Recent research by Board staff, using a database of loans primarily to U.S. borrowers but also to some foreign borrowers, suggests that lenders have indeed originated an increased number of risky syndicated loans post-crisis, based on the assessed probability of default as reported to bank supervisors. Regression results confirm that the average probability of default is significantly inversely related to U.S. long-term interest rates. This increase in riskiness of syndicated loans post-crisis has been accompanied by a shift in the composition of loan holders: An increasing share is now held not by banks but by hedge, pension, and other investment funds (figure 2). These nonbank investors also tend to hold loans with higher average credit risk (figure 3). These data suggest that a tougher regulatory environment may have made U.S.-based bank originators unable or unwilling to hold risky loans on their balance sheets.

Some additional potential regulatory devices are already under active consideration, both among U.S. bank supervisors and in international forums. These include proposals to create special charges on firms based on their systemic importance, to require contingent capital that would be available in periods of stress, and to counter pro-cyclical tendencies by establishing special capital buffers that would be built up in boom times and drawn down as conditions deteriorate. Each of these ideas has substantial appeal. A number of thoughtful proposals are being discussed, though each idea presents considerable challenges in the transition from good idea to fully elaborated regulatory mechanism.

Yet to gain traction are proposals for what might be termed structural measures--that is, steps that would directly affect the nature and organization of the financial services industry. But discussion of such concepts is clearly increasing.

One suggested approach is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions, although separating trading from hedging and other prudent practices associated directly with lending is not an altogether straightforward proposition.

In any case, this strategy would seem unlikely to limit the too-big-to-fail problem to a significant degree. For one thing, some very large institutions have in the past encountered serious difficulties through risky lending alone. Moreover, as shown by Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat. Still, imposition of higher capital and liquidity requirements for riskier trading and other capital market activities can, if well devised and implemented, achieve some of what proponents of this approach seem to have in mind.

Complacent investors also may be willing to buy new debt offerings that are light on traditional covenants if they come to believe that outcomes are assuredly benign.  Moreover, without strong covenants on existing debt, firms can raise additional funds without triggering defaults, which may decrease defaults in the short run, but perhaps increase them in the long run.  In these cases, this “gloss” of confidence could cause a misallocation of resources, if companies or consumers without compelling prospects for full repayment nonetheless readily obtain credit. 

Another area of possible financial risk that we are watching is leveraged lending.  Business borrowing for mergers and acquisitions and for corporate refinancing has been quite robust over the past few years as firms have taken advantage of relatively low interest rates to reduce their cost of capital.  As underwriters have brought these deals to the market, the good earnings of corporate borrowers and several years of very low defaults have encouraged lenders and investors to fund hundreds of billions of dollars in leveraged loans.  However, with this growth we are seeing some trends in the leveraged loan market that warrant closer monitoring:  Deals continue to be structured with thin pricing, more leverage, and looser covenants than is typical for non-investment-grade borrowers.  Further, originating banks are capitalizing on the strong investor demand for these loans by underwriting to distribute them, including through securitization, while holding only nominal exposures themselves. 

As supervisors, we want to ensure that loan-to-value standards and debt-service-coverage ratios are meeting the organization’s policies--and that there is not an undue increase in the exceptions to those standards and ratios. We also continue to monitor whether lenders routinely adjust covenants, lengthen maturities, or reduce collateral requirements. To be clear, we have not yet seen underwriting standards fall to unsatisfactory levels on a broad scale, but we are concerned about some of the downward trend in these standards.