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February IS, 1989 eCONOMIC COMMeNTORY Federal Reserve Bank of Cleveland Bank Lending to LBOs: Risks and Supervisory Response by James B. Thomson An increased use of debt financing has been a hallmark of the financial restructuring of corporate America that has taken place in the mid- and late 1980s. An organization that develops from a corporate reorganization now commonly has 80 to 90 percent of its financing in the form of debt, in contrast to the 30-percent debt-to-assets ratio that prevailed in the previous two decades. Because of the high degree of leverage employed in these deals, they are often referred to as leveraged buyouts (LBOs), a form of highly leveraged financings. The news media, Congress, and the regulatory community have all focused considerable attention on LBOs in recent months, largely because of the use of this financing arrangement to fund corporate takeovers. Media interest has been heightened by the size and volume of recent deals, particularly the reported $25.3 billion that the firm of Kohlberg, Kravis & Roberts paid for RJR Nabisco. The total volume of LBO deals for 1988 exceeded $98 billion. Congressional attention concerns the use of LBOs in takeover deals that involve a major restructuring of the acquired company. The result in such deals may be layoffs and plant closings ISSN 0428·1276 in communities where the acquired firm is the major, and sometimes only, employer. Some members of Congress are also wary of the LBO market's potential effect on consumer and smallbusiness credit and on the stability of the financial system itself. Furthermore, because the tax code makes debt financing relatively less expensive than equity financing, Congress is concerned that tax considerations alone may be a major motivation behind many of the LBO deals. The LBO situation is so important that only the $100 billion thrift-industry bailout and deposit-insurance reform take precedence over it on the 101st Congress's agenda for regulatory reform in the financial sector. Bank regulators are becoming increasingly interested in bank participation in LBO lending because of the dramatic increase in LBO credits on bank portfolios. The Comptroller of the Currency estimates that of the $150 billion to $180 billion in LBO debt outstanding, $80 billion is held by U.S. banks. 1 Most of this exposure has been accumulated in recent years. In fact, estimates of total bank lending for LBOs in 1988 may exceed $48 billion (excluding $15 billion in bank loans to RJR Nabisco). Leveraged buyouts (LBOs), a popular method of corporate restructuring in the past decade, have attracted significant attention among the news media, Congress, and bank regulators. The huge size of recent takeover deals and the dramatic increase in LBO credits on bank portfolios have raised concerns about the risks of LBO financing. This article examines these risks and discusses the current response of bank supervisory authorities to the increased use of funding by leveraged buyouts. In addition, credits analysts estimate on bank portfolios that LBO equal 18 per- cent of the total dollar volume mercial loans and 50 per- and industrial cent of bank capital? of com- Concentration LBO exposure is uneven; lished estimate of LBO exposure the 10 most active market banks of • A Brief Primer on LBOs What degree of leverage have in order for its financial ing to be defined one pub- the Federal in the LBO cites a range from 40 to 140 per- cent of equity capitalr' Bankers System debt financing examination while is now for banks. Banks the middle (deals under $500 market firms in teed by the Small Business tion can be defined Administra- as highly However, leveraged the syndication buyouts tional and multinational of na- companies TABLE 1 LEVERAGED SIZEa BUYOUTS IN 1988 BY TRANSACTION Transaction Size Number of Buyouts Percent of Total Dollar VOlumeb their own LBO risk exposure.I Percent of Total $ is a Under $50 million $50 million 105 34.5% $2,206.6 2.2% 58 19.1% 4,086.8 4.2% 105 34.5% 22,334.0 22.7% - $99.9 million $100 million - $499.9 $500 million million - $999.9 million Over $1 billion 19 6.3% 13,961.0 14.2% 17 5.6% 55,687.0 56.7% 100.0% $98,275.4 100.0% more recent phenomenon. Bank regulators the impact are concerned of increased on bank soundness the regulatory leverage returns less-leveraged the current surance leveraged concept. For example, to be associated was considered because risk and larger customers. remains a highly deal that created Assuming of federal deposit intact, federal in- deposit may cause banks to under- price the risk of LBO credits U.S. Steel in 190 I to be highly it resulted ratio