In response to concerns over the systemic risk that leveraged lending can have on the financial system, federal regulations have attempted to limit this type of lending by prescribing various guidelines impacting the underwriting, originating, and servicing of leveraged loans. A recent study found that these regulations reduce risk in some instances, but also have the effect of shifting risky loans from traditional banks to nonbank lenders, such as private equity funds and other alternative funding sources.

A staff report on so-called “macroprudential policy,” released in May 2017 by the Federal Reserve Bank of New York, studied the impact of both an Interagency Guidance on Leveraged Lending issued in March 2013 and a subsequent clarification FAQ issued in 2014 (together, the Guidance).

Macroprudential policy attempts to address and mitigate systemic risks to the financial sector and serves as a direct response to the perceived regulatory inadequacies that led to the financial crisis of 2008. The purpose of the Guidance, according to the researchers, is to “ensure that federally regulated financial institutions conduct leveraged lending activities in a safe and sound manner so that these activities do not heighten risk in the banking system or the broader financial system through the origination and distribution of poorly underwritten and low-quality loans.” To achieve that goal, the Guidance sets forth minimum standards for underwriting and valuations, best practices and expectations for pipeline management, risk rating, credit analysis, management and review, and stress testing.

The study found that the result of the initial Guidance was nothing. In fact, leveraged lending by banks increased in the year and a half between its release and the subsequent clarification FAQ. The New York Fed researchers suggested this was because the original Guidance lacked “specific numeric thresholds,” failed to “include a definition of what constitutes a leveraged loan,” and lacked “clear penalties for noncompliance.” The 2014 FAQ clarified, among other things, that the “guidance applied to leveraged lending activities of both bank and nonbank subsidiaries of bank holding companies, to new loans as well as loans acquired in the secondary market, and to loans originated to hold as well as to loans originated for complete distribution to other lenders.”

After the Guidance was clarified, there was a significant decrease in leveraged lending, but only for one segment of the banking system: large banks overseen by the Fed’s Large Institution Supervision Coordinating Committee (LISCC). The market share of leveraged loans issued by LISCC banks between the FAQ release and the end of the study period (December 2015) fell by 11 percent (by number) or 5.4 percent (by volume). Targeted enforcement by LISCC supervisors was likely the source of the decline.

In addition to a decrease in leveraged lending from large, LISCC-regulated banks, researchers found significant increase in leveraged lending on the part of nonbank entities. In the year between the FAQ and December 2015, nonbanks saw their leveraged-lending market share increase by 50 percent (by number) or 100 percent (by volume). Interestingly, the nonbank lenders borrowed money from the large, LISCC-regulated banks in substantial amounts. This means that while the large, LISCC-regulated banks were not making direct leveraged loans to corporate borrowers, they were still participating – albeit indirectly – in the very loans the regulations had sought to curtail. The study also found that nonbank lenders have different underwriting criteria and risk tolerances than bank lenders, noting that nonbank lenders are less likely to require that loans be secured, but are more likely to impose restrictions on dividends and distributions and to extend shorter term loans.

While this shift to nonbank lenders may diminish the leveraged lending risk in the banking sector, it very well may have the unintended consequence of increasing risk across the entire financial sector.