Jul 13, 2021 - Economy

Central banks call for more oversight of risky lending

Illustration of a hundred dollar bill surrounded by lasers.

Illustration: Aïda Amer/Axios

U.S. and European financial regulators have alluded to revamping oversight as a way to keep a lid on leveraged lending excesses. But doing so would be complicated since much of the world’s risk-taking doesn’t happen directly in regulated institutions like banks.

Why it matters: The European Central Bank’s supervisory chair, Andrea Enria, acknowledged in a recent speech that when central banks’ unprecedented market support goes away it could leave markets exposed to price corrections. Put another way, bubbles could pop.

Driving the news: Enria said that the ECB should take supervisory action in areas like leveraged credit, the riskiest area of corporate debt. He also called for more oversight of equity-related derivatives such as total return swap contracts, which were infamously employed by Archegos Capital to increase its positions.

The big picture: Agencies like the ECB, or the Federal Reserve and Treasury Department in the U.S., have purview over regulated institutions, but not over hedge funds and family offices, or over the rapidly growing private debt market.

What they’re saying: Treasury Secretary Janet Yellen has said she’s interested in a regulatory regime that shifts the focus from systemically important institutions to systemically important activities.

  • That would cast a broader net for who and what could be subject to government oversight.
  • Enria said that due to “the broader problem of the opaqueness of the shadow banking sector and the degree of interconnectedness in financial markets … it is necessary to revamp the regulatory and supervisory dialogue.”

Context: There’s a lot less leverage in the system now compared with before the financial crisis, somewhat mitigating the overall risk in the U.S., Steven Wagner, senior portfolio manager at Federated Hermes, tells Axios.

Flashback: U.S. regulators implemented Leveraged Lending Guidance in 2013 to minimize lending excesses like deals that leave companies with too much debt or too little cash flow.

  • The Government Accountability Office said in 2017 that the guidance was subject to Congressional Review. Enforcement pretty much died there.

What to watch: Any major oversight changes in the U.S. will likely have to come legislatively, Richard Farley, chair of Kramer Levin’s leveraged finance group, tells Axios.

  • While that’s probably not high on the Biden administration’s priority list now, don’t be surprised if a proposal comes in 2022 — before the midterm elections, when control of Congress could shift, Farley adds.

The bottom line: With a dysfunctional and closely split Congress, any financial regulation legislation is a heavy lift.

  • And if Europe moves forward with changes while the U.S. doesn’t, some multinationals may prefer financing more of their capital raises in the U.S., says Wagner.

Go deeper: Read Enria’s full speech.

Go deeper