of 80 percent common in a country drawn the majority in the absence these incentives, Because of it is likely that LBO- related credits posure in the banking are considered will be a point of ex- are the multibillion-dollar RJR Nabisco, table deals like the data presented the risks associated with LBO lending and the current response bank regulators to banks' of federal increasing participation in this market. will provide a brief overview Then we will examine sociated with lending leveraged outline companies. the current bank regulators ticipation companies looks at First, we of LBOs. the risks asto these highly Finally, response we will of federal in to the increased par- of banks and bank holding in funding LBOs. is equity. The last tier of which up 10 to 20 percent usually Inc., roughly had a transaction 88 percent lion, 19 deals were between lion and $1 billion, and 17 deals ex- $1 billion. The average LBO transactions million. the market lending, however, nearly 57 percent accounting of the $98.3 billion in total transactions 7 for on reasonable be focused real-estate Recent lending agricultural is a natural Loans to support experience in Texas the problems with il- that can arise is based on inflated values and not on accurately for LBO transac- commercial of default, because ings losses. asset projected unexpected the lender conduct a sufficient transaction that analysis and of the and that it appropriately the risks of these loans. earn- essential abilities A large part of a bank's could conceivably to serincome? inadequate. company's the valuation In their evaluation, bank examiners look for an internal definition nounced. deal is an- Furthermore. jections or or if there is a downturn. hedge against The con- are there procedures cash-flow pro- are often based on a radically reorganized firm and on overly tic assumptions optimis- about cost-cutting sures and asset sales. These ties make it difficult mea- uncertain- to use historical cash flows to project loan price during of lending stable macro- environment 1980s. Although perience higher how LBO credits loans is not loans, it is unclear will perform stable macroeconomy. leveraged loss ex- than for more tradi- tional commercial interest of the mid- banks' on LBO-related materially to finns has occurred the relatively economic in a less How much can rates rise before some highly firms can no longer meet their debt payments? would an economic Does management ability to evaluate management the LBO defaults, service and operating or industry-specific the bank's problems of an LBO firm to its debt. Through tion, the impact controls? addition, of these problems LBO portfolio on is minimized. to deal with procedures itor their risk exposure to mon- to both indiLBO credits. In the banks must have estabprocedures to handle and docu- the special legal problems associated with LBO lendIO ing. Finally, the adequacy of internal will be examined. stance, has management prudent and reasonable total amount of exposure diversifica- to have in procedures including controls is important. Even in a robust macroeconorny, can affect the ability have the the target company's For inestablished limits on the of exposure and the type to LBO credits bank and a consolidated (on both a holding com- pany basis)? future cash flows. The recent expansion leveraged risk may not by diversifying diversification regional- • highly macroeconomic portfolio, the risk of LBO loans? lished policies, be mitigated its and LBO loan expo- vidual and aggregate macro- risks in its LBO-related Although of an can the bank identify place specific of collateral as the composition LBO exposure. mentation stock may double su- manage- a bank or bank holding Banks are also expected cern is that a bank may not be able to adequately Federal ment skills and portfolio in evaluating a LBO portfolio go under if interest rates rise dramatically economic the risk there is less equity It is therefore of the proposed of leverage accentuates in the firm to absorb posi- these risks. the larger degree in LBO financing creditor, loans. so be in an excellent firms' severe economic cash flows. triple when a takeover market highly leveraged have on many vice their debt from operating and with loans in the Midwest value of a firm's tions carry many of the same risks of banks should of on col- recession) against procedures would emphasize LBO portfolio Inc., January II, 1989, page 2. Iy a prolonged projections and cash flows may be difficult, banks. pervisors LBO credit: portfolio. • Risks Associated with LBO Credits However, in terms of total primarily should cash flows and secondarily However, tion to assess and assume deals analysis of bank holding companies. more traditional size of in 1988 was $327 The multibillion-dollar dominated $500 mil- Lending when lending in the firm may be held by non- LBO financing price under $500 mil- were deemed sure? In addition, lustrates of total Some of the equity bank subsidiaries as LBOs by Venture Economics, dollar financing a. Deals announced or consummated in 1988. b. Millions of dollars. SOURCE: BIIW!