Leveraged Lending and Collateralized Loan Obligations: Frequently Asked Questions

Summary: Leveraged lending generally refers to loans made to businesses that are highly indebted or have a low credit rating. Most leveraged loans are syndicated, meaning a group of bank or nonbank lenders collectively funds a leveraged loan made to a single borrower, in contrast to a traditional loan held by a single bank. In some cases, investors hold leveraged loans directly. However, more than 60% of leveraged loans are securitized into collateralized loan obligations (CLOs)âsecurities backed by cash flow from pools of leveraged loans. These securities are then sold to investors. The largest investors in leveraged loans and CLOs are mutual funds, insurance companies, banks, and pension funds.

Summary: During the past decade, the U.S. leveraged loan market experienced periods of growth; it grew by 20% in 2018, bringing the amount outstanding to more than $1 trillion. According to some industry observers, deteriorating credit quality and decreasing investor safeguards have accompanied this growth; however, default rates have remained low. The share of leveraged loans originated by and held by banks has declined, whereas the roles of nonbank participants, such as investment management and finance companies, have increased. In addition, some observers have noted similarities between leveraged lending and CLO market characteristics and those of certain mortgage lending and mortgage-backed securities (MBS) markets in the lead-up to the 2007-2009 financial crisis. As a result, leveraged lending has raised a number of interrelated policy issues.

Summary: Observers express concerns that leveraged lending presents certain financial and economic risks, as both a potential source of systemic risk and a mechanism that could exacerbate a future recession (even if it does not cause financial instability). Leveraged lending could pose systemic risk because it couples high risk with opacity, potentially leading to unexpectedly high losses and financial disruption. Some experts have argued that potential leveraged loan losses or illiquidity could lead to contagion effects, wherein one financial firm's distress affects other firms and activities. However, banks' limited exposure to leveraged loans and stronger postcrisis capital and liquidity positions might mitigate contagion effects. For these reasons, some financial authorities (e.g., the chairman of the Federal Reserve) have indicated that although leveraged loans raise some concerns, they "do not appear to present notable risks to financial stability." Even if leveraged loans do not cause financial instability, some nonfinancial firms that rely on leveraged lending could lose access to financing during the next downturn, which could negatively affect their operations if they were unable to find alternative funding. Overall borrowing by nonfinancial firms is historically high, which could lead to a larger-than-normal cutback in their spending or more corporate failures in the next recession, exacerbating that recession.

Summary: Some assert that because certain leveraged loans, such as those involved in private nonbank transactions, face different regulation than leveraged lending by banks and comparable bond issuances, the market might be ineffectively regulated. In addition, some analysts have argued that a lack of transparency in the leveraged lending market prevents the industry and regulators from fully monitoring risks that could be addressed through increased data collection and sharing.

Summary: To date, Congress and the financial regulators have mainly limited the policy response to leveraged lending to monitoring risks. A more active regulatory intervention would be complicated by the fact there are few specific regulations governing leveraged lending. (One exception is a supervisory guidance issued by bank regulators in 2013, which the regulators have stressed is nonbinding but the Government Accountability Office declared to be a regulation for Congressional Review Act purposes in 2017.) Addressing systemic risk is under the purview of federal financial regulators, including the Financial Stability Oversight Council (FSOC), an interagency council headed by the Treasury Secretary. Although FSOC recommended in its 2018 Annual Report that the financial regulators "continue to monitor levels of nonfinancial business leverage, trends in asset valuations, and potential implications for the entities they regulate," it did not recommend regulatory or legislative changes to address leveraged lending.

R apid growth in leveraged lending, a relatively complex form of credit, in the current economic expansion has raised concerns with some policymakers because they have noted similarities between leveraged lending and mortgage lending and mortgage-backed securities (MBS) markets in the lead-up to the 2007-2009 financial crisis. This report explains how leveraged lending works; identifies the borrowers, lenders, and investors who participate in the market; and examines the characteristics of a leveraged loan. It then explains the characteristics of collateralized loan obligations (CLOs)âsecurities backed by cash flow from pools of leveraged loansâand their investors. Understanding CLOs is crucial to a discussion of the policy issues surrounding leveraged lending because more than 60% of investment in leveraged lending occurs through CLOs. The report also provides data on trends and investor composition. Once these basics are explained, the report explores the regulation ofâand some of the potential risks posed byâleveraged lending and CLOs. Finally, it discusses how policymakers have addressed leveraged lending issues to date.

Put simply, leveraged lending refers to loans to companies that are highly indebted (in financial jargon, highly leveraged ). Conceptually, a leveraged loan is understood to be a relatively high-risk loan made to a corporate borrower, but there is no consensus definition of leveraged lending for measurement purposes. Instead, different observers or industry groups use various working definitions that may refer to the borrower's corporate credit rating or a ratio of the company's debt to some measure of its ability to repay that debt, such as earnings or net worth. Because they are high risk, leveraged loans typically have relatively high interest rates, and thus offer higher potential returns for lenders.

Leveraged loans are made to companies from all industries, and the concentration of leveraged lending in each industry varies over time based on industries' economic conditions. In the second quarter of 2018, healthcare and service were the top two industries using leveraged lending. Leveraged loans are often used to complete a buyout or merger, restructure a company's balance sheet (by buying back shares, for example), or refinance existing debt.

Several types of institutions provide funds to borrowers in leveraged lending, including banks, insurance companies, pension funds, mutual funds, hedge funds, and other private investment funds. Put simply, those institutions are the lenders. However, this concise explanation does not capture certain important characteristics and dynamics within the leveraged lending market.

