Investment bankers are already starting to push their compliance teams to allow aggressive deals in leveraged finance, as the stars begin to align for a loosening of post-crisis guidelines intended to curb excessive risk-taking, according to numerous leveraged finance bankers.
After the guidelines were officially opened up for Congressional review in October, the federal agencies tasked with enforcing them—the Fed, the OCC and the FDIC—signaled to Congress that they would be open to revising them.
Now that Congress and the agencies appear to be aligned, the odds of the guidelines being loosened have increased. Investment bankers said that within their institutions, sentiment toward more highly levered deals is already starting to shift, despite the fact that no specific changes to the guidelines have been announced.
“They’ve trial-ballooned it,” said a senior leveraged loans banker. “The market knew it was coming. You don’t have to actually get rid of the guidelines—you just have to send the right signals and then everyone starts to push a bit harder.”
The compliance staff at many banks that are tasked with ensuring their institutions don’t flout regulation are now coming under pressure from within to approve transactions that might previously have been considered too risky for an environment defined by an abundance of caution, the bankers added.
“We’re already starting to push our people a bit harder, to define [leverage] a little differently,” the banker said.
Heads of leveraged finance at two other investment banks insisted their banks were not yet taking such measures, but said they had seen signs of change at other institutions. Bankers are now less fearful of being hauled in front of regulators for underwriting deals that would previously have been subject to more scrutiny, said one of those sources.
“It would be more unusual now for a bank to get a letter from the head of the OCC, saying they are out of compliance,” said the first levfin head. “That should make people feel more comfortable they can get closer to the [leverage] limit.”
President Trump appointee Randal Quarles was confirmed as the Fed’s vice chairman for supervision in October, in a move seen as crucial to financial deregulation. The president also appointed Joseph Otting, a former employee of Treasury Secretary Steven Mnuchin at OneWest Bank, to run the OCC earlier this year. And this month he appointed Jelena McWilliams, formerly the chief legal officer at Fifth Third Bancorp, to head the FDIC.
Appetite to do the more aggressive deals never went away, even after the guidelines were introduced, said a second leveraged loans banker.
“We never stopped pitching those deals,” the banker said. “It was just that compliance wouldn’t let us do them anymore.”
But after spending the best part of four years adapting to a more punitive regulatory environment, compliance teams are unlikely to change their attitudes overnight.
“A lot of these guys were hired under the banner of ‘let’s make sure we have this place in shape and are complying,’” said the levfin head. “It will be hard to dismantle all that infrastructure. It will be an evolution.”
While banks are expected to ramp up leverage, the change is likely to be incremental, as bankers eager to satisfy their clients slowly chip away at the ingrained risk-averse mentality of their compliance departments, he added.
“It will be around the edges, with those deals that might have been borderline before,” he said. “Now we might think we can defend to an examiner that this deal has a 55% paydown over a certain period, based on profit margin improvements, whereas six months ago we might have said the examiner will never believe those projections.”
Unpopular but effective
The guidelines cap pro forma leverage at 6x for new deals originated by regulated banks, with additional requirements around how quickly debt needs to be paid down.
When the guidance was introduced in 2013, it quickly became clear that even though it was not a formal rule, regulators meant business when it came to enforcing it, informing banks of more frequent reviews and taking a harder line in late 2014.
Banks have still been able to push leverage over the 6x limit in certain cases, for example if leverage is projected to fall quickly enough after the deal. But still, the rules helped pull the average leverage in US buyouts down to a two-year low of 5.91x EBITDA in 2015, according to Thomson Reuters.
Both debt syndication teams and their private equity clients have complained bitterly about the restrictions, arguing that the 6x total leverage limit is arbitrary and that they are the ones best placed to determine underwriting risks.
Borrowers wanting to exceed the guidance looked to the non-regulated banking sector, helping institutions like Jefferies, Nomura and Macquarie to increase their share of origination fees.
Around 20% of leveraged loan deals in 2017 were arranged entirely by non-regulated banks, compared to 6% of deals in 2013, according to Debtwire data. In terms of deal volume, deals without a regulated bank on the syndicate accounted for 3.8% of the market in 2017 versus 1.9% in 2013.
If regulated banks become more aggressive, they will be able to compete for more of those deals, said both of the levfin heads. “More of the regulated banks will regain the market share that we lost to the Jefferies of the world,” said one.
Political resistance to the rules has been led publicly by Republican lawmakers—many with strong industry ties—opposed to what they see as government overreach. At the urging of US Senator Pat Toomey, the Government Accountability Office (GAO) announced in October that the guidance constituted a formal rule and was subject to the Congressional Review Act (CRA)—meaning it could be invalidated by Congress.
The CRA process also bans any attempt to reinstate the voided rules at a later date, potentially crippling any future regulation that restricts leveraged lending. US legislators now have 60 Congressional days, which could stretch into spring 2018, to review the guidelines.
However, now that the agencies that enforce the guidelines have said they are open to reviewing them, change could well happen outside of the CRA process—especially given the political environment, according to Elliott Ganz, general counsel at the Loans Syndications and Trading Association.
“The heads of the banking agencies are all changing,” he said. “Those new leaders may be more amenable to reworking the guidelines.”
Whatever the process, change appears to be on the horizon—but it may take a while to filter through into new deals, said market participants.
“It is about changing a mindset, and turning around the mentality of ‘less risk is better’ in these big banks,” said David Knutson, head of credit research at Schroders. “People don’t realize how much work goes on behind the scenes to get one of these deals to market, even after you see some regulatory relief. We are not going to see banks go hog wild in 2018—it will take time.”