Federal Banking Agencies Sharpen Scrutiny of Leveraged Lending

Expressing continued concern over loosening lending standards and continuing increases in leveraged loan volume, the federal banking agencies have issued new guidance in the form of FAQs as a follow-up to their earlier Interagency Guidance on Leveraged Loans (Interagency Guidance), issued in March 2013, which was intended to encourage more robust risk management practices related to this type of lending.

The Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation jointly issued the FAQs along with the Shared National Credits Program 2014 Review and a special supplement that focuses on leveraged lending and its impact on the shared national credit portfolio (collectively, the 2014 SNC Review). The 2014 SNC Review pointed out increasingly high leverage and deteriorating covenant protection as causes for concern and, together with the FAQs, appears intended to highlight the risks posed by these trends to regulated banking institutions and to the broader financial sector and to strongly encourage banking institutions to reduce these risks through more stringent underwriting and risk management. The increased scrutiny will likely mean tightening credit standards for leveraged loans from regulated banking institutions, and borrowers may increasingly have to look to unregulated investment funds, and face higher pricing, if they seek covenant lite loans.

In a report, issued November 11, analyzing the U.S. leveraged loan market for the first nine months of this year, Standard & Poor’s Rating Services (S&P) pointed out that senior secured loan volume increased again in 2014 and that first lien leverage of 4x EBITDA or higher “trended above 2007 levels.” S&P also reports that leverage for middle-market loan transactions has increased to 5.0x EBITDA from 3.4x over the past five years.

The 2014 SNC Review made very similar observations, expressed significant concerns regarding these trends, and reminded readers that the Interagency Guidance “states that financial institutions should ensure that they do not heighten risk in the financial system by originating poorly underwritten loans[.]” To be clear, this guidance applies to insured depository institutions, bank and savings and loan holding companies and their nonbank affiliates and subsidiaries, as well as U.S. branch and agency offices of non-U.S. banks and, in some circumstances, business development companies (BDCs) and issuers of collateralized loan obligations (CLOs).

The Interagency Guidance requires financial institutions to adopt and implement well-defined underwriting standards, but it stops short of adopting a uniform definition of leveraged lending applicable to all banking institutions. Instead, it encourages banking institutions to develop their own institution-specific definition of leveraged lending. This approach has led to significant questions among financial institutions and prospective borrowers about the types of lending to which the guidance applies and the degree to which banking institutions can originate leveraged loans. There have been reports that the banking agencies have more closely scrutinized leveraged lending activities at financial institutions through the supervisory examination process, but have shown different degrees of tolerance for leveraged lending, further contributing to uncertainty about the types of leveraged lending permissible for banking institutions. The FAQs provide additional guidance that appears intended to address these uncertainties.

That said, the Interagency Guidance notes that leveraged lending typically refers to loans having some combination of the following four characteristics:

• Use of proceeds for buyouts, acquisitions or special distributions (capturing LBOs and recapitalizations).
• Transactions where the borrower’s ratio of total leverage exceeds 4x or the borrower’s senior leverage exceeds 3x.
• A borrower recognized in the debt markets as a highly leveraged firm.
• Transactions where the borrower’s post-financing leverage exceeds industry norms or historical levels.

The FAQs explain that these characteristics are simply a starting point for a banking institution to develop a definition of leveraged lending that takes into account the institution’s own risk management framework and risk appetite. However, the FAQs go on to emphasize that a banking institution’s definition should, at a minimum, include borrower characteristics that are recognized in the debt markets as leveraged for each industry in which the banking institution makes loans.

The FAQs also warn that banking institutions must carefully avoid heavy reliance on a borrower’s projections and should avoid unsupported adjustments to EBITDA. The FAQs also remind institutions of the banking agencies’ guidance on workouts, refinancings and modifications, and suggest that the practice of amending and extending may not be a sufficient risk mitigant.

Notably, the FAQs indicate that the banking agencies do not view leverage exceeding 6x as a bright line limit when evaluating the risk in a transaction but clarify that loans to borrowers that exceed this leverage level are likely to attract close scrutiny and suggest that such loans would need to be supported by compensating factors. Similarly, in the FAQs, the banking agencies pointed out that so-called “covenant lite” loans do not automatically warrant a non-pass rating from examiners but that loans with few or weak loan covenants should have other mitigating factors to support credit quality.

Fearing that the original Interagency Guidance did not gain enough traction in the marketplace, the federal banking agencies appear to have issued the FAQs as a reminder (and perhaps a warning shot) to both financial institutions and their borrowers of where the banking agencies would like to see market trends move. If the banking agencies seek to push this guidance forcefully in their examinations of regulated institutions, it could have a material market impact driving higher leveraged transactions further into the shadow banking market and increasing pricing.

For a more complete description and analysis of the 2013 Interagency Guidance and the FAQs, please contact Goodwin Procter’s Financial Institution Group members Bill Stern or Anna Dodson.