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5/21/2018 Banks might not have long to cheer for reg relief | American Banker
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BankThink Banks might not have long to cheer for reg relief
By Mayra Rodríguez Valladares Published May 21 2018, 10∶13am EDT
More in Regulatory reform, Regulatory relief, Dodd-Frank, Consumer lending, Commercial lending, CLOs, Leveraged loans, Auto lending, Credit cards, Subprime lending
It has been a decade since Bear Stearns imploded, and bankers are ready to stock up on
champagne for the likely passage of significant legislative changes to the Dodd-Frank Act.
But before they uncork those bottles, they should be put on notice that credit signals are not
good.
Recent data show that commercial and industrial loans extended are at the highest point they
have ever been since the Federal Reserve started tracking the data in the 1940s. Since 2009,
corporate debt has been growing faster than consumer debt.
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And there are additional worrying signs: The leveraged loan market has, for example, doubled
in just five years to $1 trillion. This growth comes despite new guidance about better risk
management requirements for leveraged loans released by the Fed and the Office of the
Comptroller in 2013. In April 2018, covenant-lite, first-lien institutional loans outstanding hit a
record high of 77% of that market. Covenant-lite loans typically come with fewer periodic
financial performance obligations for the borrower that other loans require. This is a significant
rise from 2007 when these types of loans represented about 20% of outstanding leveraged
loans in the U.S.
When an economic downturn begins, these covenant-lite loans are at higher risk of default
than other similar loans because lenders have fewer protections. Not only are banks at risk
when they hold these loans on their balance sheets, but so are a wide array of global investors
in collateralized loan obligations, which are disproportionately backed by leveraged loans.
Unsurprisingly, banks are big investors in CLOs. Additionally, since a court ruled in April 2018
that CLOs are exempt from the risk retention rule, which required CLO issuers to retain 5% of
the risk on its books, there has been a glut of CLO issuance. Even before this court decision,
CLO issuance by the end of 2017 was already at record levels with $120 billion in outstanding
CLO issues, higher even than in 2006.
On the consumer loan side, the rapidly growing student loan market is of greatest concern.
College loan balances now stand at almost $1.5 trillion. The Brookings Institution calculated
that by 2023 the default rate could reach 40%. Even if the default rate turns out to be half of
that, that would still amount to billions of dollars in losses. Like with other loans, banks are
exposed to student debt because they are packaged into securitizations.
Another trouble spot is in the auto loan market. While the big lenders in this market are auto
financing companies, banks have been entering this market. Moreover, banks invest in auto
loan asset-backed securities, in which issuances have been rising. Lenders in the U.S. $1.2T
auto loan market are extending terms to borrowers for as long as eight years — 10 years ago
the average auto loan maturity was five years. This increases the probability that defaults will
rise and that loan recoveries will decrease. Already, auto loan subprime borrowers are
defaulting at a higher rate than in 2007.
Credit card debt and exposure to it through credit card asset-backed securities should also be
monitored carefully by bank risk managers as well as bank supervisors and rating agencies.
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The number of credit card accounts and credit card debt per borrower has been rising. Serious
credit card delinquency rates rose to 1.78% in the first quarter of 2018, up from 1.69% a year
ago. Given that the level of credit card debt is rising, what seem like small losses actually
represent millions of dollars.
The mortgage market is the only bright spot across all forms of consumer debt. For over a year
and a half, mortgage delinquencies have been declining. Delinquencies have also been
declining among subprime mortgages. Yet given the high likelihood that the Fed will continue
to raise interest rates this year, anyone with a floating-rate mortgage or credit card will start to
feel the pinch of higher borrowing costs.
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I fear that legislators are choosing a terrible moment to lighten up regulations on big banks.
No one should think for a moment that the changes to Dodd-Frank are just for well-deserving
community banks across the country. Given the current level of corporate and consumer
indebtedness, allowing banks to take on more risk could be detrimental to Main Street
precisely when employment and GDP levels are finally improving. Historically, what we see
every time we reach growing levels of GDP, banks pursue fewer regulations to reduce their
auditing, reporting and compliance costs. This frees up cash for banks to engage in riskier
lending and capital markets transactions. In order to compete with other banks that are trying
to capture more market share, banks let go of their due diligence standards in the chase for
higher profits.
