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Leveraged loan risks lurk amid OCC's rosy credit outlook for banks

While underlying fundamental factors of economic growth in the U.S. are strong, there are still risks to the banking industry, according to a banking regulator's report released May 20.

One of the key threats to stability is the prevalence of leveraged lending, the Office of the Comptroller of the Currency wrote in its "Semiannual Risk Perspective" spring report.

Banking regulators found that many leveraged loan transactions have "weak structures with increased reliance on revenue growth or anticipated cost savings and synergies to support borrower repayment capacity."

Leveraged lending, or lending to companies with already-high levels of debt obligations, has received continual scrutiny from other federal regulators. While regulators, industry stakeholders and others have underscored leveraged lending as a risk, none have set off sirens about the issue.

The report also stopped short of a call for a complete withdrawal from the space. It emphasized positive credit quality trends across the banking industry by all metrics, including delinquencies, nonperforming loans, net charge-off rates, and allowance for loan and lease losses.

The report from the OCC noted that it is difficult for banking regulators to fully examine the risks in leveraged lending, as much of the credit risk associated with it lies outside the banking industry.

Still, the report noted that a "material downturn in the economy could result in a significant increase in classified exposures and higher losses." Banks should remain alert to any direct and indirect risks they may face from leveraged lending, the report said.

On a conference call with reporters to discuss the report, Comptroller of the Currency Joseph Otting said leveraged lending is a concern for the agency.

"While most of the risk is held outside the bank, we are watching for potential indirect efforts to affect banks we oversee," Otting said. "We expect entities to understand the food chain, meaning their suppliers, their distributors [and] their customers, for their potential risk in that process," Otting said.

Otting's comments are similar to statements he made before the House Financial Services Committee during a regulator hearing days before the report was released. The comptroller said in prepared remarks during the hearing that nonbank financial institutions may not be required to hold the levels of capital and liquidity that supervised financial institutions must hold to protect them during times of economic stress.

The OCC report also flagged the uncertain environment for deposit costs as one risk for banks, noting that they will have to adjust to "untested depositor behavior after an extended low-rate environment." Technological changes have made it easier for customers to move their funds to online institutions, increasing competition for deposits with local banks.