For release on delivery
7:00 p.m. EDT
May 20, 2019
Business Debt and Our Dynamic Financial System
Remarks by
Jerome H. Powell
Chair
Board of Governors of the Federal Reserve System
at
"Mapping the Financial Frontier: What Does the Next Decade Hold?"
24th Annual Financial Markets Conference, sponsored by
the Federal Reserve Bank of Atlanta
Amelia Island, Florida
May 20, 2019
It is a pleasure to be here at this important annual event sponsored and organized
by the Federal Reserve Bank of Atlanta's Center for Financial Innovation and Stability.
The risks in our financial system are constantly evolving. Fifteen years ago, everyone
was talking about whether households were borrowing too much. Today everyone is
talking about whether businesses are borrowing too much. This evening, I will focus on
the implications of the increase in business debt over the past decade and review the steps
the Federal Reserve and other agencies are taking to understand and limit the associated
risks.
In public discussion of this issue, views seem to range from "This is a rerun of the
subprime mortgage crisis" to "Nothing to worry about here." At the moment, the truth is
likely somewhere in the middle. To preview my conclusions, as of now, business debt
does not present the kind of elevated risks to the stability of the financial system that
would lead to broad harm to households and businesses should conditions deteriorate. At
the same time, the level of debt certainly could stress borrowers if the economy
weakens. The Federal Reserve continues to assess the potential amplification of such
stresses on borrowers to the broader economy through possible vulnerabilities in the
financial system, and I currently see such risks as moderate.
Discussion
Many commentators have observed with a sense of déjà vu the buildup of risky
business debt over the past few years. The acronyms have changed a bit-"CLOs"
(collateralized loan obligations) instead of "CDOs" (collateralized debt obligations), for
example-but once again, we see a category of debt that is growing faster than the
income of the borrowers even as lenders loosen underwriting standards. Likewise, much
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of the borrowing is financed opaquely, outside the banking system. Many are asking
whether these developments pose a new threat to financial stability.
At the Federal Reserve, we take this possibility seriously. The Fed and other
regulators are using our supervisory tools and closely monitoring risks from the buildup
of risky business debt. Business debt has clearly reached a level that should give
businesses and investors reason to pause and reflect. If financial and economic
conditions were to deteriorate, overly indebted firms could well face severe strains.
However, the parallels to the mortgage boom that led to the Global Financial Crisis are
not fully convincing. Most importantly, the financial system today appears strong
enough to handle potential business-sector losses, which was manifestly not the case a
decade ago with subprime mortgages. And there are other differences: Increases in
business borrowing are not outsized for such a long expansion, in contrast to the
mortgage boom; business credit is not fueled by a dramatic asset price bubble, as
mortgage debt was; and CLO structures are much sounder than the structures that were in
use during the mortgage credit bubble.
Could the increase in business debt pose greater risks to the financial system than
currently appreciated? My colleagues and I continually ask ourselves that question. We
are also taking multiple steps to better understand and address the potential risks. In
conjunction with other U.S. regulatory agencies, both domestically through the Financial
Stability Oversight Council (FSOC) and internationally through the Financial Stability
Board (FSB), we are monitoring developments, assessing unknowns, and working to
develop a clearer picture. We are also using our supervisory tools to hold the banks we
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supervise to strong risk-management standards. And we are using our stress tests to
ensure banks' resilience even in severely adverse business conditions.
The Rise of Business Leverage
Let's start with the basic facts. Many measures confirm that the business sector
has significantly increased its borrowing as the economy has expanded over the past
decade. Business debt relative to the size of the economy is at historic highs. Corporate
debt relative to the book value of assets is at the upper end of its range over the past few
decades (figure 1). And investment-grade corporate debt has shifted closer to the edge of
speculative grade.
At the moment, the business sector is quite healthy overall. Business income is
strong, reflecting healthy profit margins. And because interest rates are quite low by
historical standards, the costs of servicing today's higher levels of debt remain low
relative to business income (figure 2). Despite crosscurrents, the economy is showing
continued growth, strong job creation, and rising wages, all in a context of muted
inflation pressures.
