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US bank regulators on March 21st issued a guidance on leveraged loans.  The regulators—from the Federal Reserve, the Comptroller of the currency and the FDIC—apparently are concerned that US banks are loosening their credit standards for highly leveraged loans.  Standards are looser, the thinking goes, because most banks sell off these loans.  The buyers—typically pension funds and insurance companies—are seeking higher interest rates, so are willing to accept higher risk.  The guidance tells banks that the regulators are going to closely monitor underwriting of these loans.

 

What neither the guidance nor the Federal Reserve statement regarding it do, however, is address the primary (if not sole) reason for the banks’ and buyers’ actions:  extraordinarily low interest rates.  The Federal Reserve, by keeping rates low, is forcing investors to take greater risks to meet their return expectations/needs.  Banks, eager to put funds to work, but unwilling to increase their risk, are more than happy to meet market demand.

 

In other words, the Federal Reserve is encouraging risky behavior, while federal banking regulators are admonishing participants not to do so.

 

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