The institution that originates a leveraged loan rarely, if ever, subsequently holds the loan entirely on its own balance sheet, because a lender often would be wary of taking on a large exposure to a single highly indebted company. Instead, the originating lender typically will either (1) partner with colenders, (2) sell pieces of a single loan to investors, or (3) bundle part or all of the loan into a pool of other leveraged loans in a process called securitization , then sell pieces of the pool to investors. The first two optionsâreferred to as syndicat ion and participation , respectivelyâare described in more detail below. The third option creates securities called collateralized loan obligations (CLOs), which are described in more detail in the " What Are CLOs? " section. When examining statistics or regulations related to leveraged loans, this report will distinguish between institutions that issue (i.e., originate or create) leveraged loans and institutions that hold (i.e., invest in or purchase pieces of) leveraged loans or CLOs.

One notable recent trend is the migration of activity from the banking sector to the nonbank sector. Historically, banks played a primary role in both issuing and holding leveraged loans. However, in recent decades, nonbank credit investors, such as private investment funds and finance companies, have increasingly overtaken market share. As shown in Figure 1 , in the primary market , where leveraged loans are first created, bank financing has fallen from about 70% in the mid-1990s to below 10% in 2018, whereas all other nonbank financing combined now comprises more than 90% of leveraged loan investments. As discussed below, this migration of activity from the banking industry to nonbank institutions has implications for systemic risk and how leveraged loans are regulated.

What Are Loan Syndication and Participation?

In general, a single lender does not want to hold a whole leveraged loan because such loans are large and risky. Instead, lenders typically use economically similar but contractually different arrangementsâsyndication and participationâto divide the loan among multiple lenders. Under both arrangements, multiple lenders provide a portion of the loan's funding and share in its risk and returns.

The contractual relationship between the parties differs in syndications and participations. In a syndicated loan, the borrower enters into a single loan agreement with multiple lenders. Hence, all lenders have a direct contractual relationship with the borrower. Alternatively, a single lender could enter into the loan agreement with the borrower, and this originating lender could then sell portions of the loan, called participations , to other lenders. In this case, the borrower has a direct contractual relationship with the originating lender, who in turn has contractual relationships with the other participants. In either case, the loan has in effect been split up between multiple lenders, even though the particulars of the various parties' contractual rights and responsibilities differ.

Syndication and participation require a relatively high degree of coordination among various institutions and stakeholders, and industry practice is that one company acts as an arranger of the deal. The arranger gathers information about the borrower and the loan's purpose, determines appropriate pricing and loan terms, and brings together lenders to join a loan syndication or buy participations. After the deal is closed, the arranger or another company acts as the loan's agent by collecting the payments and fees and passing the appropriate amounts to the loan's holders. The arranger and agent collect fees for these services.

Traditionally, arrangers and agents were banks, who would also hold a large portion of the loan, and the colenders were also banks. Since the mid-1990s, colenders have increasingly been nonbank lenders, such as finance companies and private investment funds, and the portions of loans held by banks have decreased. In some cases, nonbank lenders have taken on the arranger and agent roles. How syndications and participations are regulated is covered in " How Are Leveraged Loans Regulated? "

What Are Covenants and Covenant-Lite Loans?

Leveraged loan agreements typically include covenants âprovisions in the loan contract that set conditions the borrower must meet to avoid technical default (as opposed to a payment default, wherein a scheduled payment is missed). Often these conditions relate to indications of the borrower's ability to repay the loan, such as cash flow and financial performance, or restrict certain actions the borrower may take, such as management changes or asset sales. If the borrower violates a covenant, the lender can accelerate or call the loan (possibly forcing the borrower into bankruptcy), but often lenders will instead restructure the loan with stricter terms that may include additional restrictions on the borrower's behavior.

Lenders see covenants as an important mechanism to monitor the borrower's ability to repay the loan and avoid repayment defaults. Loan agreements that include fewer or more lax covenants than are found in traditional leveraged lending contracts are often characterized as covenant-lite . A number of industry observers have noted that covenant-lite loans are becoming more common, and some have argued this indicates credit standards are declining and could lead to higher losses in the future. However, the causes of the increase in covenant-lite loans and the level of concern this trend warrants are subject to debate.

What Is the Size of the Leveraged Lending Market, and How Much Has It Grown Recently?

The Federal Reserve states that there were approximately $1.15 trillion of leveraged loans outstanding at the end of 2018. For comparison, this amount was similar to U.S. auto loans ($1.16 trillion) or credit card debt ($1.06 trillion) outstanding.

In recent years, leveraged lending has grown much faster than other categories of credit reported by the Federal Reserve (see Table 1 ). The $1.15 trillion outstanding was a 20.1% increase from a year earlierâmore than four times the growth of overall business creditâand annual growth has averaged 15.8% since 2000. By comparison, student loans outstanding grew 5.3% last year and have averaged 9.7% annual growth since 1997.

In part, the rapid growth in leveraged loans reflects growing nonfinancial business indebtedness, but overall nonfinancial business indebtedness grew only about a fifth as quickly as leveraged lending. This suggests that leveraged lending growth may reflect a substitution of one type of debt for another.

Investors can hold leveraged loans by either (1) investing directly in individual leveraged loans, typically through syndications and participations or (2) investing in CLOs. Institutions that directly hold large shares of outstanding leveraged loans include mutual funds (19%), banks (8%), and insurance companies (6%), as shown in Figure 2 . According to one study, mutual fund holdings are split fairly evenly between funds offered to institutional investors and funds offered to retail investors. Nearly all of the remainder of leveraged loans (62%) are held by CLOs. Portions, or tranches , of CLOs are then sold, largely to the same types of investors that invest directly in leveraged loans. CLOs will be discussed in more detail in the next section. As discussed above, banks' share of funding in the leveraged loan market has exhibited a long-term decline.

Collateralized loan obligations are securities backed by portfolios of corporate loans. Although CLOs can be backed by a pool of any type of business loan, in practice, U.S. CLOs are primarily backed by leveraged loans, according to the Federal Reserve. The outstanding value of U.S. CLOs has grown from around $200 billion at year-end 2006 to $617 billion at year-end 2018. As noted above, about 60% of leveraged loans are held in CLOs.

