Banks’ Stress Tests to Focus on Leveraged Lending

The 2020 tests will give the Fed "increased information on how leveraged loans and collateralized loan obligations may respond to a recession."
Matthew HellerFebruary 7, 2020

The “global shock” portion of the Federal Reserve’s stress tests for the largest U.S. banks has a new focus on leveraged lending this year, reflecting concerns over the rapid growth of the corporate debt market.

The Fed announced Thursday that in the 2020 stress tests, banks must evaluate how they would respond to a severe global recession that causes elevated stress in corporate debt markets and commercial real estate.

In the “severely adverse” scenario, a broad selloff in corporate bonds and leveraged loans hits an array of risky credit instruments and private-equity investments, sending shocks through a variety of markets.

“This year’s stress test will help us evaluate how large banks perform during a severe recession, and give us increased information on how leveraged loans and collateralized loan obligations may respond to a recession,” Randal Quarles, the Fed’s vice chair for supervision, said in a news release.

The stress tests examine how banks with more than $50 billion in assets would perform under hypothetical future scenarios of varying degrees of economic stress. If banks fail to maintain a minimum capital level throughout each of the scenarios, they can be penalized by blocking their payments of dividends.

The Fed also plans to test banks with substantial trading or processing operations against a hypothetical counterparty default as part of the 2020 round of stress tests.

As Reuters reports, the Fed’s focus on leveraged lending “comes after regulators and some in the [banking] industry have aired concern for years over the rapid growth in the corporate debt market, particularly in loans to already heavily-indebted firms.”

Leveraged loans are typically extended by banks to low-rated corporate borrowers, with many being packaged into collateralized loan obligations. U.S. non-financial corporate debt has risen to a record high of nearly 47% of gross domestic product, according to regulators.

Eleven of the 34 largest U.S. banks, including Goldman Sachs, Morgan Stanley, Citibank, Wells Fargo and JPMorgan Chase, will be subject to the leveraged lending component of this year’s stress tests.