BANKS ARE A PROXY FOR CREDIT BUBBLE FEARS / THE FINANCIAL TIMES

On Wall Street

March 7, 2014 9:07 am

Banks are a proxy for credit bubble fears

By Tracy Alloway in New York

Regulators better able to target banks in quest to eliminate risk

Can nothing stop the runaway capital markets train? It seems not, after the US delivered record corporate bond sales this week, despite significant geopolitical turmoil to the east and growing concerns that markets are becoming overstretched.

Sales of corporate debt and leveraged loans have boomed in recent years. Issuance figures are through the roof and some hallmarks of pre-financial crisis lending practices have returned. The amount of borrowing used to fund the leveraged buyouts undertaken by big private equity firms is creeping back to levels last seen in 2007, for instance.

The issue has not escaped regulatory attention. Authorities including the Federal Reserve and the Office of the Comptroller of the Currency have sent letters to major banks asking them essentially to cut back on making riskier loans.

Regulatory guidelines issued last year mean that bankers need to think seriously before underwriting a loan that is more than six times “levered” or that fails a number of other tests aimed at gauging the deal’s perceived riskiness.

Understandably, the regulatory edict has not been wildly popular with the bankers who make a living by facilitating these deals. They argue that the authorities are targeting leveraged loans facilitated by banks not because they are worried about the banks themselves taking on too much risk – since the loans are sold to investors they rarely remain on bank balance sheets – but because they are concerned about overheating in the wider credit markets.

Sympathising with bankers is likely to set off a symphony of the world’s tiniest violins, but they have hit upon a point worth exploring.

Although the continuing acceleration of the stock market has made all the headlines in recent months, it is the credit market that has been experiencing the biggest boom since the US Federal Reserve began its unconventional monetary policies in 2009. While $132bn has flowed into global equity funds in the past five years, a staggering $1.2tn has poured into global bond funds, according to net figures from Goldman Sachs.

“Regulators believe they’ve created a credit bubble,” says one leveraged loan banker, bemoaning the regulatory crackdown on his business. “But if the banks can’t do a loan, the private equity guys could simply go out to a bunch of hedge funds and basically underwrite the deal themselves.”

And while it comes as no surprise to hear bankers take this view, their position has been given some serious support by a quartet of highly respected academics.

In a paper published last week*, Michael Feroli, Anil Kashyap, Kermit Schoenholtz and Hyun Song Shin argue that regulators should be taking a wider view when considering the issue of a potential credit bubble.

Taming the credit market “cannot easily be accomplished via the usual list of macroprudential tools such as bank capital ratios, bank liquidity requirements, haircut regulation on repurchase agreements or loan to value ratios”.

Without precise tools directly to address overheating in the wider system, regulators are in effective forced to rely on a more surreptitious route by going through the banks over which they exert far greater control.

The problem is that focusing on bank regulation may well end up being a blunt instrument that is not be best suited to the job at hand.

Banks’ holdings of corporate debt have shrivelled to a size that would make the “Big Swinging Dicks” – the 1980s bond traders described in Michael Lewis’ Liar’s Poker – hang their heads in embarrassment.

In terms of credit, the best-endowed Wall Street players are now at places like Pimco and Apollo. These are large institutional investors who have built up huge credit portfolios worth hundreds of billions of dollars but who remain largely outside the grasp of traditional financial regulation.

In the discussion surrounding the leveraged lending guidelines, there is a tentative recognition that the next financial crisis may not begin in the banking system but with the buyside investors whom bankers claim to serve.

The good news is that a crisis concentrated among buyside investors is, in theory, unlikely to generate the kind of amplified fallout that rippled through the wider financial system when Lehman Brothers collapsed in 2008.

This is arguably what regulators were aiming for when they focused their post-crisis energies on cracking down on leveraged institutions in the financial system – namely, the banks.

The bad news, of course, is that the longer the capital markets train runs on, the greater the potential fallout should it come to an abrupt halt.


*Market Tantrums and Monetary Policy – a report for the 2014 US Monetary Policy Forum

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