/IfS. vol. 2, issue I. Venture Economics. lateral values. in- of LBO deals last year were rela- identified ceeded (junk bonds). reorganized tively small. Of the 304 deals in 1988 This Economic Commentary of the total. These debentures financing. I show that the bulk of the $98.3 billion system. lately 30 speculative using their supervisory would take action in place for evaluating of unse- up roughly highly 304 of secured which consists vestments makes of the tier is mezza- cured debt and makes to be that have of attention consists nine financing, percent and to folios than they would up 50 to 60 percent a U.S. leveraged. the transactions The first tier is senior debt, bank loans. The second is not un- like Japan, have three tiers of total and mainly a debt- firm with this ratio is considered Even though guarantees." leveraged Although financing. which makes in a debt-to-assets book more LBO loans for their portof deposit LBOs typically the J.P. Morgan to-assets highly Totals that constitutes firm is a relative ratio of 35 perceru." than most loans to system guarantees on of leverage net. High levels of safety with both increased expected LBO exposure and, ultimately, are thought The degree about Regulators, authority, bank only if its internal for years. Most loans guaran- of loans for leveraged guideliner' firms leveraged financings. as a leveraged have lent to highly million) debt financing, Reserve using 75 percent general restructur- a firm as highly leveraged if it has 70 percent for loans to highly is not a new activity as an LBO? There seems to be no consensus: Trust defines Making must a firm What effects downturn (especial- Current Currently, Supervisory federal supervise bank authorities and regulate the banking portfolios system on the activities 8 overdrafts no addi- Moreover, as the bank's to much like the system, banks are being asked to define, manage, and impose internal limits on industry overall Specifically. as well exposure to on both a firm and basis. In the context may be treated they of the credits diversification, asset portfolio, tion of credit. of will pay to the composition total capital the LBO portfolio, taken to reign in daylight in the payments attention and the overall only the existing pertain particular with their evaluation bank examiners will look at the quality of banks participating for bank lending LBO loans approach Because management, of the LBO portfolio. have been imposed in the LBO market, regulations both risks posed to from the LBO of banks. tional restrictions In conjunction Response of the total LBO loans as a specific concentra- In addition, credits analysts estimate on bank portfolios that LBO equal 18 per- cent of the total dollar volume mercial loans and 50 per- and industrial cent of bank capital? of com- Concentration LBO exposure is uneven; lished estimate of LBO exposure the 10 most active market banks of • A Brief Primer on LBOs What degree of leverage have in order for its financial ing to be defined one pub- the Federal in the LBO cites a range from 40 to 140 per- cent of equity capitalr' Bankers System debt financing examination while is now for banks. Banks the middle (deals under $500 market firms in teed by the Small Business tion can be defined Administra- as highly However, leveraged the syndication buyouts tional and multinational of na- companies TABLE 1 LEVERAGED SIZEa BUYOUTS IN 1988 BY TRANSACTION Transaction Size Number of Buyouts Percent of Total Dollar VOlumeb their own LBO risk exposure.I Percent of Total $ is a Under $50 million $50 million 105 34.5% $2,206.6 2.2% 58 19.1% 4,086.8 4.2% 105 34.5% 22,334.0 22.7% - $99.9 million $100 million - $499.9 $500 million million - $999.9 million Over $1 billion 19 6.3% 13,961.0 14.2% 17 5.6% 55,687.0 56.7% 100.0% $98,275.4 100.0% more recent phenomenon. Bank regulators the impact are concerned of increased on bank soundness the regulatory leverage returns less-leveraged the current surance leveraged concept. For example, to be associated was considered because risk and larger customers. remains a highly deal that created Assuming of federal deposit intact, federal in- deposit may cause banks to under- price the risk of LBO credits U.S. Steel in 190 I to be highly it resulted ratio of 80 