Regulators are concerned that banks are loosening their standards for one of the riskiest forms of corporate lending, a trend that harkens back to perilous practices common in the run-up to the financial crisis.
In the past 18 months, banks have relaxed the criteria they use to determine whether to issue loans to highly indebted companies, a type of borrowing known as leveraged finance, according to a report on risk released Thursday by the U.S. Office of the Comptroller of the Currency.
The agency, which regulates national banks such as Bank of America and JPMorgan Chase, is noticing more institutions allowing companies to take on higher levels of debt. Banks are also signing off on deals that provide limited lender protection if the borrower fails to keep up with payments.
Although the activity has not reached pre-crisis levels, regulators are keeping a watchful eye on the trend.
“We’ve seen underwriting standards broadly easing, which is kind of a normal part of the cycle as we come off very tight lending criteria,” said Darrin Benhart, deputy comptroller for credit and market risk at the OCC. “But in the leveraged space, the standards are really concerning.”
Leveraged financing is a popular source of funding for corporate acquisitions and private-equity buyouts. These loans are often carved up and sold to pension funds and hedge funds, which are attracted to their high yields. Banks were churning out these loans before the financial crisis, but once investors lost their appetite for risk, lending dissipated.
Demand for leveraged loans has taken off this year as low interest rates have enticed companies to borrow more money or refinance their debt. Investors are once again taking a shine to these loans in search of higher returns.
Banks have issued $464 billion in leveraged loans so far this year, compared with $480 billion for all of 2006 and $535 billion in 2007, the peak of the cycle, according to Standard & Poor’s.
“The activity is getting close to pre-recession level, which is why we are concerned. The underwriting levels are not quite back to that period, but they are clearly on a trend line,” Benhart said. “The key driver is banks are seeking some type of earning asset.”
One of the more troubling trends regulators are tracking is the rise of “covenant lite” deals — arrangements that lack controls that banks use to monitor how a loan is being paid. Those types of deals constitute about 30 percent of the market.
Benhart noted that a lot of these deals are not sitting on banks’ balance sheets as they are typically pooled into securities, but regulators remain wary of high volumes of risky products being pumped into the marketplace.