Academic journal article Economic Commentary (Cleveland)

Bank Exposure to Highly Leveraged Transactions

Academic journal article Economic Commentary (Cleveland)

Bank Exposure to Highly Leveraged Transactions

Article excerpt

The commercial banliing jndustry as a whole fared well in 1992. with many institutions citing improvements in profitability.(1) Despite this overall good news, however, analysts continue to question the health of some sectors of the industry. Such doubts ring familiar to those who recall banks' difficulties in the 1980s as a result of overinvestment in loans to agricultural and energy interests, to less-developed countries, and to commercial real-estate ventures in the Northeast and Southwest.

The underlying concern seems to be that banks are "too risky," referring either to the volatility of bank assets or to threats to the overall economy, depositors, the deposit insurance fund, or taxpayers. Perhaps banks made a series of investments that, while seemingly reasonable at the time, have since turned out to be bad bets. On the other hand, some economists would arue that a combination of regulations, including govemment guarantees, has induced banks to assume greater risk, and at lower borrowing rates, than they otherwise would have.

Measuring the riskiness of bank liabilities in absolute terms is difficult. In theory, potential lenders to a bank (such as purchasers of equity or debt instruments or certificates of deposit) incorporate their assessment of the soundness of the bank's assets into the rate of return they require on their investment. If this in fact occurs, and banks must pay for their risk, one could measure risk simply by looking at market-determined interest rates.

There may be reasons, however, why bank funding costs do not fully reflect risk or why regulators would not want to rely on market discipline. The presence of a system of deposit insurance in which premiums incorrectly gauge risk may induce bank management to assume greater levels of risk, and has been cited as a justification for capital regulation and for detailed examinations of bank balance sheets. Some argue that the deposit insurance subsidy to risk increases with greater leverage (lower capital-to-asset ratios), necessitating more regulatory control.

All of these perspectives are useful to consider in evaluating banks' exposure to highly leverdged transactions (HLTs). The aftermath of the wave of leveraged buyouts in the 198Os brought a realization that banks had played a key role in financing such transactions. In response, regulators required financial institutions to report information on their involvement in HLTs, beginning in the first quarter of 1991. Since this practice began, there has been a general perception that banks have abandoned the HLT market. Nonetheless, many market observers were surprised when regulators announced that banks would no longer be required to report HLT involvement separately. Effective the third quarter of 1992, bank HLT activity is simply combined with other loans, and most of these loans will now fall into the commercial and industrial (C&I) category.(2)

In response to increased bank involvement in highly leveraged transactions (HLTs) in the 1980s, regulators collected confidential data in 1991 and 1992. In examining these data, this study finds that while some banks remain heavily involved in HLTs, overall bank exposure to these activities poses little threat to bank capital or to the bank insurance fund.

This Economic Commentary characterizes changing bank involvement in HLs. Using confidential information supplied by banks from the first quarter of 1991 to the first quarter of 1992, I assess the data in terms of the various risks posed by highly leveraged activity.(3) These data show a steadily declining scope of bank involvement. However, the institutions that dealt most in HL at tbe onset of the report period generally continued to be the most strongly involved at the end.

* REGULATORY RESPONSE TO BANK INVOLVEMENT WITH HLTS

With mounting evidence of the potential aggregate impact of HLTs in the 1980s also came an awareness of the rough magnitude of banks' involvement. …

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