But if a downturn were to arrive unexpectedly, some firms would face challenges.
Not only is the volume of debt high, but recent growth has also been concentrated in the
riskier forms of debt. Among investment-grade bonds, a near-record fraction is at the
lowest rating-a phenomenon known as the "triple-B cliff." In a downturn, some of
these borrowers could be downgraded into high-yield territory, which would require
some investors to sell their holdings, thereby confronting traditional high-yield investors
with a sudden influx of bonds.
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There have also been sizable shifts within the non-investment-grade, or riskier,
debt universe. Higher-risk businesses have traditionally funded themselves with a mix of
high-yield bonds and leveraged loans. Over time, the balance between the two has swung
back and forth because of investor demand, the interest rate environment, and other
factors. In the past few years, leveraged loans have grown far more quickly (figure 3). In
fact, while net new issuance of high-yield bonds in 2018 was close to nil, leveraged loans
outstanding rose 20 percent and now stand at more than $1 trillion. So far this year,
issuance of high-yield bonds and leveraged loans has been more balanced. In addition,
underwriting standards have weakened. With leveraged loans, covenants intended to
protect lenders may be an endangered species; more loans now feature high debt-to-
earnings ratios; and the use of optimistic projections including "earnings add-backs" is
becoming more common.
The rise in riskier business borrowing has been funded principally by nonbank
lenders. Collateralized loan obligations are now the largest lenders, with about
62 percent of outstanding leveraged loans (figure 4). These lenders are actively managed
securitization vehicles that mostly buy higher-risk assets like leveraged loans. CLOs, in
turn, are funded by a slice of equity and layers of debt of varying seniority. After CLOs,
mutual funds are the next-largest vehicle for holding leveraged loans, with about
20 percent of the market. These funds allow investors to redeem their shares daily,
although the underlying loans take longer to sell. As a result, investors may react to
financial stress by trying to redeem their shares before the funds have sold their most
liquid assets. Widespread redemptions by investors, in turn, could lead to widespread
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price pressures, which could affect all holders of loans, including CLOs and those that
hold CLOs.
Risks to Financial Stability: Using the Framework Deployed since the Crisis
As you can see, there are similarities to the subprime mortgage crisis. As with the
mortgage boom, the business debt story begins with rapid growth of debt to new highs
and a surge in lending to risky borrowers made possible by aggressive underwriting using
securitization vehicles.
But there are also important differences. One difference is that financial
authorities now closely monitor financial stability vulnerabilities on an ongoing basis,
armed with lessons learned from the crisis. The Board of Governors meets at least four
times a year to assess threats to the financial system and is constantly monitoring
developments. We use a checklist of potential financial vulnerabilities that we have
described elsewhere, most recently in the Financial Stability Report we published earlier
this month.1 This approach gives us a way to organize and weigh the mass of facts,
anecdotes, and speculation we confront as we monitor financial stability.
In assessing financial stability risks, we constantly consult our four-point
checklist: borrowing by businesses and households, valuation pressures, leverage in the
financial system, and funding risk. If households or businesses have borrowed too much,
they will be forced to cut back spending and investing or even default if their incomes fall
or the value of the collateral backing their loans declines. Valuation pressures give us a
sense of overall risk appetite and, should investors lose that appetite, how far prices could
fall. If lenders face defaulting borrowers and have too little loss-absorbing capacity, they
1
See Board of Governors (2019).
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risk insolvency. At best, they will cut back on lending to other borrowers, dragging the
economy down. At worst, they will fail, which can lead to severe economic damage to
households and businesses. Finally, when the financial system funds long-maturity assets
with short-maturity liabilities, we risk a classic "fast burn" crisis-a bank run, or its
equivalent involving investors and institutions outside traditional banking.2
In our framework, the story of the mid-2000s goes something like this: Amid a
self-reinforcing cycle of house price gains and mortgage credit expansion, households
borrowed (and lenders lent) far too much, and property prices rose far too high. Financial
institutions of all shapes and sizes also borrowed too much. And the financial sector was
highly susceptible to a run because it funded risky, long-maturity mortgages with
extended chains of fragile and opaque financing structures that ultimately rested on short-
maturity liabilities.
