Agencies Propose Revisions to Leveraged Finance Guidance
In a joint news release, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (the agencies) are seeking comment on proposed revisions to the interagency leveraged finance guidance issued in 2001. Transactions that are covered by this guidance are characterized by a borrower with a degree of financial or cash flow leverage that significantly exceeds industry norms as measured by various debt, cash flow or other ratios.
The agencies observed tremendous growth in the volume of leveraged credit leading up to the crisis and in the participation of non-regulated investors. While there was a pullback in leveraged lending during the crisis, volumes have since increased while prudent underwriting practices have deteriorated.
The agencies said as the market has grown, debt agreements have frequently included features that provide relatively limited lender protection, including the absence of meaningful maintenance covenants and the inclusion of other features that can affect lenders’ recourse in the event of weakened borrower performance. In addition, capital structures and repayment prospects for some transactions, whether originated to hold or to distribute, have been aggressive. Management information systems (MIS) at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis, and many institutions have found themselves holding large pipelines of higher-risk commitments at a time when buyer demand for risky assets diminished significantly.
Leveraged finance is an important type of financing for the economy, and banks play an integral role in making credit available and syndicating that credit to investors. It is important that banks help provide financing to creditworthy borrowers in a safe and sound manner, the agencies noted.
In light of the market’s evolution, the agencies propose replacing the 2001 guidance with revised leveraged finance guidance that refocuses attention to five key areas: Establishing a Sound Risk-Management Framework; Underwriting Standards; Valuation Standards; Pipeline Management & Reporting and Analytics.
To read the full text of the joint news release posted by the FDIC, click here.