CLOs offer a way for investors to receive cash flows from many loans, instead of being completely exposed to potential payments or defaults on a single loan. To isolate financial risks, CLOs are structured as bankruptcy-remote special purpose vehicles (SPVs) that are separate legal entities. Each CLO has a portfolio manager, who is responsible for constructing the initial portfolio as well as the CLO's ongoing trading activities. CLO managers are primarily banks, investment firms (including hedge funds), and private equity firms.

CLOs are sold in separate tranches , which give the holder the right to the payment of cash flow on the underlying loans. The different tranches are assigned different payment priorities, so some will incur losses before others. This tranche structure redistributes the loan portfolios' credit risk. The tranches are often known as senior , mezzanine , and equity tranches, in order from highest to lowest payment priority, credit quality, and credit rating. Through this process, the loan portfolio's risks are redistributed to the lower tranches first, and tranches with higher credit ratings are formed.

In general, the financial industry views CLOs' tranched structure as an effective method for providing economic protection against unexpected losses. As Figure 3 illustrates, in the event of default, the lower CLO tranches would incur losses before others. Hence, tranches with higher payment priority have additional protection from losses and receive a higher credit rating. The pricing of the tranches also reflects this difference in asset quality and credit risk, with lower tranches offering potentially higher returns to compensate for greater risks taken.

CLOs are often sold to institutional investors, including asset managers, banks, insurance companies, and others. The asset management industry, which includes hedge funds and mutual funds, mainly holds the riskier mezzanine and equity tranches, and banks and insurers hold most of the lower-risk senior CLO tranches. The Federal Reserve estimated that U.S. investors held approximately $556 billion in CLOs based on U.S. loans at the end of 2018. Of this, an estimated $147 billion in U.S. CLO holdings were issued domestically. Detailed data on domestic CLOs' holders are not available; certain detailed data, however, can be found in the reporting of cross-border financial holdings, which comprise a large majority of U.S. CLOs. The cross-border financial reporting indicates that $409 billion of U.S. CLO holdings were issued in the Cayman Islands, apparently the only offshore issuer. Figure 4 provides an overview by investor type for domestic holdings of these CLOs.

Could Leveraged Loans Exacerbate an Economic Downturn?

The rapid growth of leveraged lending has led to concerns that this source of credit could dry up in the next downturn. A slowdown in leveraged loan issuance could pose challenges for the (primarily) nonfinancial companies relying on leveraged loans for financing. Were these firms to lose access to financing, they could be forced to reduce their capital spending, among other operational constraints, if they were unable to find alternative funding sources. Capital spending (physical investment) by businesses is typically one of the most cyclical components of the economy, meaning it is highly sensitive to expansions and recessions. Overall borrowing by nonfinancial firms is historically high at present. This raises concerns that heavily indebted firms could experience a debt overhang âwhere high levels of existing debt curtail a firm's ability to take on new debtâin the next downturn. If a debt overhang at nonfinancial firms leads to a larger-than-normal reduction in capital spending or more corporate failures, this might exacerbate the overall downturn.

If a downturn in the leveraged loan market had a negative effect on financial stability, as discussed in the next section, negative effects on the overall economy could be greater.

What Are the Risks Associated with Leveraged Loans and CLOs?

Leveraged loans and CLOs pose potential risks to investors and overall financial stability. Some risks, such as potential unexpected losses for investors, are presented by both leveraged loans and CLOs. Some apply to only one, such as risks posed by securitization presented by CLOs. This section considers the risks posed by both, highlighting differences between the two where applicable.

Risks to investors. Like any financial instrument, leveraged loans and CLOs pose various types of risk to investors. In particular, they pose credit risk âthe risk that loans will not be repaid in full (due to default, for example). Credit risk is heightened because the borrowers are typically relatively indebted, have low credit ratings, and, in the case of covenant-lite loans, certain common risk-mitigating protections have been omitted. The ways borrowers often use the funds raised from leveraged loans, such as for leveraged buyouts, can also be high risk. Nevertheless, the overall risk of leveraged loans should not be exaggeratedâleveraged loans have historically had lower default rates and higher recovery rates in default than high-yield ( junk ) bonds, another form of debt issued by financially weaker firms. Credit risk is mitigated to a certain degree because leveraged loans are typically secured and their holders stand ahead of the firm's equity holders to be repaid in the event of bankruptcy. Furthermore, leveraged loans typically have floating interest rates, so interest rate risk is borne by the borrower, not the investor.

As mentioned in the "What Are CLOs?" section, when leveraged loans are securitized and packaged into CLOs, the credit risk of the original leveraged loans is redistributed by the CLOs' tranched structure, with senior tranches (mostly held by banks and insurers) often receiving the highest credit rating (e.g., AAA) and junior tranches (mostly held by hedge funds and other asset managers) receiving lower credit ratings. Subordinated debt and equity positions provide additional protection to the senior tranches. Tranching distributes CLO credit risk differently across investors in different tranches.

Up to this point in the credit cycle, the risks associated with leveraged loans and CLOs have largely not materializedâleveraged loan default rates have been relatively low because of low interest rates and robust business conditions. But some analysts fear that default rates could spike if economic conditions worsen, interest rates rise, or bothâand these possibilities may not have been properly priced in. Default rates on leveraged loans rose from below 1% to almost 11% during the last recession. An unanticipated spike in default rates would impose unexpected losses on leveraged loan and CLO holders.

Systemic risk. Investment losses associated with changing asset values, by themselves, are routine in financial markets across many types of assets and pose no particular policy concern if investors have the opportunity to make informed decisions. The main policy concern is whether leveraged loans and CLOs pose systemic risk ; that is, whether a deterioration in leveraged loans' performanceâparticularly if it were large and unexpectedâcould lead to broader financial instability. This depends on whether channels exist through which problems with leveraged loans could spill over to cause broader problems in financial markets. Losses on leveraged loans or liquidity problems with leveraged loans could lead to financial instability through various transmission channels discussed below.