While the macro economic data are positive, the yield curve, an important market signal, is
flatter than it has been in over a decade. Despite slowly improving GDP, there has been a rise
in purchases of Treasurys, which has brought down the yield. This is happening because the
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market is being weighed down by policy uncertainty in terms of a number of government
initiatives such as trade tariffs, the direction of the North American Free Trade Agreement, and
what the true effects of tax reform will be on economic growth. If the yield flattens more or
even inverts, this will give rise to concerns that we are starting to get into a recessionary part
of the credit cycle.
As a result of these market signs, I would encourage bankers to consider buying “cheap and
cheerful” bottles of champagne rather than vintage ones. Trouble could be bubbling up just
around the corner.
Mayra Rodríguez Valladares Mayra Rodríguez Valladares is managing principal at MRV Associates.
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Banks to get another Volcker Rule win as hedging demands eased
Published May 21 2018, 10∶58am EDT
More in Volcker Rule, Regulatory reform, Regulatory relief, Commercial banking, Federal Reserve, OCC, SEC, FDIC
Banks have long complained that steep compliance burdens make it almost impossible to use
an important break they got in the Volcker Rule to hedge against losses.
In their coming overhaul, the Federal Reserve and other regulators are expected to address
Wall Street’s grievance, another way the landmark post-crisis rule is shifting in the industry’s
favor under President Donald Trump.
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At issue is what’s known as the hedging exemption included in Volcker, which stipulated that
banks aren’t violating the rule’s restrictions on speculative trading as long as they can show
transactions offset market risk.
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To make it much easier to take advantage of the exemption, Trump-appointed regulators
intend to eliminate some requirements that firms document their hedges and the market
positions they’re tied to, said three people familiar with the proposal. Instead, regulators would
allow more general assurances from banks that they’re keeping track of risks, said two of the
people who asked not to be named because the proposal isn’t public.
Volcker 2.0
The revamp, known within agencies as Volcker 2.0, is the latest effort by financial regulators to
soften rules that the Trump administration blames for holding back economic growth. Volcker,
one of the most sweeping demands that followed the 2008 financial crisis, banned banks from
trading purely for their own benefit.
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In another key change reported by Bloomberg News last week, regulators plan to scrap a
presumption in Volcker that all short-term trading violates the rule. That revision would give
banks more leeway to conclude that their buying and selling complies with Volcker, putting the
onus on regulators to challenge such judgments. Federal agencies are also likely to make it
easier for lenders to stockpile assets that their customers might want to buy in the near term.
Taken together, the tweaks could blunt the edges of Volcker, which named after former Fed
Chairman Paul Volcker. Its advocates say the rule was necessary to make the industry safer
after the crisis. But critics say the regulation is overly complex and difficult to comply with.
The ability to hedge was one of the few exemptions that the Fed and other agencies granted
banks when they approved Volcker in 2013. Still, lenders have said that the many hoops they
have to jump through to rely on it are unreasonable. In response, regulators are now
considering removing language in the rule that says hedges must “demonstrably" reduce
specific risks, said two of the people.
Revamp coming
The five agencies that oversee this core section of the 2010 Dodd-Frank Act — the Fed, Office
of the Comptroller of the Currency, Federal Deposit Insurance Corp., Securities and Exchange
Commission and Commodity Futures Trading Commission — are expected to propose their
overhaul as early as next week. The banking agencies are set to be the first to sign off on the
proposal, with the SEC and CFTC following soon after, the people said.
Spokesmen for the Fed, OCC, FDIC and SEC declined to comment. A CFTC spokeswoman
didn’t respond to a request for comment.
How much latitude banks should have to hedge became a focus of intense debate after a
JPMorgan Chase trader known as the London Whale lost $6.2 billion betting on credit
derivatives in 2012. JPMorgan characterized the trades as part of a strategy to balance risks
on the bank’s balance sheet, but lawmakers expressed outrage over the magnitude of the
losses. When regulators approved Volcker in December 2013, they included tougher restrictions
on hedging than originally proposed.
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Since then financial executives have argued the documentation and compliance requirements
are too onerous. A sign that Wall Street was making headway came in June 2017, when
Trump’s Treasury Department issued a report that said some of the demands were
"unnecessarily burdensome.”
The unveiling of the regulators’ plan will be the first step in a lengthy process that will include
votes at the agencies on whether to seek public comment on the proposal followed by what
could be months of rewriting before a final round of votes on making the changes official.
Bloomberg News
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