Let's compare this story with the current situation using our four-point checklist,
beginning with borrowing by businesses and households. Business debt has grown faster
than gross domestic product (GDP) for several years and today is high. But the growth in
the ratio of business debt to GDP in the past decade is much less than the growth in
household debt to GDP that we saw in the run-up to the Global Financial Crisis. Back
then, household debt grew from 60 percent of GDP to 90 percent, or by half (figure 5).
At its recent low, business debt was 65 percent of GDP. Now, even after rapid growth, it
is still below 75 percent of GDP. Overall, the increase in business debt relative to the
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size of the economy is one-third the increase in household debt seen in the previous
decade. Business debt rises in expansions. It is a steady upward plod in borrowing over
the long expansion-not a rapid expansion-that has now brought business debt to GDP
back to historic highs. Seen this way, the current situation looks typical of business
cycles. The mortgage credit boom was, because of its magnitude and speed, far outside
historical norms.3
As for household debt, we see that household debt-to-income ratios have steadily
declined post-crisis. Moreover, a high and rising fraction of this debt is rated prime. All
told, household debt burdens appear much more manageable.
Our second factor-valuation pressures-also points to moderate risks to
financial stability. Valuations are high across several financial markets. Equity prices
have recently reached new highs, and corporate bond and loan spreads are narrow. Both
commercial and residential property prices have moved above their long-run relationship
with rents, although price gains slowed substantially last year. All of these developments
point to strong risk appetite-as might be expected given the strong economy. But there
does not appear to be a feedback loop between borrowing and asset prices, as was the
case in the run-up to the financial crisis. While borrowing by businesses has been strong,
it is not fueling excessive prices or investment in a critical sector such as housing, whose
collapse would undermine collateral values and lead to outsized losses. Instead, the
increase in business borrowing has been broad based across sectors, including
technology, oil and gas production, and manufacturing.
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Regarding the third factor-leverage in the financial system-today banks at the
core of the financial system are fundamentally stronger and more resilient. Our post-
crisis regulatory framework is based on robust capital requirements backed by strong
stress tests, resulting in much higher levels of capital in the banking system (figure 6).
These stress tests are a way to estimate the direct and indirect effects of extremely bad
macroeconomic and financial developments on our banking system. We publish the
scenarios that describe the macro and financial developments every year by mid-February
and release the test results in June. In the pre-crisis environment, supervisors focused
more on the most likely outcomes, not on these tail risks. Since we began routine stress-
testing in 2011, the scenarios we use have featured severe global recessions characterized
by major stress in the corporate sector, where large numbers of firms default on their
loans and bonds. As actual economic conditions have improved, the scenarios have
gotten tougher. The most recent stress tests indicate that, even after the losses from the
scenario, capital levels at the largest banks would remain above the levels those banks
had before the crisis. Loss-absorbing capacity elsewhere in the financial system is also
much improved. Leverage at broker-dealers is far below levels before the crisis and
remains low relative to the norms of the past several decades. Insurers also appear well
capitalized.
As for our fourth factor-funding risk-the susceptibility of the financial system
to runs also appears low. In part because of the post-crisis regulatory regime, large banks
hold substantial amounts of highly liquid assets and rely relatively little on short-term
wholesale funding (figure 7). Money market funds hold much safer assets. And CLOs,
which have facilitated the growth of leveraged loans, have stable funding: Investors
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commit funds for lengthy periods, so they cannot, through withdrawals, force CLOs to
sell assets at distressed prices.
Addressing the Risks: Monitoring and Acting
Overall, vulnerabilities to financial stability from business debt and other factors
do not appear elevated. We take the risks from business debt seriously but think that the
financial system appears strong enough to handle potential losses. We also know that our
dynamic financial system does not stand still. We can always learn more about financial
markets, and we will always act to address emerging risks. Together with our domestic
and international counterparts, we are monitoring developments in business debt markets,
working to develop and share data on how these markets operate, studying ways to
further strengthen the system, and working to ensure that banks are properly managing
the business debt risks they have taken on.