During the financial crisis, problems with mortgage-backed securities (MBS) demonstrated how a class of securities can pose systemic risk. Similar to CLOs, MBS are complex, opaque securities backed by a pool of underlying assets that are typically tranched, with the senior tranches receiving the highest credit rating. Unexpected declines in housing prices and increases in mortgage default rates revealed that MBSâboth highly rated and lowly rated tranchesâhad been mispriced, with the previous pricing not accurately reflecting the underlying risks. The subsequent repricing led to a cascade of systemic distress in the financial system: liquidity in the secondary market for MBS rapidly declined and fire sales pushed all MBS prices even lower. MBS losses caused certain leveraged and interconnected financial institutions, including banks, investment firms, and insurance companies, to experience capital shortfalls and lose access to the short-term borrowing markets on which they relied. Ultimately, these problems caused financial panic and a broader decline in credit availability as financial institutions deleveraged âreducing new lending activity to restore their capital levelsâin response to MBS losses. The resulting reduction in credit in turn caused a sharp decline in real economic activity.

CLOs today share some similarities with MBS before the crisis, but there are important differences. Similarities include the rapid growth in available credit and erosion of underwriting standards. Both types of securities are relatively complex and opaque, potentially obfuscating the underlying assets' true risks. Outstanding leveraged loans and CLOs are small relative to overall securities markets, which in isolation is prima facie evidence that they pose limited systemic risk, even if they were to become illiquid or subject to fire sales. However, before the financial crisis, policy concerns were mainly focused on potential problems in subprime mortgage markets, which were also relatively small. Nevertheless, problems with subprime mortgages turned out to be the proverbial tip of the iceberg, as the deflating housing bubble caused losses in the much-larger overall mortgage market. Analogously, a disruption in the leveraged lending market could create spillover effects in related asset classes, similar to how problems that started with subprime mortgages eventually spread to the entire mortgage market and nonmortgage asset-backed securities in the financial crisis. Ultimately, the underlying cause of the MBS meltdown was the bursting of the housing bubble. Despite the high share of business debt to gross domestic product (GDP) at present, experts are divided on whether there is any underlying asset bubble in corporate debt markets (analogous to the housing bubble) that could lead to a destabilizing downturn.

In addition, it is not clear whether unexpected losses in leveraged lending would lead to broader systemic deleveraging by financial firms or problems for systemically important institutions. Losses on leveraged loans or CLOs might not cause problems for leveraged financial institutions, such as banks, because (1) their leveraged loan and CLO holdings are small relative to total assets and limited mostly to AAA tranches; and (2) banks face higher capital and liquidity requirements to protect against losses or a liquidity freeze, respectively, than they did before the crisis. Furthermore, the largest holders of leveraged loans and CLOs are asset managers. They generally hold these assets as agents on their clients' behalf and thus are normally not vulnerable to insolvency from asset losses because those losses are directly passed on to account holders, who own the assets.

Another source of systemic risk relates to a liquidity mismatch for certain holders. There is potentially an incentive for investors in leveraged loan mutual funds and exchange traded funds (ETFs), respectively, to redeem their shares on demand for cash or sell their shares during episodes of market or systemic distress, similar to a bank run. Because the underlying leveraged loans and CLOs are illiquid, investors who are first to exit could limit their losses if they redeem them while the fund still has cash on hand and is not forced to sell the underlying assets at fire sale prices. This incentive could act as a self-fulfilling prophecy, as the incentive to run could cause mass redemptions that then force fire sales that reduce the fund's value. Leveraged loan mutual funds generally allow withdrawal on demand, but other run risk may be limited because "U.S. CLOs are not required to mark-to-market their assets, and early redemption by investors is generally not permissible" and other private investment funds, such as hedge funds, often feature redemption restrictions.

Although the financial crisis is a cautionary tale, there are other historical examples where a sudden shift in an asset class's performance did not lead to financial instability. For example, a collapse in the junk bond market following a spike in defaults from 1989 to 1990 did not pose problems for the broader financial system or economy. In addition, while CLO issuance slowed during the last financial crisis, the rating agency and data provider Standard & Poor's reports that CLO default rates remained low and "no tranches originally rated AAA or AA experienced a loss" throughout the crisis. However, the amount of CLOs outstanding was much smaller then compared to now, and product features have changed over time. More recently, in December 2018, relatively large investor withdrawals from bank loan mutual funds did not result in instability in the leveraged loan market.

The goals of financial regulation, and the tools used to achieve those goals, vary based on the type of financial institution, market, or instrument involved. Thus, to answer this question, it is useful to break down leveraged loan regulation by the type of institution and activity (issuance, investment, and securitization).

Leveraged lending falls under the purview of multiple regulators with different regulatory approaches and authorities. This regulatory fragmentation could encourage activities to migrate to less-regulated sectors, limits the official data available, and may complicate the evaluation and mitigation of any potential systemic risk to financial stability associated with leveraged lending.

Following the 2007-2009 financial crisis, the Financial Stability Oversight Council (FSOC), an interagency council of regulators headed by the Treasury Secretary, was created to address threats to financial stability and issues where regulatory fragmentation hinders an effective policy response. In its 2018 Annual Report, FSOC recommended that the financial regulators "continue to monitor levels of nonfinancial business leverage, trends in asset valuations, and potential implications for the entities they regulate." Outside of monitoring risk, FSOC has not, to date, recommended any regulatory or legislative changes to address leveraged lending.

How Are Leveraged Loan Issuance and Syndication Regulated?

The regulations applicable to leveraged loan issuance and syndication differ between banks and nonbank lenders. In both cases, though, leveraged lending falls under the laws and regulations applied to business lending in general, rather than rules that apply specifically to leveraged lending.

