Comptroller of the Currency Joseph M. Otting told lawmakers that increased liberalization in the leveraged loan market carries the risk of destabilizing the economy, and nonbank financial institutions are leading the charge.

During testimony May 15 before the House Financial Services Committee, Otting said that federal banking agencies have increasingly observed transactions that include elevated leverage, including fewer and less stringent protective covenants, more liberal repayment terms, and incremental debt provisions "that allow for increased debt that may inhibit deleveraging capacity and dilute repayment to senior secured creditors."

"Although supervised banks originate a significant portion of leveraged loans, nonbank entities have substantially increased their purchases of leveraged loans," Otting testified. "Most of the problem loan leveraged loan exposure is held outside of the regulated banking system where there is much less transparency. While purchases of leveraged loan participations by nonbank entities allows the risks to be shared more broadly, the nonbank entities may not be required to hold the levels of capital and liquidity that supervised financial institutions must hold to protect them in an economic downturn or during a period of market disruption."

As ABL Advisor previously reported, the Federal Reserve's Financial Stability Report for May warned that debt owed by the business sector has expanded more rapidly than output for the past several years, pushing the business-sector credit-to-GDP ratio to historically high levels.

According to Otting: "Leveraged loans can also present indirect risk and we will continue to assess OCC regulated banks’ management of risks from lending to leveraged loan investors, lending to and investing in collateralized loan obligations, and from other borrowers that may have critical suppliers or vendors that are highly leveraged. In addition, although less transparent to the federal banking agencies, we will continue to monitor nonbank leveraged lending activity and its potential impacts to the extent possible."

Click here for Otting's full testimony.