percent common in a country drawn the majority in the absence these incentives, Because of it is likely that LBO- related credits posure in the banking are considered will be a point of ex- are the multibillion-dollar RJR Nabisco, table deals like the data presented the risks associated with LBO lending and the current response bank regulators to banks' of federal increasing participation in this market. will provide a brief overview Then we will examine sociated with lending leveraged outline companies. the current bank regulators ticipation companies looks at First, we of LBOs. the risks asto these highly Finally, response we will of federal in to the increased par- of banks and bank holding in funding LBOs. is equity. The last tier of which up 10 to 20 percent usually Inc., roughly had a transaction 88 percent lion, 19 deals were between lion and $1 billion, and 17 deals ex- $1 billion. The average LBO transactions million. the market lending, however, nearly 57 percent accounting of the $98.3 billion in total transactions 7 for on reasonable be focused real-estate Recent lending agricultural is a natural Loans to support experience in Texas the problems with il- that can arise is based on inflated values and not on accurately for LBO transac- commercial of default, because ings losses. asset projected unexpected the lender conduct a sufficient transaction that analysis and of the and that it appropriately the risks of these loans. earn- essential abilities A large part of a bank's could conceivably to serincome? inadequate. company's the valuation In their evaluation, bank examiners look for an internal definition nounced. deal is an- Furthermore. jections or or if there is a downturn. hedge against The con- are there procedures cash-flow pro- are often based on a radically reorganized firm and on overly tic assumptions optimis- about cost-cutting sures and asset sales. These ties make it difficult mea- uncertain- to use historical cash flows to project loan price during of lending stable macro- environment 1980s. Although perience higher how LBO credits loans is not loans, it is unclear will perform stable macroeconomy. leveraged loss ex- than for more tradi- tional commercial interest of the mid- banks' on LBO-related materially to finns has occurred the relatively economic in a less How much can rates rise before some highly firms can no longer meet their debt payments? would an economic Does management ability to evaluate management the LBO defaults, service and operating or industry-specific the bank's problems of an LBO firm to its debt. Through tion, the impact controls? addition, of these problems LBO portfolio on is minimized. to deal with procedures itor their risk exposure to mon- to both indiLBO credits. In the banks must have estabprocedures to handle and docu- the special legal problems associated with LBO lendIO ing. Finally, the adequacy of internal will be examined. stance, has management prudent and reasonable total amount of exposure diversifica- to have in procedures including controls is important. Even in a robust macroeconorny, can affect the ability have the the target company's For inestablished limits on the of exposure and the type to LBO credits bank and a consolidated (on both a holding com- pany basis)? future cash flows. The recent expansion leveraged risk may not by diversifying diversification regional- • highly macroeconomic portfolio, the risk of LBO loans? lished policies, be mitigated its and LBO loan expo- vidual and aggregate macro- risks in its LBO-related Although of an can the bank identify place specific of collateral as the composition LBO exposure. mentation stock may double su- manage- a bank or bank holding Banks are also expected cern is that a bank may not be able to adequately Federal ment skills and portfolio in evaluating a LBO portfolio go under if interest rates rise dramatically economic the risk there is less equity It is therefore of the proposed of leverage accentuates in the firm to absorb posi- these risks. the larger degree in LBO financing creditor, loans. so be in an excellent firms' severe economic cash flows. triple when a takeover market highly leveraged have on many vice their debt from operating and with loans in the Midwest value of a firm's tions carry many of the same risks of banks should of on col- recession) against procedures would emphasize LBO portfolio Inc., January II, 1989, page 2. Iy a prolonged projections and cash flows may be difficult, banks. pervisors LBO credit: portfolio. • Risks Associated with LBO Credits However, in terms of total primarily should cash flows and secondarily However, tion to assess and assume deals analysis of bank holding companies. more traditional size of in 1988 was $327 The multibillion-dollar dominated $500 mil- Lending when lending in the firm may be held by non- LBO financing price under $500 mil- were deemed sure? In addition, lustrates of total Some of the equity bank subsidiaries as LBOs by Venture Economics, dollar financing a. Deals announced or consummated in 1988. b. Millions of dollars. SOURCE: BIIW!