In general, banks are required to act in a safe and sound manner to mitigate the potential for failure and are subject to supervision to ensure that they are doing so. As such, regulators generally will check banks' leverage loan origination, syndication, and participation practices as part of regular examinations. This supervision could uncover cases in which a bank is originating or syndicating excessively risky leveraged loans. In addition, the bank regulators have issued guidance documents, most recently in 2013, describing certain standards and practices and communicating regulator expectations related to leveraged lending. Whether this guidance qualifies as regulation that must go through the rulemaking process is a matter of debate examined in the " What Is the Status of the Bank Regulators' Leveraged Loan Guidance? " section later in this report. In any case, the guidance covers only the leveraged loan activities of banks, is not meant to cover nonbank activity or bank investment in CLOs, and cannot address potential systemic risk originating outside of the banking system.

Nonbank participants, with the exception of insurance companies, generally are not subject to similar oversight. To the extent that banks' role in leveraged lending is decreasing, and particularly in cases where a bank is not involved in a leveraged loan at all, this could result in reduced regulatory oversight of leveraged loan issuance and syndication.

What Regulations Do Investors Face When They Hold Leveraged Loans or CLOs?

Regulations applicable to holding leveraged loans or CLOs depend on what type of entity is involved. Nonbank investment funds, banks, and insurance companies all face different requirements. As with regulations applying to issuance, these rules generally are not uniquely or specifically applied to leveraged loans and CLOs, but rather to all types of loans and assets held by these institutions.

Banks. Banks face a number of prudential (or safety and soundness) regulations related to all bank activities, including leveraged lending. Capital requirements and the Volcker Rule are notable prudential regulations banks must consider when engaged in leveraged lending.

Certain payments banks make on capital are flexible, unlike the rigid payment obligations they face on deposits and liabilities. Thus, capital gives banks the ability to absorb some amount of losses without failing. Banks are required to satisfy several requirements to ensure they hold enough capital. In general, these requirements are expressed as minimum ratios between certain balance sheet items that banks must maintain. L everage ratios require banks to hold a certain amount of capital for all loans regardless of riskiness, whereas r isk -weighted ratios require banks to hold an amount of capital based on the riskiness of the loan. When a bank holds leveraged loans or CLO tranches or makes credit available to others to finance leveraged loans or CLOs, it must comply with both types of requirements. Based on the characteristics of individual loans and assets, a bank might be required to hold a relatively large amount of capital for leveraged loans and CLOs to comply with risk-weighted ratios.

Banks also face certain permissible activity restrictions , which prohibit them from engaging in certain risky activities. Section 619 of the Dodd-Frank Act (called the Volcker Rule) is one such regulation that prohibits banks from proprietary trading and certain relationships with hedge funds and certain other funds. The latter restriction may be pertinent to banks' involvement in CLOs, depending on how they are structured. Although CLOs may be structured in a manner similar to loan participations (which generally are allowed under the Volcker Rule), they can also be structured such that banks' ownership interests appear similar to those associated with hedge funds (which is generally not allowed under the Volcker Rule). The Volcker Rule establishes criteria for a CLO to qualify for an exemption. Moreover, the final rule provides guidance on how banks may construct CLO structures to avoid retaining impermissible ownership or equity interests that resemble hedge funds.

In addition, banks are subject to periodic examination by federal bank regulators. If examiners determine a bank is holding overly risky loans, they can give it a worse rating (which in turn could increase the fees it pays for deposit insurance or restrict it from certain activities) or direct it to take corrective action. Because leveraged loans are considered more risky than other loan types, they may be more likely to draw examiners' attention and elicit a response.

Furthermore, the bank regulators established the Shared National Credit Program in 1977 to more closely monitor and assess risk related to large syndicated loans. The program requires banks to report data on syndicated loans larger than $100 million.

To inform banks of their regulatory obligations and regulator expectations related to leveraged lending, the federal bank regulatory agencies have issued a guidance document to banks. Whether this document qualifies as an official regulation, as well as, whether it inappropriately discouraged banks from engaging in leveraged lending, is a subject of debate covered in this report's section " What Is the Status of the Bank Regulators' Leveraged Loan Guidance? " below.

Asset management . Relative to banking, investment funds in the asset management industry involve different operational frameworks and regulatory requirements. The asset management industry's operating framework is an agent-based model that separates investment management functions from investment ownership. In this model, risk is largely borne by the investors who own the assets, not by the companies managing them. This is different from the model used for banking, in which banks own and retain the assets and risks. Asset managers are generally not subject to safety and soundness regulations that apply to banks.

The Securities and Exchange Commission (SEC) is the primary regulator overseeing the asset management industry. The main components of the SEC's asset management regulatory regime include disclosure requirements, investor access restrictions, examinations, and risk mitigation controls. In addition, the SEC's Office of Compliance Inspections and Examinations (OCIE) is responsible for conducting examinations and certain other risk oversight of the asset management industry. Examples of violations involving leveraged loan capital markets participants that could trigger a SEC investigation include market manipulation and violation of fiduciary duties. Industry self-regulatory organizations under SEC oversight, such as the Financial Industry Regulatory Authority (FINRA), could also examine broker-dealers involved with leveraged lending.

Restrictions or requirements for investment funds in the leveraged lending and CLO markets depend on whether a fund is public (broadly accessible by investors of all types) or private (accessible only by institutional and individual investors who meet certain size and sophistication criteria). Public funds that invest in leveraged lending and CLOs include mutual funds and exchange-traded funds (ETFs), whereas private fund investors include hedge funds and private equity. Depending on the types of the funds, they could also be subject to other requirements, such as disclosure of portfolio holdings through prospectus, conflict of interest mitigation through fiduciary requirements, liquidity and leverage restrictions, as well as operational compliance requirements to safeguard client assets.

Insurance. Insurance firms are regulated for safety and soundness, but at the state level rather than by a federal entity. Insurance firms also face risk-based capital requirements that affect how many leveraged loans and CLOs they hold. Insurance capital requirements focus significantly on the riskiness of insurers' contingent liabilities (i.e., potential claims), in addition to the riskiness of the assets they hold. The National Association of Insurance Commissioners (NAIC) assigns a risk assessment to the assets (including leveraged loans and CLOs) insurance companies purchase to back their claims. Riskier assets get less credit toward fulfilling those capital requirements. Thus, the risk assessment assigned to individual leveraged loans and CLOs largely determines the limits that capital requirements impose on insurers' holdings of those loans and securities. In 2017, 97% of CLOs held by insurers received an investment-grade rating from the NAIC (NAIC-1 or NAIC-2), posing less expected risk and requiring less capital to guard against that risk than lower-rated holdings.

