Fed’s top supervisor Quarles downplays risks posed by leveraged lending

Heightened business debt – primarily through leveraged lending – is not increasing overall financial stability risks, the Fed’s top regulatory official said Thursday.

In a speech, Federal Reserve Board Vice Chairman for Supervision Randal Quarles said his assessment of the risk posed by increased leveraged lending by businesses – which has been cited by other regulators as at least worth monitoring to avert threats to financial stability – is mitigated by the financial sector’s “substantial loss-absorbing capacity.” He indicated that, in his view, the financial sector is not “overly reliant on unstable short-term funding.”

“Yet, even if the risk of financial system disruption does not seem high, it will remain true that if the economy weakens, some businesses may default on this debt, potentially leading to a contraction in investment, a slow-down in hiring, and possibly to an unusual tightening in financial conditions,” Quarles said at a research conference sponsored by the Federal Reserve Board and the Federal Reserve Bank of New York in Washington, D.C. “These concerns highlight how cyclical factors influencing monetary policy borrowers may overlap with financial stability considerations,” he said.

In any event, Quarles said, effective supervisory, regulatory, and macroprudential policy tools “appear to be well placed to address financial vulnerabilities.” He said tools may be used to increase the resilience of the financial sector against a broad range of adverse shocks and, perhaps, lean against the buildup of specific financial vulnerabilities.

“At the Federal Reserve, we have emphasized a set of structural, or through-the-cycle, regulatory and supervisory policies as our primary macroprudential tools to promote financial stability,” he said. “These measures include strong capital and liquidity requirements for banks, especially the largest and most systemic institutions.”

He pointed to the Fed’s supervisory stress tests as key to evaluating the ability of large banks to weather severe economic stress and the failure of their largest counterparty as well as examining the risk‑management practices of the firms. “Moreover, the stress-test scenarios are designed to generally be more severe during buoyant economic periods when vulnerabilities may build.”

He added that the stress tests consider the potential effects of specific risks identified by the Fed in its financial stability monitoring work. “For example, the tests in recent years have included hypothetical severe strains in corporate debt markets, exploring the resilience of the participating banks to the risks associated with the increase in business borrowing,” he said.

Vice Chair for Supervision Randal K. Quarles: Monetary Policy and Financial Stability