On March 22, 2013, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation (“FDIC”), and Office of the Comptroller of the Currency (collectively, the “agencies”) published “Interagency Guidance on Leveraged Lending (78 Fed. Reg. 17766) (the “Guidance”).

The stated purpose of the Guidance is to ensure that federally regulated financial institutions conduct leveraged lending activities in a safe and sound manner so that they do not heighten risk in the U.S. banking system or the broader financial system through the origination and distribution of poorly underwritten and low-quality loans. The agencies issued frequently asked questions (“FAQs”) on November 7, 2014, to further clarify and reiterate their expectations.

Definition of Leveraged Lending

The term “leveraged lending” is not defined in the Guidance or the FAQs. Instead, the agencies state that numerous definitions exist throughout the financial services industry, but they share certain common characteristics. The agencies identified the following common characteristics of leveraged loans:

• proceeds used for buyouts, acquisitions, or capital distributions;

• transactions where the borrower’s Total Debt divided by EBITDA or Senior Debt divided by EBITDA exceed 4.0X EBITDA or 3.0X EBITDA, respectively, or other defined levels appropriate to the industry or sector;

• a borrower recognized in the debt markets as a highly leveraged firm, which is characterized by a high debt-to-net-worth ratio; and

• transactions when the borrower’s post-financing leverage, as measured by its leverage ratios (for example, debt-to-assets, debt-to-net-worth, debt-to-cash flow, or other similar standards common to particular industries or sectors), significantly exceeds industry norms or historical levels.

The agencies explained in the FAQs that the common characteristics outlined in the Guidance should serve as a starting point for developing an institution-specific definition of leveraged lending. At a minimum, the agencies expect this definition to include borrower characteristics that are recognized in the debt markets as leveraged for each industry to which a bank lends.

The agencies indicated that a loan that meets one of the common characteristics identified in the Guidance should not automatically be considered a leveraged loan. For example, the agencies recognize that loans that are secured by tangible collateral and do not rely on enterprise valuations for repayment could be excluded from the definition of leveraged loans even if leverage exceeds three times senior debt or four times EBITDA, because the bank has additional sources of repayment beyond the cash flow from the operations of the borrower. Although leverage is an important indicator, it is not definitive and should be considered in relation to other loan characteristics. For this reason, the agencies expect that most loans secured by commercial real estate and small business loans would be excluded from an institution’s leveraged lending definition because such loans are usually secured by tangible collateral.

The agencies also indicated that in developing an institution-specific definition, banks should not adopt a definition solely based on the borrower’s use of the loan proceeds. The agencies believe that excluding a loan solely because the proceeds will not be used for a buyout, acquisition or capital distribution is inconsistent with a comprehensive leveraged lending risk management framework.

In addition, the agencies explained that the exclusion for asset-based loans (“ABLs”) provided in the Guidance is intended to be used only when ABL facilities are a borrower’s primary source of funding. Institutions should not exclude ABLs that are part of a borrower’s larger debt structure.

The agencies also clarified that the FDIC’s definition of a higher risk commercial and industrial loan for purposes of the deposit insurance assessment rule is not the same as the definition of a leveraged loan for purposes of the Guidance. Accordingly, the agencies will assess compliance with the Guidance and the deposit insurance rules separately.

Financial Stability Concerns

It is well known that prior to mid-2007, banks were entering into very large, long-term commitments to fund deals and were left holding approximately $350 billion in loans and commitments that they could not sell during the credit crunch. Remarkably, according to Federal Reserve Board Governor Jerome H. Powell (who spoke at the Stern School of Business on February 18, 2015), approximately $800 billion of institutional loans are now outstanding in the post-crisis market. This huge increase has been driven by the historically low interest rates on offer since the financial crisis which has increased investors’ demand for higher-yielding assets. In light of market conditions encouraging growth in leveraged lending in this way, the agencies have been focusing more on banks’ loan portfolios.

The Office of Financial Research (“OFR”), which is an office within the U.S. Department of the Treasury, indicated in its 2014 Annual Report that the Guidance had initially done little to curb banks’ risk-taking. Based on its research, the OFR reported that underwriting standards had continued to deteriorate and the overall volume of leveraged loans continued to rise. The OFR reported that before the Guidance was issued, new large corporate loans with leverage higher than six times EBITDA accounted for about 15 percent of total issuance. Approximately a year later, new loans with higher leverage made up about 33 percent of corporate bank loans.

According to the OFR, the results of the Shared National Credit Program indicate that there were gaps between industry practices and the expectations of the agencies articulated in the Guidance. The Shared National Credit Program, which was established in 1977 by the agencies to provide an efficient and consistent review and classification of large syndicated loans, covers a loan or loan commitment of at least $20 million that is shared by three or more institutions supervised by the agencies. In the past, the agencies performed a review of these loans on an annual basis. Recent reports indicate that the agencies will increase their syndicated loan reviews to twice a year in light of the supervisory concerns raised by leveraged lending. The agencies have broad discretion to further increase these reviews and it appears that some banks are already undergoing monthly reviews.

Approximately two years after the Guidance was published, banks are starting to decrease leveraged lending. Some industry analysts believe that this decrease among regulated institutions will provide an opportunity for unregulated lenders to step in to fill unmet financing needs, which has the potential to further inflate a credit bubble. The OFR refers to this phenomenon as risk migration and suggests that credit excesses may be tempered by the credit risk retention rule promulgated in October 2014, which generally requires banks to retain some of the economic exposure to loans that are securitized after origination.

The OFR also reported that after the Volcker Rule was finalized, banks stopped purchasing large shares of collateralized loan obligations (“CLOs”), which often include leveraged loans. Around the same time, hedge funds started to increase their shares of CLOs. The OFR cautions that increased investment in corporate bond funds may pose a threat to financial stability because investors expect fund managers to liquidate assets faster than they are capable of being liquidated. However, the OFR suggests that these risks can be mitigated by imposing withdrawal fees on certain funds to discourage a “run” on the fund due to a large number of simultaneous redemptions.

Potential Regulatory Action in Europe

According to recent reports, the Bank of England has approached the Loan Market Association on an informal basis to gain insights on leveraged lending by UK banks. Industry commentators have suggested UK regulators are preparing to take actions similar to the actions that their American counterparts have already taken by imposing a leveraged loan cap. If such actions are taken in the UK, this could have a significant impact on the financial markets across Europe. It is not clear whether other regulators in Europe would follow the U.S. example, but we will continue to monitor the situation.

The full and original memorandum was published by Hogan Lovells on March 26, 2015 and is available here.