Through the FSOC, the banking and market regulators coordinate our monitoring
of financial conditions. In recent meetings, the FSOC has discussed leveraged lending in
depth. We recognize that each regulator directly sees only a part of the larger picture,
and we are working to stitch these parts together so we can collectively see that larger
picture and the risks it holds. For example, the Securities and Exchange Commission is
examining the potential for liquidity strains at mutual funds, and the Commodity Futures
Trading Commission is working to understand the use of derivatives to hedge risks
associated with leveraged loans.
What else are we watching for? Business debt growth has moderated somewhat
since early 2018, but this might be just a pause. Another sharp increase in debt, unless
supported by strong fundamentals, could increase vulnerabilities appreciably.
Businesses, investors, and lenders need to focus on these vulnerabilities-as will the
Federal Reserve.
In addition, regulators, investors, and market participants around the world would
benefit greatly from more information on who is bearing the ultimate risk associated with
CLOs. We know that the U.S. CLO market spans the globe, involving foreign banks and
asset managers. But right now, we mainly know where the CLOs are not-only
$90 billion of the roughly $700 billion in total CLOs are held by the largest U.S. banks.
That is certainly good news for domestic banks, but in a downturn institutions anywhere
could find themselves under pressure, especially those with inadequate loss-absorbing
capacity or runnable short-term financing. The Federal Reserve is participating in
international efforts, under the auspices of the FSB, to improve our knowledge of these
key issues. Through the FSB, we are focused on determining the size of the global
leveraged loan market and the holders of the loans as an important step toward a better
understanding of the underlying risks.
Beyond monitoring markets and collecting new data, several supervisory efforts
are also under way. To complement the quantitative analysis in our stress tests, our
supervisors have been qualitatively assessing how well banks are managing the risks
associated with leveraged lending. Through the Shared National Credit Program, which
evaluates large syndicated loans, our supervisors are continuing to work with their
counterparts at the Office of the Comptroller of the Currency and the Federal Deposit
Insurance Corporation to ensure that banks are properly managing the risks of losses they
face from participating in the leveraged lending market.
Conclusion
Let me wrap up with three thoughts. First, business debt is near record levels, and
recent issuance has been concentrated in the riskiest segments. As a result, some
businesses may come under severe financial strain if the economy deteriorates. A highly
leveraged business sector could amplify any economic downturn as companies are forced
to lay off workers and cut back on investments. Investors, financial institutions, and
regulators need to focus on this risk today, while times are good.
Second, today business debt does not appear to present notable risks to financial
stability. The debt-to-GDP ratio has moved up at a steady pace, in line with previous
expansions and neither fueled by nor fueling an asset bubble. Moreover, banks and other
financial institutions have sizable loss-absorbing buffers. The growth in business debt
does not rely on short-term funding, and overall funding risk in the financial system is
moderate.
Third, we cannot be satisfied with our current level of knowledge about these
markets, particularly the vulnerability of financial institutions to potential losses and the
possible strains on market liquidity and prices should investors exit investment vehicles
holding leveraged loans. We are committed to better understanding the areas where our
information is incomplete. This commitment includes coordination with other domestic
and international agencies to understand who is participating in business lending and how
their behavior could potentially amplify stress events.
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Board of Governors of the Federal Reserve System (2019). Financial Stability Report.
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Business Debt and
Our Dynamic
Financial System
Jerome H. Powell
Chair
Board of Governors of the Federal Reserve System
at
"Mapping the Financial Frontier: What Does the Next Decade Hold?"
24th Annual Financial Markets Conference, sponsored by
the Federal Reserve Bank of Atlanta
Amelia Island, Florida
Business Leverage Historically High
Debt Servicing Costs Low Relative
to Business Income
Issuance of Risky Debt Has Seen
Sizable Shifts
CLOs Are the Largest Holders of
Leveraged Loans
Business Debt Growth Lags
PreCrisis Run-Up for Households
Capital Levels Much Higher at Bank
Holding Companies
Bank Liquidity Is Much Higher