A Lesson on Financial Risk, Leveraged Lending Edition

Last Friday, US financial regulators rolled back one of the safeguards implemented over a decade ago: their guidance on leveraged lending. The guidance aimed to ensure a “safer” financial system after the 2007 – 2009 global financial crisis by providing clear lines around standards the government dubbed risky. Now, more than 12 years later, regulators apparently have determined the old system governing leveraged lending wasn’t so bad. The round trip, and some of the story behind it, offers a useful lesson for investors: You can’t really de-risk the financial system, which is worth keeping in mind whenever chatter about new regulations—or their rollback—arises. This story of leveraged lending guidance is instructive in this regard.

Let us visit ghosts of Christmas past, dear reader, when the global financial crisis inspired a boatload of new rules for the financial sector. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which sought to prevent the “excessive risk-taking” many politicians alleged was the root of the crisis. Internationally, governments agreed to a regulatory framework for banks (Basel III). Amid this alphabet soup of new rules, the FDIC, Office of the Comptroller of the Currency (OCC) and Fed issued their “leveraged lending guidance” in 2013.

Officials sought to address weakening lending standards, as many blamed the crisis on “bad” mortgages extended by banks lending aggressively. Regulators cracked down on that—and extended the logic to corporate lending—which was part of Washington’s attempt to address behavior it cast as potentially harmful to the financial system. They pressured banks to forgo making loans worth more than six times a company’s annual earnings, calling those deals “too risky.” The guidance wasn’t a hard rule, but the financial industry interpreted it as binding—understandable considering the stigma banks carried post-2008.

But as well-intentioned as regulatory efforts may have been, none of these rules and reforms would have prevented the financial crisis. It is true American lending standards eased after the SEC relaxed its Net Capital Rule in 2004, which allowed the biggest Wall Street firms to increase their leverage while the government also encouraged more loans to lower-income folks. That is part of the backdrop of how certain illiquid assets ended up on financial institutions’ balance sheets. But these weren’t central to the financial crisis. Rather, the trigger was the mark-to-market accounting rule (FAS 157) that took effect November 2007, which changed overnight how these illiquid, hard-to-value securities affected banks’ financial position on paper. Banks had to treat all assets on their balance sheets as if they had to sell on a day’s notice.

This isn’t a problem for stocks, which have frequent, publicly available pricing. But for more complex, illiquid assets like securitized loans? Far harder. FAS 157 required banks to mark to the latest price for a comparable security, which led to a disastrous spiral when some hedge funds sold securities at fire-sale prices to meet margin calls, followed by several banks who wished to simply “clean” their books. That kicked off a destructive feedback loop, which decimated trillions of dollars of bank capital. FAS 157 turned about $200 billion in expected loan losses into $2 trillion of writedowns, crushing lending capacity and freezing credit.^[i] Combine this with the US government’s schizophrenic response, which only fomented uncertainty about which firms would be bailed out and which forced to fail, and markets crashed and the economy tanked.

Whatever the intent, there is a reality to reckon with: You can’t de-risk the financial system. Activity will simply morph or migrate. Now, leveraged lending guidance did “work” in that it discouraged banks from pursuing those deals. For instance, in 2014, traditional lenders reported ongoing confusion over guidelines—which were in effect for nearly two years at that point—and some complained they were missing out on lucrative opportunities due to this uncertainty.^[ii]

But those deals weren’t cancelled. They went through. How? Leveraged lending went to other corners of the market. Pundits initially called this shadow banking, a moniker with a nefarious tilt.^[iii] It calls to mind credit transactions taking place in dark alleys. But in reality, it is just lending that happened outside the traditional, highly regulated and documented banking system. Today it has another name: private credit. According to the Bank for International Settlements, leveraged lending grew by approximately $600 billion between 2010 – 2018.^[iv]

That said, it is wrong to assume traditional banks weren’t exposed to the leveraged lending space, as they were providing capital to the very companies funding private credit loans. Per the Boston Federal Reserve, large banks’ loan commitments to private equity and private credit funds grew from around $10 billion in 2013 to $300 billion in 2023.^[v] As for worries this surge in private lending is planting seeds of future trouble, we agree there are weak spots—as evidenced by some high-profile, privately held firms’ bankruptcies a couple months ago. But as we wrote in October, the market recognizes a handful of company failures in a niche economic segment doesn’t spell trouble for the financial system at large.

With their leveraged lending guidance now a relic of the past, the FDIC and OCC are saying banks should apply “general principles for prudent risk management,” aka, do what they always did pre-2008. Fair enough. Leveraged lending guidance did make it tougher for banks to perform one of their core roles in the economy directly (i.e., providing capital for businesses). But we wouldn’t say rescinding the guidance is necessarily better or worse since leveraged lending isn’t innately “good” or “bad”—just as regulators aren’t “right” or “wrong” for wanting to reduce risk.

A basic truth about fractional reserve banking is that the system is inherently risky. Consider the business model: Banks borrow short-term money (deposits) to make longer-term investments (loans). Nothing guarantees an investment’s return. A borrower may not make good on their obligations due to poor management, industry-specific headwinds and/or macroeconomic conditions turning south. Regulators can mandate basic safeguards and guardrails (e.g., capital requirements) on the financial sector, which can provide a buffer against losses. But just as water always finds a way to its own level, firms seeking capital are likely to find a source—whether from a traditional bank or a private lender.

The OCC seemed to recognize this reality, as one expert said the regulator hasn’t been enforcing compliance for years.^[vi] Why have guidance if you don’t back it up and instead allow the same exposures to grow indirectly anyway? In this vein, rescinding the guidance is more formality than gamechanger. And, positively, if more traditional banks engage directly in leveraged lending, it will likely be more transparent and visible to the market.

Investors benefit from keeping these regulatory matters in mind. Beyond understanding the limits of financial rules and guidance, remember that participating in financial markets means accepting a certain amount of risk—which no rule or regulation can ever fully remove.