/IfS. vol. 2, issue I. Venture Economics. lateral values. in- of LBO deals last year were rela- identified ceeded (junk bonds). reorganized tively small. Of the 304 deals in 1988 This Economic Commentary of the total. These debentures financing. I show that the bulk of the $98.3 billion system. lately 30 speculative using their supervisory would take action in place for evaluating of unse- up roughly highly 304 of secured which consists vestments makes of the tier is mezza- cured debt and makes to be that have of attention consists nine financing, percent and to folios than they would up 50 to 60 percent a U.S. leveraged. the transactions The first tier is senior debt, bank loans. The second is not un- like Japan, have three tiers of total and mainly a debt- firm with this ratio is considered Even though guarantees." leveraged Although financing. which makes in a debt-to-assets book more LBO loans for their portof deposit LBOs typically the J.P. Morgan to-assets highly Totals that constitutes firm is a relative ratio of 35 perceru." than most loans to system guarantees on of leverage net. High levels of safety with both increased expected LBO exposure and, ultimately, are thought The degree about Regulators, authority, bank only if its internal for years. Most loans guaran- of loans for leveraged guideliner' firms leveraged financings. as a leveraged have lent to highly million) debt financing, Reserve using 75 percent general restructur- a firm as highly leveraged if it has 70 percent for loans to highly is not a new activity as an LBO? There seems to be no consensus: Trust defines Making must a firm What effects downturn (especial- Current Currently, Supervisory federal supervise bank authorities and regulate the banking portfolios system on the activities 8 overdrafts no addi- Moreover, as the bank's to much like the system, banks are being asked to define, manage, and impose internal limits on industry overall Specifically. as well exposure to on both a firm and basis. In the context may be treated they of the credits diversification, asset portfolio, tion of credit. of will pay to the composition total capital the LBO portfolio, taken to reign in daylight in the payments attention and the overall only the existing pertain particular with their evaluation bank examiners will look at the quality of banks participating for bank lending LBO loans approach Because management, of the LBO portfolio. have been imposed in the LBO market, regulations both risks posed to from the LBO of banks. tional restrictions In conjunction Response of the total LBO loans as a specific concentra- Another concern of bank regulators is this approach is that banks should be al- the syndicated loans in a bank's LBO portfolio. To the extent that the lead banks in the LBO loan syndicate primarily perform an investment banking lowed to choose the risk of their portfolio without regulatory inter- function and retain only a small percentage of the loans on their books, the banks purchasing the loans must conduct their own independent evaluation of the loan. Examiners will scrutinize this part of the portfolio to determine the adequacy of internal procedures for evaluating and managing the risks of the syndicated loans. In addition, examiners are concerned with banks' potential higher risk of obtaining liens on collateral and participating in any debt renegotiation. • LBO Loans and Risk-Based Capital Standards Bank regulators view capital as the last line of defense between unexpected earnings losses on a bank's portfolio and both uninsured bank depositors and the regulatory safety net. The traditional approach to capital regulation has been to set a uniform capital-toassets ratio for all banks, regardless of their risk, and to control portfolio risk through supervision and regulation. This approach has been criticized for two reasons. First, regulators do not know with much precision how much capital an individual bank (let alone all banks) needs to hold to protect against insolvency. Second, the amount of capital required to protect the federal deposit insurance funds and uninsured depositors from loss varies from bank to bank depending on risk. In response to the second criticism, bank regulators in the United States and in the other