A significant difference between the insurance and banking industries, and thus how they are regulated for safety and soundness, is the importance of matching the durations of assets and liabilities in insurance, particularly life insurance. Insurance often entails much longer-term liabilities than does banking, allowing insurers to safely hold longer-term assets to match these longer-term liabilities. This allowance for duration matching may influence the leveraged loans and CLOs an insurer can safely hold. However, insurance regulators have recently increased their focus on the liquidity of insurers' assets, which could discourage insurers from holding many leveraged loans and CLOs because of their relative illiquidity.

How Is the Securitization Process to Create CLOs Regulated?

Through the securitization process, securities (CLOs) backed by leveraged loans are issued and sold to investors. This section highlights the regulatory requirements applied to CLOs and CLO managers. Notably, it discusses the initial application of risk-retention rules to CLOs, and their subsequent partial removal.

The securitization process traditionally allowed managers creating the securities to fully transfer their portfolio assets (and risks) to capital markets investors. This process could result in a misalignment of incentives between managers and investors because the managers did not share much of the securitized products' risks, which has been referred to as a lack of "skin in the game." The 2007-2009 financial crisis revealed this misalignment as a structural flaw that contributed to the crisis. To address the issue, the SEC and other financial regulators adopted credit risk-retention rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( P.L. 111-203 ) for securitization structures, including CLOs, in December 2016. The risk retention rule requires CLO managers to retain 5% of the original value of CLO assets, thus aligning their own interests with those of investors (i.e., imposing skin in the game). Subsequently, in 2018, the U.S. Court of Appeals ruled that managers of open-market CLOs, which are reportedly the most common form of CLOs, are no longer subject to risk-retention rules. However, other types of CLOs are still subject to risk-retention requirements.

CLOs are securities instruments. The federal securities laws, including the Securities Act of 1933 (P.L. 73-22) and the Securities Exchange Act of 1934 (P.L. 73-291), require all offers and sales of CLO securities to either be registered under its provisions or qualify for an exemption from registration. Registration requires public disclosure of material information, such as the underlying security's financial details. However, most CLOs are created under private exemptions, which require less registration than public offerings but confine offerings to a more limited investor base.

As discussed above, a CLO manager oversees the securitization process. CLO managers are generally registered as investment advisers under the Investment Advisers Act of 1940. As a result, they are subject to the SEC's registration and compliance requirements as well as the fiduciary duties that obligate them to place clients' interests above their own.

What Is the Status of the Bank Regulators' Leveraged Loan Guidance?

Bank regulators use guidance to provide clarity to banks on supervision, such as how supervisors treat specific activities in their exams. In 2013, the federal bank regulators jointly issued an updated 15-page guidance document that described their "expectations for the sound risk management of leveraged lending activities." Subsequently, banks asserted that following the guidance constrained them from making sound loans and that regulators enforced the guidance as if it were a binding regulation. As opposed to guidance, a regulation can be issued only if the agency follows the Administrative Procedure Act's requirements (5 U.S.C. Â§551 et seq.), including the notice and comment process and other relevant requirements. Under the Congressional Review Act (CRA; P.L. 104-121 ), regulators must submit new regulations and certain guidance documents to Congress, which can then prevent a regulation or guidance from taking effect by enacting a joint resolution of disapproval. Because the bank regulators appeared to have the view that the document did not meet the CRA's definition of "rule," they did not submit it to Congress.

In 2017, Senator Pat Toomey asked the Government Accountability Office (GAO) to analyze the guidance and determine whether it qualified as a rule subject to CRA review. GAO concluded that the guidance is a rule subject to CRA review. Following GAO's determination, the bank regulators reportedly sent letters to Congress indicating they would seek further feedback on the guidance, and Federal Reserve Chairman Jerome Powell indicated at a hearing on February 27, 2018, that the Federal Reserve has emphasized to its bank supervisors that the guidance was nonbinding. The Comptroller of the Currency, Joseph Otting, reportedly stated in 2018 that the guidance provides flexibility for leveraged loans that do not meet its criteria, provided banks operate in a safe and sound manner. To date, no changes have been made to the guidance and no joint resolution of disapproval under the CRA has been introduced. The Congressional Research Service has been unable to locate a submission of the guidance to Congress following the GAO finding that it was required under the CRA.

How Has Congress Responded to Leveraged Lending?

The House Financial Services Committee held a hearing on June 4, 2019, entitled Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending . Two unnumbered draft bills related to leveraged lending were considered at this hearing. The draft Leveraged Lending Data and Analysis Act would require the Office of Financial Research, a Treasury office that supports FSOC, to gather information, assess risks, and make recommendations in a report to Congress on leveraged lending. The draft Leveraged Lending Examination Enhancement Act would require the Federal Financial Institutions Examination Council (FFIEC), an interagency council of federal bank regulators, to set prudential standards for leveraged lending by depository institutions. It would also require the FFIEC to report quarterly on leveraged lending by depository institutions.


