Revision to Dodd-Frank Loosens Collateral Requirements for Leveraged Credit Transactions

Michael Teague  |

Back on March 21st of this year federal regulatory agencies announced the first update to leveraged lending guidelines since 2001, an attempt to ensure that banks be more conservative and cautious when providing financing to borrowers.

The move was as a response to the explosion of leveraged credit transactions in the run-up to the financial crisis of 2008. In the wake of the crisis, the number of these transactions was greatly reduced, but according to the fed they are back on the rise.

On its website, the Federal Reserve cited concerns that “some debt agreements have included features that weaken lender protection by excluding meaningful maintenance covenants and including other features that can limit lenders' recourse in the event of weakened borrower performance. In addition, capital and repayment structures for some transactions, whether originated to hold or to distribute, have been aggressive. Management information systems at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis.”

The guidance that was issued back in March was concerned with risk-management and rating strategies, underwriting and valuation standards, pipeline management, reporting and analytics, the creditworthiness of borrowers, and stress testing. The Fed was careful to point out that small community banks would largely not be inconvenienced by the new rules due to the fact that most of them are not involved with leveraged lending in any significant way.

Rather, the letters sent out on Friday went to the biggest banks like JPMorgan Chase (JPM), Citigroup (C), and Goldman Sachs (GS). These financial institutions were informed that the earlier rules that would have forced them to provide double the collateral in some for portfolio margin accounts at the Atlanta Intercontinental Exchange (ICE) had been changed to allow banks to get collateral from their own clients in accordance with clearinghouse rules for the next six months.

Essentially, the big banks are being given time to formulate their own trading models that will then have to be approved by the SEC. The 2010 Dodd-Drank law had stipulated that the majority of swaps be guaranteed at clearinghouses, bringing many off-exchange trades under some level of scrutiny, as a means of reducing the sort of systemic risk that many believe to play a vital role in undermining the health of the U.S. financial system.

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