major developed countries have recently announced new international capital standards for banks. II These new standards require banks to hold a level of capital that corresponds to the credit risk in their portfolio. The new capital standards partition a bank's asset portfolio into four risk categories according to perceived default risk. The amount of capital a bank must hold against a particular asset (or activity) is then determined by its risk category. The premise behind ference, so long as increased risk to depositors and to the federal deposit insurance funds is offset by increased capital protection. Critics of the new capital guidelines claim that they do not explicitly recognize the increased risk associated with LBO-related loans. Under the current risk-based capital standards, loans to highly leveraged companies are placed into the same risk category as more traditional commercial and industrial loans. This means that a bank must hold the same amount of capital to back up an LBO-related credit as it would a similar credit to a lessleveraged firm. Admittedly, the standards are not perfect because they do not take into account all risks. However, risk distinctions beyond those contained in the regulatory framework are difficult to define with precision. Additionally, regulating risk runs the danger of introducing unwanted effects on credit allocation. More important, the riskbased ratio is only a first step in assessing capital adequacy. As is the case with other loans, the quality of LBO-related loans and investments must also be taken into account. Moreover, the final risk-based capital guidelines are the result of negotiation and compromise between bank regulators in the nations adopting the new capital standards. Given the differences in capital structure for nonfinancial firms across countries (as noted earlier, Japanese firms tend to be much more leveraged than U.S. firms), it would be difficult to gain a consensus among nations to adopt capital guidelines that differentiate among loans according to the leverage of the borrower. Consequently, it is unlikely that LBO-related loans will be assigned their own risk class under the international capital guidelines. • Conclusion LBO financing is a natural market for banks to excellent this risk. much as engage in, and they are in an position to assess and assume With returns on LBO loans as four percentage points higher than those available on more traditional commercial loans, it appears that the higher risk may currently be offset by higher expected returns. 12 The high debt-to-equity ratio in the resulting firm leaves little or no margin for error when evaluating and pricing these loans, however. Lenders therefore need to adopt adequate controls and procedures for evaluating, pricing, and managing the risks of this type of lending activity. As long as banks adopt appropriate internal controls, bank regulators should reasonably expect that supervision-not regulationis the appropriate approach to LBOrelated lending. 1. See Barbara A. Rehm, "Regulators Mull Steel: J.P. Morgan Paved the Way for LBOs: Changes in Fees on LBO Loans: Bank Exposure to Firms in Debt Raises Concerns," Bidding for RJR Nabisco Has Precedents Dating Back to the Turn of the Century," The - American Banker, January 31, 1989, page I. Wall Street Journal, Midwest Edition, Balik of Cleveland. The author would like to 2. See Nancy J. Needham, "Son ofLDCs: November 15, 1989,pageAl. thank Lawrence Cuy, William Osterberg, and Banks Are Borrowing Trouble with Loans to 7. See Buyouts, vol. 2, issue I, Venture LBOs," Barron's, December 26, 1988, page Economics, Inc., January II, 1989. • Footnotes 13. 6. See George Anders, "Shades of U.S. 8. Additional reporting requirements for 3. See Sarah Bartlett, "Bankers Defend LBO loans may be required. The Y-9 report Buyout Loans But Investors Fret," The New for bank holding companies may include a York Times, October 28, 1988, page D I. line item for LBOs in the near future. Further- 4. As I discussed in an earlier article, the more, the federal bank regulators may current system of federal deposit guarantees subsidizes risk-taking behavior by banks. change the accounting treatment of fees on LBO credits. See Barbara A. Rehm, op. cit. The value of the subsidy increases with the 9. For a discussion of the payments system risk of the bank. Therefore, banks will tend and daylight overdrafts, see E.J. Stevens, to hold riskier portfolios than they would if "Reducing Risk in Wire Transfer Systems," there were no deposit insurance subsidy. See James B. Thomson, "Equity, Efficiency, and Economic Review. Federal Reserve Bank of Cleveland, Quarter 21986, pages 17-22; and Mispriced Deposit Guarantees," Economic E.J. Stevens, "Pricing Daylight Overdrafts," Commentary, Federal Reserve Bank of Cleveland, July 15, 1986. of Cleveland, December 1988. 