Contaminants of Emerging Concern under the Clean Water Act

Summary: Recent decades have seen increased national attention to the presence of "emerging contaminants" or "contaminants of emerging concern" (CECs) in surface water and groundwater. Although there is no federal statutory or regulatory definition of CECs, generally, the term refers to unregulated substances detected in the environment that may present a risk to human health, aquatic life, or the environment and for which the scientific understanding of potential risks is evolving. CECs can include many different types of manufactured chemicals and substancesâsuch as those in pharmaceuticals, industrial chemicals, agricultural products, and microplasticsâas well as naturally occurring substances, such as algal toxins. Data on CECs that would help determine their risk to humans and aquatic life or other aspects of the environment are often limited. Increased monitoring and detections of one particular group of chemicals, per- and polyfluoroalkyl substances (PFAS), has recently heightened public and congressional interest in these CECs and has also prompted a broader discussion about how CECs are identified, detected, and regulated and whether additional actions should be taken to protect human health and the environment. While several statutes provide authorities to the U.S. Environmental Protection Agency (EPA) and states to address CECs, this report examines authorities available under the Clean Water Act (CWA)âwhich Congress established to restore and protect the quality of the nation's surface waters.

Summary: EPA has several CWA authorities it may use to address CECs, although it faces some challenges in doing so. Under the CWA, a primary mechanism to control contaminants in surface waters is through permits. The statute prohibits the discharge of pollutants from any point source (i.e., a discrete conveyance) to waters of the United States without a permit. The CWA authorizes EPA and states to limit or prohibit discharges of pollutants in the National Pollutant Discharge Elimination System (NPDES) permits they issue. These permits incorporate technology-based and water-quality-based requirements.

Summary: The CWA authorizes EPA and states to address CECs through technology-based effluent limitations using national Effluent Limitation Guidelines and Standards (ELGs) or by setting technology-based effluent limits in NPDES permits on a case-by-case basis. The CWA requires EPA to publish ELGs, which are the required minimum standards for industrial wastewater discharges. The CWA also requires EPA to annually review all existing ELGs and to publish a biennial plan that includes a schedule for review and revision of promulgated ELGs, identifies categories of sources discharging toxic or nonconventional pollutants that do not have ELGs, and establishes a schedule for promulgating ELGs for any newly identified categories. In cases where EPA has not established an ELG for a particular industrial category or type of facility, or where pollutants or processes were not considered when an ELG was developed, the permitting authority (EPA or states) may still impose technology-based effluent limits on a case-by-case basis. Although EPA and states have these authorities available to address CECs, there are some challenges to doing so, including a lack of data available to support new ELGs or updates to existing ELGs. Agency officials stated that it is difficult for the agency to keep pace with the growth of new chemicals in commerce.

Summary: The CWA also authorizes EPA and states to address CECs through water-quality-based requirements. States are required to adopt water quality standards for waters of the United States and review them at least once every three years. The CWA requires EPA to publish, and "from time to time thereafter revise" water quality criteria that reflect the latest scientific knowledge. States use EPA's criteria as guidance in developing their water quality standards. The CWA directs states to adopt criteria to protect their water bodies' designated uses and to also adopt criteria for all pollutants on the Toxic Pollutant List, for which EPA has published criteria. Once a state adopts water quality criteria for a contaminant as part of its water quality standards, several CWA tools are available to the state for achieving them. The primary tool is to establish water-quality-based effluent limitations in NPDES permits. Although EPA and states have authority to address CECs through water-quality-based requirements, they often lack data needed to support development of criteria or water-quality-based effluent limitations.

Summary: The CWA also authorizes EPA to designate contaminants as toxic pollutants or as hazardous substances, which may trigger other actions under the CWA and the Comprehensive Environmental Response, Compensation, and Liability Act.

Summary: Recent congressional interest in CECs has focused on addressing one particular group of CECsâPFASâand on addressing them through other statutes. However, in the 116 th Congress, H.R. 3616 and H.Amdt. 537 , Section 330A, of the House-passed version of the National Defense Authorization Act for FY2020 ( H.R. 2500 ), would direct EPA to add PFAS to the CWA Toxic Pollutant List and publish ELGs that establish effluent limitations and standards for PFAS within specified time frames.

Over the past couple of decades, national attention to "emerging contaminants" or "contaminants of emerging concern" (CECs) in surface water and groundwater has been increasing. Although there is no federal statutor y or regulatory definition of CECs, generally, the term refers to unregulated substances detected in the environment that may present a risk to human health, aquatic life, or the environment. CECs can include many different types of manmade chemicals and substancesâsuch as those in personal care products, pharmaceuticals, industrial chemicals, lawn care and agricultural products, and microplasticsâas well as naturally occurring substances such as algal toxins or manganese.

CECs often enter the environment, including ground and surface waters, via municipal and industrial wastewater discharges and urban and agricultural storm runoff. Although municipal and industrial wastewater are both treated prior to discharge into waterways, treatment facilities are often not designed to remove CECs. The availability of data on CECsâsuch as concentration and pervasiveness in the environment or exposure or toxicity data that would help determine their risk to humans and aquatic lifeâmay be limited.

In some cases, detections of CECs in the environment have triggered a call for action from federal, state, and local government, as well as Congress. Increased monitoring and detections of one particular group of chemicals, per- and polyfluoroalkyl substances (PFAS), has recently heightened public and congressional interest in these CECs and has also prompted a broader discussion about how CECs are identified, detected, and regulated and whether additional actions should be taken to protect human health and the environment.

Several statutesâincluding the Safe Drinking Water Act; the Toxic Substances Control Act (TSCA); the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA); and the Clean Water Act (CWA) âprovide authorities to the U.S. Environmental Protection Agency (EPA) and states to address particular CECs. In the 116 th Congress, Members have introduced more than 40 bills to address PFAS through various means. Multiple bills, including House- and Senate-passed National Defense Authorization Act (NDAA) bills for FY2020 ( H.R. 2500 and S. 1790 , respectively), would direct EPA to take regulatory and other actions to address PFAS under several environmental statutes. Two of these bills ( H.R. 2500 and H.R. 3616 ) would direct EPA to address PFAS using authorities provided to the agency under the CWA, which Congress established to restore and protect the quality of the nation's surface waters.

