies.

The focus of the FSB’s review, which is expected in the autumn, will be on so-called collateralised loan obligations, bundles of leveraged loans that are sold in tranches. The FSB wants to identify the holders of CLOs around the world and assess the risks that investors could pull money from exposed institutions during a severe downturn. Among the investors in CLOs are banks, investment funds and insurers.

“From a financial stability risk [point of view] we need to know more about that than we do and we have set up a process at the FSB to understand that,” Mr Quarles, who also serves as the Federal Reserve Board’s vice-chairman for supervision, said in an interview on Tuesday.

“Is there a cross-border or cross-cutting supervisory or regulatory response that ought to be taken to mitigate that risk? That is how we would expect to see this evolving if the analysis were to show there [are] some respondable risks there.”

What is the right amount of pre-positioning of capital and liquidity in local jurisdictions relative to in home countries? That will be a very key issue going forward

Randal Quarles, chairman of the Financial Stability Board

The review is part an attempt by Mr Quarles to refocus the FSB on identifying possible hazards on the horizon after the body spent the past decade helping preside over the post-crisis framework for financial regulation. Mr Quarles, who was appointed to the FSB late last year, said financial stability risks — as opposed to business cycle risks — have “abated very modestly” this year compared with last.

Among the areas currently on his radar is the risk that regulatory barriers between countries fragment global banking and damage financial stability — something that will be in focus under Japan’s presidency of the G20 this year. Other areas under scrutiny are potential vulnerabilities in the fintech arena and among central counterparties.

The key area of unfinished business for the FSB is arguably the shadow banking sector, which is often more lightly regulated and is swelling in size around the world. The FSB’s latest assessment of what it now calls “non-bank financial intermediation” found the sector has ballooned to more than $50tn — according to a narrow definition.

Companies have been amassing cheap loans thanks to low interest rates and loosening lending standards, and in the US non-financial corporate debt is now a higher share of gross domestic product than before the crisis.

US banks do not have “excessive” exposure to CLOs, Mr Quarles said, but “we have less of a handle on that globally, as to whether there are ‘runnable’ institutions that may be exposed to leveraged lending”. By “runnable”, Mr Quarles was referring to institutions such as banks that could experience a run on deposits.

The drive to reduce fragmentation of the global banking system is also “top of mind” at the FSB, he added. The ultimate goal would be to prevent international co-operation from breaking down as countries engage in a destabilising scramble to hold capital and liquidity in a crisis.

“What is the right amount of pre-positioning of capital and liquidity in local jurisdictions relative to in home countries?” Mr Quarles added. “That will be a very key issue going forward — not just in this G20 cycle but over a longer period of time.”

Press reports this week suggested that the Fed was considering new liquidity requirements on branches of foreign-owned banks, but Mr Quarles stressed that “a change along those lines would be a significant shift to our regulatory approach, and we would take our time to get something like that right before we would do it”. He added: “We would want to allow ourselves and the public plenty of time to consider the costs and benefits to any shift.”

Mr Quarles said the Fed will “soon” unveil new proposals on foreign banks that are closely tailored to their individual business models as well as assets — mirroring the treatment of US equivalents. “They have a broad range of business models and levels of US activity and that should be recognised in a tailored regulatory framework for the foreign banks.”

The Fed has come under fire from some Democrats and consumer advocates for easing aspects of the post-crisis framework — including by disclosing greater information about its stress tests and overhauling part of its leverage ratio regime.

The latest significant Fed decisions came on Wednesday, when the central bank eliminated an element of its stress tests for domestic banks and decided not to impose the so-called countercyclical capital buffer, a measure that guards against financial stability risks.

Mr Quarles has in the past insisted that the Fed does not intend to weaken the resiliency of the system or big financial institutions through its reforms. In the interview he said that if financial stability risks were rising “we have tools to address them”. The same message applied globally, he said.

“Countries have done that with higher loan-to-value ratios, by turning on their countercyclical capital buffers if they see financial stability risks in their jurisdictions; I think that is the right tool as opposed to monetary policy.”

As a member of the Federal Open Market Committee, Mr Quarles has a regular vote on monetary policy and will participate in upcoming discussions over whether the Fed should amend its approach to its inflation target.

Among the proposals has been a shift to targeting an average rate of inflation over time, which would mean the Fed seeks to overshoot the 2 per cent target to make up for past undershoots. Mr Quarles stressed that the Fed is not talking about changing the inflation target but has announced “symmetry” around the goal.

The question was how to think about that, and he appeared to take a conservative approach, saying: “I myself in advance of that discussion . . . view symmetry as meaning we should be as comfortable missing above as missing below, but we should be aiming for the target.”

He added: “I come from the American west. We hunt elk out here. If you miss the elk one foot to the right, you do not respond by missing it one foot to the left. You should be indifferent as to which direction you miss it, because you should be trying to hit it.”

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