The Federal Reserve is taking increased levels of riskier corporate borrowing seriously, but comparisons to the subprime mortgage lending crisis are "not fully convincing," Fed Chairman Jerome Powell said May 20.
In his most detailed comments yet on the issue, the Fed chief sounded some warnings over leveraged lending and other forms of riskier corporate borrowing, noting that business debt is at historically high levels and should give firms and investors "reason to pause and reflect."
But Powell pushed back against worries that business debt loads could spark the next financial crisis, saying regulators are closely monitoring the issue and that post-crisis rules have made the financial system much more resilient to stress.
"The parallels to the mortgage boom that led to the Global Financial Crisis are not fully convincing," Powell said in prepared remarks he delivered at an Atlanta Fed conference on financial markets. "Most importantly, the financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages."
His comments come amid growing attention from regulators on leveraged loans, a subset of the corporate debt market for non-investment grade firms where loans outstanding now total more than $1 trillion.
Underwriting standards on leveraged loans have weakened, and stronger covenants intended to protect lenders "may be an endangered species," Powell said. Nonbank lenders have fueled much of the lending in the sector, with collateralized loan obligations and mutual funds accounting for most of the outstanding loans, he said.
Business debt has grown faster than GDP for several years, but Powell described it as a "steady upward plod in borrowing over the long expansion" that looks to be consistent with a typical business cycle. He also contrasted it to the mortgage credit boom, which he said was "far outside historical norms."
A sudden economic downturn could lead to "severe strains" for overly indebted firms and put pressure on those nonbank lenders, Powell said. It could also amplify an economic downturn if businesses are forced to lay off workers, an issue that Powell said companies and regulators need to focus on "today, while times are good."
But Powell said that the post-crisis regulatory framework made banks "fundamentally stronger and more resilient" to shocks, noting that the Fed's stress tests have forced big banks to prepare themselves against more dire downturns as the economy has improved. Capital levels outside the banking system are also healthier, and the overall financial system relies less on the short-term wholesale funding sources that caused a liquidity crunch during the crisis, Powell said.
Still, Powell said that officials "cannot be satisfied with our current level of knowledge about these markets," particularly the potential vulnerabilities among financial institutions if the leveraged loan market turns sour.
Regulators are "committed to better understanding the areas where our information is incomplete," Powell said, pointing to the Financial Stability Board's work to gather data on the global leveraged loan market. The group of international regulators is chaired by Randal Quarles, the Fed's vice chairman for supervision.
In the U.S., interagency discussions through the Financial Stability Oversight Council are helping regulators at different agencies collaborate and get a better sense of the "larger picture and the risks it holds." For example, he said, the Securities and Exchange Commission is studying potential liquidity stresses at mutual funds, while the Commodity Futures Trading Commission is looking at how investors use derivatives to hedge against risks associated with leveraged lending.
He also pointed to the banking regulators' work on the Shared National Credit Program, through which the Fed works with other federal banking agencies to evaluate how banks are managing leveraged lending risks.
"We take the risks from business debt seriously but think that the financial system appears strong enough to handle potential losses," Powell said. "We also know that our dynamic financial system does not stand still. We can always learn more about financial markets, and we will always act to address emerging risks."