Regulators address leveraged finance risks

US regulators are working to create an updated set of guidelines they say will provide additional protection for banks and other financial institutions that have been left holding risky leveraged loans on their balance sheets.

The Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency have proposed a revised version of lending guidelines to the rules issued in 2001. The three agencies are requesting comments on the proposed revisions. The rules are being updated in part to address an increase of debt agreements containing limited levels of lender protection.

“While there was a pull-back in leveraged lending during the crisis, volumes have since increased while prudent underwriting has deteriorated,” according to a statement.

Despite the resurgence of leveraged loans after the economic crisis, demand for such risky debt offerings has not rebounded. As a result, banks and other institutions have been unable to offload what was once a highly sought-after product.

“This was not just a periodic update,” a spokesperson for the Office of the Comptroller of the Currency told Private Equity Manager. “It was conducted to address weakness and changes in the industry since 2001.”

Prior to the economic crisis, institutions that lent into “covenant lite” private equity deals had limited protection against borrowers that defaulted on loans.

“It’s understandable that the regulators would like to prevent a recurrence of the aggressive lending that characterized the boom period,” global credit strategist at BNP Paribas Investment Partners Martin Fridson told the Wall Street Journal. “This really comes down to how much self-restraint the regulators will expect the banks to show.”

The leveraged finance guidance will affect larger institutions but not smaller banks that don’t hold leveraged loans on their balance sheets.

The amendments suggest a risk-management framework that would identify an institution’s risk appetite for leveraged finance, set “appropriate credit limits” and “ensure prudent oversight of the approval process”, according to the statement.

Other key areas for revision include underwriting standards such as expectations for cash flow capacity, amortisation and covenant protection.

Comments on the proposed guidelines are welcomed by the agencies with a deadline of the 8th June 2012.