Underwriting limits could tackle rising risks posed by corporate debt, according to the IMF’s Tobias Adrian, head of the monetary and capital markets department. The US leveraged lending limits were an effective policy tool — but have not been enforced since 2017, while corporate leverage levels have climbed.
High corporate debt levels were a big focus for the IMF’s financial stability assessment this year, as lower interest rates have encouraged companies to pile up new debt. The IMF suggested in its report that countries “may also consider developing prudential tools for highly leveraged firms”.
The US already has such a tool in the shape of leveraged lending guidance originally promoted by the Federal Reserve and the OCC. But since a decision in 2017 by the general audit office, this guidance has barely been enforced — and credit standards have weakened.
“Corporates are readjusting their optimal liability structure — with much lower rates, you probably should have higher leverage,” said Adrian. “And there’s a degree to which that’s fine, but a danger that it goes too far, and we would like to see some limits on how far that can go. The US used to have supervisory guidance on the leveraged loan market, and it’s still in place, but it’s not enforced.”
He continued: “To the extent that loans are staying on balance sheet, you can limit leverage directly, but even if they’re sold to insurance companies and so on, you can put a limit to leverage at the underwriting stage. That would be a pretty good proposal.”
The IMF argues that the riskiness of corporate debt has increased substantially in advanced economies, with more speculative grade credit, weaker lender protections, and more optimistic leverage calculations. This, the Fund argues, makes economies more vulnerable to a downturn.
But Adrian argued that reforms since the crisis have meant corporate weakness are less likely to spill over and endanger banks.
“In Q4 2018, when there was a massive selloff, we didn’t see distress in any major financial institution, so I think the system is far more resilient,” said Adrian. “There might be a sharp adjustment and some surprises but we don’t see that being associated with a systemic crisis like in 2008. We might see losses spread around the world through market-based finance, but we don’t expect as much run risk or disorderly liquidation of financial intermediaries.”
The Fund’s previous financial stability report in April focused on the potential risks posed by corporates rated just above speculative grade — some of which, if downgraded, are large enough to swamp the high yield markets.