Big banks well capitalized – yet concern remains over lending to risky firms, Fed report tells Congress

Key financial institutions, including the largest banks in the nation, continue to be well capitalized and hold large quantities of liquid assets – but concern continues about the rapid build up of “leveraged lending” to risky firms, according to a report issued Friday.

in the Federal Reserve’s Monetary Policy Report (released in advance of testimony Wednesday and Thursday before House and Senate Committees by Board Chairman Jerome H. (“Jay”) Powell), the Fed notes that the solid and liquid position of big banks contributes to an overall financial system that is “substantially more resilient” than in the period leading up to the financial crisis of a decade ago.

The semiannual report, mandated by law, notes that vulnerabilities stemming from leverage at financial institutions remain low. Overall, the report notes, measures of bank profitability remained solid in the first quarter of 2019, supported by wider net interest margins and steady loan growth.

“Results of the annual Dodd-Frank Act Stress Tests, released on June 21, 2019, indicate that participating banks are sufficiently resilient to continue lending to creditworthy borrowers even in a severe macroeconomic scenario,” the report states. “The exposure of banks to nonbank financial institutions – such as finance companies, asset managers, securitization vehicles, and mortgage real estate investment trusts – continued to increase in the first quarter of 2019. Some of those firms are significant business lenders, adding to banks’ exposure to elevated losses in the corporate sector.”

But the report does take specific note about increased lending to the riskiest firms, sometimes referred to as “leveraged lending.”

The report states that leverage in the business sector remains near its highest level in the past 20 years, and business debt has grown faster than gross domestic product (GDP) since 2012.

“Rapid debt growth, while broad based across different parts of the business sector, is concentrated among the riskiest firms, and there are signs that credit standards for new leveraged loans are weak and have deteriorated further over the past six months,” the report states. “In the corporate bond market, the distribution of credit ratings among investment-grade bonds has worsened, with the share of bonds rated Baa (or triple-B) reaching near-record levels.”

The report warns that a broader repricing of risk or a slowdown in economic activity could pose notable risks to borrowing firms and their creditors. “Such developments could increase the downside risk to economic activity more generally.”

July 2019 Federal Reserve Monetary Policy Report