5. However, not all loans to companies with 10. Working Paper 8816, Federal Reserve Bank Unique legal problems can arise during 75 percent debt financing are classified as the first year of an LBO loan. mostly con- LBOs by the Federal Reserve. In addition to cerning fraudulent conveyance, equitable sub- the leverage criteria, the loans must be for ordination. and state bulk transfer laws. the purpose of acquiring or reorganizing the firm to be considered as LBO credits by the Federal Reserve System. Economic Commentary is a biweekly below are available through periodical the Public ton, "New Guidelines for Capital: An Attempt to Reflect Risk," Business Review Federal Reserve Bank of Philadelphia. July/August 12. 1987, pages 19-33. See Stan Hinden, "Executive Urges LBO Loan Curbs: Moody's Official Sees His- published by the Federal and Bank Relations Reserve Department, Bank of Cleveland. Copies of the titles listed 216/579-2157. James B. Thomson is an assistant vice president and economist at the Federal Reserve Mark Sniderman for helpful comments. The views stated herein are those of the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Has Manufacturing's Presence in the Economy Diminished? Randall W. Eberts and John R. Swinton 1/1/88 Stable Inflation Fosters Sound Economic Decisions James G. Hoehn 5/1/88 The Case for Zero Inflation William T. Gavin and Alan C. Stockman 9/15/88 Public Infrastructure and Economic Development Douglas Dalenberg and Randall W. Eberts 1/15/88 What's Happening Compensation? Erica L. Groshen 5/15/88 How Are the Ex-ODGF Thrifts Doing? Paul R. Watro 10/1/88 Bank Runs, Deposit Insurance, and Bank Regulation, Part I Charles T. Carlstrom 2/1/88 Debt Repayment and Economic Adjustment Owen F. Humpage 6/1/88 Bank Runs, Deposit Insurance, and Bank Regulation, Part II Charles T. Carlstrom 2/15/88 Measuring the Unseen: A Primer on Capacity Utilization Measures Paul W. Bauer and Mary E. Deily 6/15/88 The Bank Credit-Card Some Explanations and Consequences Paul R. Watro 3/1/88 A User's Guide to CapacityUtilization Measures Paul W. Bauer and Mary E. Deily 7/1/88 Boom: Federal Budget Deficits: Sources and Forecasts John J. Erceg and Theodore G. Bernard 3/15/88 11. For a more detailed discussion of the new capital guidelines, see Janice M. Moul- Affairs International Developments and Monetary Policy W. Lee Hoskins . 4/1/88 Merchandise Trade and the Outlook for 1988 Gerald H. Anderson 4/15/88 to Labor Three Common Misperceptions Foreign Direct Investment Gerald H. Anderson 7/15/88 Assessing and Resisting Inflation Gerald H. Anderson 10/15/88 What's Happened ing Jobs? Randall W. Eberts 11/1/88 Productivity, Costs, and International Competitiveness John J. Erceg and Theodore G. Bernard 11/15/88 About Humphrey-Hawkins: The July 1988 Monetary Policy Report William T. Gavin and John N. McElravey 8/1/88 Is the Thrift Performance Gap Widening? Evidence from Ohio Paul R. Watro 8/15/88 Intervention and the Dollar Owen F. Humpage 9/1/88 tory as a Warning," The Washington Post, February 2, 1989, page F2. to Ohio's Manufactur- Commercial Lending of Ohio's S&Ls Gary Whalen 12/1/88 Service-Sector Wages: the Importance of Education John R. Swinton 12/15/88 International Policy Coordination: Can We Afford It? W. Lee Hoskins 1/1/89 Money and Velocity in the 1980s John B. Carlson and John N. McElravey 1/15/89 Monetary Policy, Information, and Price Stability W. Lee Hoskins 2/1/89 BULK RATE U.S. Postage Paid Cleveland,OH Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Permit No. 385 Cleveland, OH 44101 Material may be reprinted provided that the source is credited. Please send copies of reprinted materials to the editor. Address Correction Requested: Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101 1. See Barbara A. Rehm, "Regulators Mull Steel: J.P. Morgan Paved the Way for LBOs: Changes in Fees on LBO Loans: Bank Exposure to Firms in Debt Raises Concerns," Bidding for RJR Nabisco Has Precedents Dating Back to the Turn of the Century," The - American Banker, January 31, 1989, page I. Wall Street Journal, Midwest Edition, Balik of Cleveland. The author would like to 2. See Nancy J. Needham, "Son ofLDCs: November 15, 1989,pageAl. thank Lawrence Cuy, William Osterberg, and Banks Are Borrowing Trouble with Loans to 7. See Buyouts, vol. 2, issue I, Venture LBOs," Barron's, December 26, 1988, page Economics, Inc., January II, 1989. • Footnotes 13. 