US banks that flout new regulatory guidance on leveraged lending risk facing higher capital penalties when the Federal Reserve undertakes its annual stress tests of the banking sector, according to people familiar with the process.

The Fed has begun to warn banks defying its guidelines that making risky leveraged loans could affect its assessment of their loan loss rates in the next stress test, these people said. That, in turn, would affect the Fed’s capital ratio projections.

Capital analysis

The decision to link leveraged lending specifically to the Fed’s annual “comprehensive capital analysis and review” for the first time is likely to alarm Wall Street, since failing the test constrains a bank’s ability to pay dividends to shareholders or to its parent company.

The Fed and the office of the comptroller of the currency issued guidelines last year to govern the kind of loans banks are able to make to debt-laden companies, as they sought to cool potentially overheated credit markets.

The guidance ostensibly prohibits banks from making loans that regulators deem risky, such as those where the loan is more than six times a company’s annual earnings.

More than a third of loans sold in 2014 have come with leverage that exceeds the six- times earnings guidance.

The leveraged lending guidance is one of the first US experiments with a so-called macroprudential tool aimed at counteracting the effects of loose monetary policy.

Years of historically low interest rates have encouraged banks to once again offer relatively cheap financing to companies, spurring a revival of leveraged lending to rival the private-equity fuelled buyout boom of the mid-2000s.

But it is unclear that the guidelines have had much impact on what remains a roaring market. Leveraged loan issuance stands at $445 billion so far this year – slightly below the $470 billion sold in the same period last year but still high by historical standards, according to S&P Capital IQ.

The Fed move is not an enforcement action and is not considered to be an additional capital surcharge but it is likely to influence bank actions. The stress reviews are already a critical way for the central bank to rein in risky behaviour and banks see passing the tests as a top priority. – Copyright The Financial Times Ltd 2014