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Why Are Bank Regulators looking at loan profitability?

Why Are Bank Regulators looking at loan profitability and the capacity to repay

The Federal Deposit Insurance Corporation and the FDIC said in their 2014 bank-lending summary “In many cases, examiners question the borrower capacity to repay newly underwritten loans if economic conditions deteriorated or if interest rates rose to historical norms.” This is quite strong language, and there is more to it than meets the eye.

Why are banks being directed to stop arranging loans to more leveraged borrowers? It isn’t because they place the banks at risk, because these loans are quickly sold off to hedge funds and mutual funds which are outside of the FDIC umbrella. If you read the reports it is clear that regulators do not want the banks to set up these loans even if there is no risk that the banks will end up holding the loans.

The FED wants banks be the gate-keeper, and stop making highly leveraged loans because they are afraid when interest rates eventually rise again, all this floating-rate debt will cause another solvency crisis.

Investor appetite for these loans is high in spite of how federal regulators feel about them. Which means the loans will still take place if banks cease to make them. Insurance companies, hedge funds, private-equity funds, and other financial institutions outside the reach of federal bank regulators will take up the slack and banks will be cut out of a profitable low-risk niche.

Federal regulators know the score. They know how this policy will play out. So why are they pursuing this policy so aggressively when it will only reduce leverage in the banking system for a short time? It could be that they are hoping there is still enough anxiety in the banking world about what caused the last banking implosion to cause institutions they don’t regulate to line up with them. Or it might be that they think an imperfect policy is better than none at all.

Looking at current investor appetite for highly regulated loans, it does not seem likely that they will stop. Either we are headed for another financial system correction sometime in the future or the bank regulators are behind the power curve.

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Alan Lee