Almost 50% of 2014 U.S. private-equity deals breached bank regulators' leverage guidance

News report: Federal Reserve Demands Bank to Address Problems With Leveraged Lending

It was only a few months ago that I pointed you to a tongue-lashing doled out to the U.S. banking industry by a Federal Reserve supervisor (see prior post “Bloomberg: Regulators stand by while U.S. bank lenders get footloose” May 14-14). Things have gotten worse since then, and the Fed is now making examples of banks in writing, such as Credit Suisse, as reported by Gillian Tan and Ryan Tracy in the WSJ last week:

The Swiss bank in recent weeks received a letter from the Federal Reserve demanding the bank immediately address problems with its underwriting and sale of leveraged loans, or high-interest-rate loans used by private-equity firms and others to finance purchases of companies, among other uses.

The letter to Credit Suisse, known as a Matters Requiring Immediate Attention, found problems with the bank’s adherence to guidance issued last year, warning banks to avoid deals that included too much debt or too few protections for the lenders in case of a default, according to the person familiar with the matter.

These topics are of great interest to anyone in the specialty finance space, since banks are granted a host of benefits by the government that aren’t available to the rest of the private sector. The luxury of deposit insurance means that many U.S. banks have a cost of funding of less than 0.25%, versus the 6-10% cost of capital that the rest of the market lives with. There’s also the matter of balance sheet leverage. Many banks carry loan books which approach 18x their equity capital, versus the zero to two times leverage of the non-bank sector.

Those two luxuries make for a very nice business model indeed, and since the taxpayer is on the hook, society requires that bank regulators do their jobs. According to the WSJ, banks are pushing back:

Banks dispute the risk levels attached to leveraged lending and said they are taking steps to ensure strong underwriting standards are applied to such loans.

They said Washington’s efforts are driving more financing into unregulated sectors of the financial system, putting banks at a competitive disadvantage to other lenders.

Now, if the bank managers don’t like the fact that regulators are mandating that they should require covenants on every commercial loans, and must abide by certain leverage limits, they should be forced to read every NYT or Wall Street Journal edition from 1928, 1929, 2007, 2008 and early 2009. If that refresher isn’t sufficient, bank regulators need to outline for management the steps a bank can take to shed itself of deposit insurance, de-lever the balance sheet, and live with the consequences just as every other private lender that doesn’t benefit from the inherent government guarantee that keeps them in business.

Banks have a structural competitive advantage over the rest of the lending space, which is why their market share is so overwhelmingly high. It is disingenuous to complain about the apparent luxuries of the non-bank lending space, and Regulators shouldn’t duck from doing their jobs.

MRM