6. See George Anders, "Shades of U.S. 8. Additional reporting requirements for 3. See Sarah Bartlett, "Bankers Defend LBO loans may be required. The Y-9 report Buyout Loans But Investors Fret," The New for bank holding companies may include a York Times, October 28, 1988, page D I. line item for LBOs in the near future. Further- 4. As I discussed in an earlier article, the more, the federal bank regulators may current system of federal deposit guarantees subsidizes risk-taking behavior by banks. change the accounting treatment of fees on LBO credits. See Barbara A. Rehm, op. cit. The value of the subsidy increases with the 9. For a discussion of the payments system risk of the bank. Therefore, banks will tend and daylight overdrafts, see E.J. Stevens, to hold riskier portfolios than they would if "Reducing Risk in Wire Transfer Systems," there were no deposit insurance subsidy. See James B. Thomson, "Equity, Efficiency, and Economic Review. Federal Reserve Bank of Cleveland, Quarter 21986, pages 17-22; and Mispriced Deposit Guarantees," Economic E.J. Stevens, "Pricing Daylight Overdrafts," Commentary, Federal Reserve Bank of Cleveland, July 15, 1986. of Cleveland, December 1988. 5. However, not all loans to companies with 10. Working Paper 8816, Federal Reserve Bank Unique legal problems can arise during 75 percent debt financing are classified as the first year of an LBO loan. mostly con- LBOs by the Federal Reserve. In addition to cerning fraudulent conveyance, equitable sub- the leverage criteria, the loans must be for ordination. and state bulk transfer laws. the purpose of acquiring or reorganizing the firm to be considered as LBO credits by the Federal Reserve System. Economic Commentary is a biweekly below are available through periodical the Public ton, "New Guidelines for Capital: An Attempt to Reflect Risk," Business Review Federal Reserve Bank of Philadelphia. July/August 12. 1987, pages 19-33. See Stan Hinden, "Executive Urges LBO Loan Curbs: Moody's Official Sees His- published by the Federal and Bank Relations Reserve Department, Bank of Cleveland. Copies of the titles listed 216/579-2157. James B. Thomson is an assistant vice president and economist at the Federal Reserve Mark Sniderman for helpful comments. The views stated herein are those of the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Has Manufacturing's Presence in the Economy Diminished? Randall W. Eberts and John R. Swinton 1/1/88 Stable Inflation Fosters Sound Economic Decisions James G. Hoehn 5/1/88 The Case for Zero Inflation William T. Gavin and Alan C. Stockman 9/15/88 Public Infrastructure and Economic Development Douglas Dalenberg and Randall W. Eberts 1/15/88 What's Happening Compensation? Erica L. Groshen 5/15/88 How Are the Ex-ODGF Thrifts Doing? Paul R. Watro 10/1/88 Bank Runs, Deposit Insurance, and Bank Regulation, Part I Charles T. Carlstrom 2/1/88 Debt Repayment and Economic Adjustment Owen F. Humpage 6/1/88 Bank Runs, Deposit Insurance, and Bank Regulation, Part II Charles T. Carlstrom 2/15/88 Measuring the Unseen: A Primer on Capacity Utilization Measures Paul W. Bauer and Mary E. Deily 6/15/88 The Bank Credit-Card Some Explanations and Consequences Paul R. Watro 3/1/88 A User's Guide to CapacityUtilization Measures Paul W. Bauer and Mary E. Deily 7/1/88 Boom: Federal Budget Deficits: Sources and Forecasts John J. Erceg and Theodore G. Bernard 3/15/88 11. For a more detailed discussion of the new capital guidelines, see Janice M. Moul- Affairs International Developments and Monetary Policy W. Lee Hoskins . 4/1/88 Merchandise Trade and the Outlook for 1988 Gerald H. Anderson 4/15/88 to Labor Three Common Misperceptions Foreign Direct Investment Gerald H. Anderson 7/15/88 Assessing and Resisting Inflation Gerald H. Anderson 10/15/88 What's Happened ing Jobs? Randall W. Eberts 11/1/88 Productivity, Costs, and International Competitiveness John J. Erceg and Theodore G. Bernard 11/15/88 About Humphrey-Hawkins: The July 1988 Monetary Policy Report William T. Gavin and John N. McElravey 8/1/88 Is the Thrift Performance Gap Widening? Evidence from Ohio Paul R. Watro 8/15/88 Intervention and the Dollar Owen F. Humpage 9/1/88 tory as a Warning," The Washington Post, February 2, 1989, page F2. to Ohio's Manufactur- Commercial Lending of Ohio's S&Ls Gary Whalen 12/1/88 Service-Sector Wages: the Importance of Education John R. Swinton 12/15/88 International Policy Coordination: Can We Afford It? W. Lee Hoskins 1/1/89 Money and Velocity in the 1980s John B. Carlson and John N. McElravey 1/15/89 Monetary Policy, Information, and Price Stability W. Lee Hoskins 2/1/89 BULK RATE U.S. Postage Paid Cleveland,OH Federal Reserve Bank of Cleveland Research Department P.O. 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