Global concern about another group of CECsâmicroplasticsâand their potential impacts has also been mounting. Recent studies have found that treated effluents from wastewater treatment plants can be key sources of microplastics, as can runoff from agricultural sites where sewage sludge from the wastewater treatment process has been applied as fertilizer. As with many other CECs, wastewater treatment facilities are generally not designed to screen for microplastic debris, such as microbeads, plastic fragments, or plastic fibers from clothing. Congress has shown interest in addressing the impacts of plastic pollution. In 2015, Congress passed legislation to ban plastic microbeads from rinse-off personal care products ("Microbead-Free Waters Act of 2015," P.L. 114-114 ). More recently, some Members in the 116 th Congress announced plans to introduce comprehensive legislation to address plastic waste in fall 2019.

Some stakeholders have asserted that EPA could be more effective in using its existing CWA authorities to address CECs, while others have suggested a need to identify and address potential gaps in CWA authorities through amendments to the statute. This report examines authorities available to address CECs under the CWA.

Addressing CECs through the Clean Water Act

EPA has several CWA authorities it may use to address CECs, although it faces some challenges in doing so. The CWA's stated objective is "to restore and maintain the chemical, physical, and biological integrity of the Nation's waters." To help achieve this objective, the CWA prohibits the discharge of pollutants from any point source (i.e., a discrete conveyance, such as a pipe, ditch, etc.) to waters of the United States without a permit. Under the CWA, one of the primary mechanisms to protect or improve surface water quality is to limit or prohibit discharges of contaminants, including CECs, in National Pollutant Discharge Elimination System (NPDES) permits. The CWA authorizes EPA and delegated states to set limits or prohibit discharges of pollutants in permits through technology-based effluent (i.e., discharge) limitations and standards and through water-quality-based effluent limitations, which are established through water quality standards and criteria. Technology-based effluent limitations are specific numerical limits (i.e., maximum allowable levels of specific pollutants) that represent the minimum level of control that must be established in a permit. In cases where technology-based effluent limitations are not adequate to meet applicable water quality standards, the permits also incorporate water-quality-based effluent limitations. Water-quality-based effluent limitations are specific limits established in a permit that, if not exceeded in the discharge, allow for attainment of water quality standards in the receiving water. Water quality standardsâestablished by states, territories, tribes, and EPAâdefine the desired condition or level of protection of a water body and what is needed to achieve or protect that condition. In addition, the CWA authorizes EPA to designate contaminants as toxic pollutants (CWA Â§307) or as hazardous substances (CWA Â§311), which may trigger other actions under the CWA and CERCLA. This section first identifies the authorities available under the CWA, their applicability to CECs, and potential challenges with EPA use of these authorities.

The CWA requires EPA to establish technology-based effluent limitations for various categories of point sources/dischargers . Technology-based requirements consider the performance of specific technologies as well as economic achievability. These limits do not specify what technologies must be employed; rather , they establish the levels of specific pollutants that are allowable in the discharge based on the performance of technologies identified as representing specified levels of control (e.g., best available technology economically achievable, best conventional pollutant control technology). CWA Section 301 prescribes the levels of control required. EPA broadly classifies NPDES permittees as either (1) publicly owned treatment works (POTWs) or (2) non-POTWs, which include all other point sources and are also often called n on municipal facilities or industrial facilities .

The CWA requires POTWs to meet secondary treatment standards as determined by EPA. Secondary standards are based on performance data for POTWs that use physical and biological treatment to remove or control conventional pollutants.

As shown in Figure 1 , the CWA requires non-POTW dischargers to achieve specified levels of control based on (1) whether a discharger directly or indirectly discharges into a water of the United States (an indirect discharger discharges to a POTW for treatment prior to discharge into a water of the United States), (2) whether the discharger is a new or existing source, and (3) the category of pollutant (conventional, toxic, or nonconventional ).

Effluent Limitation Guidelines and Standards (ELGs)

The CWA requires EPA to publish national regulations for non-POTW dischargersâcalled Effluent Limitation Guidelines and Standards (ELGs)âwhich set minimum standards for specific pollutants in industrial wastewater discharges based on the specified levels of control. Since 1972, EPA has developed ELGs for 59 industrial categories. For direct dischargers, states or EPA incorporate the limits established in ELGs into the NPDES permits they issue. For indirect dischargers, pretreatment standards established in ELGs to prevent pass through and interference at the POTW apply.

The CWA requires EPA to annually review all existing ELGs to determine whether revisions are appropriate. In addition, CWA Section 304(m) requires EPA to publish a plan every two years that includes a schedule for review and revision of promulgated ELGs, identifies categories of sources discharging toxic or nonconventional pollutants that do not have ELGs, and establishes a schedule for promulgating ELGs for any newly identified categories.

In its 2002 draft Strategy for National Clean Water Industrial Regulations , EPA described a process for identifying existing ELGs that the agency should consider revising as well as industrial categories that may warrant development of new ELGs. As outlined in the strategy, EPA considers four main factors when prioritizing existing ELGs for possible revision: (1) the amount and type of pollutants in an industrial category's discharge and the relative hazard to human health or the environment, (2) the availability of an applicable and demonstrated wastewater treatment technology, process change, or pollution prevention measure that can reduce pollutants in the discharge and the associated risk to human health or the environment; (3) the cost, performance, and affordability or economic achievability of the wastewater treatment technology, process change, or pollution prevention measure; and (4) the opportunity to eliminate inefficiencies or impediments to pollution prevention or technological innovation or promote innovative approaches. EPA considers nearly identical factors in deciding whether to develop new ELGs.

EPA uses a variety of screening-level analyses to address these factors. These analyses evaluate discharge monitoring reports and EPA's Toxic Release Inventory to rank industrial categories according to the total toxicity of their wastewater. In 2012, the Government Accountability Office recommended that the annual review include additional industrial hazard data sources to augment its screening-level reviews. In response, EPA has begun to use additional data sources that provide information about CECs or new pollutant discharges, industrial process changes, and new and more sensitive analytical methods, among other things. For example, EPA has reviewed data from the agency's Office of Pollution Prevention and Toxics to identify potential CECs.

If EPA identifies an industrial discharge category warranting further review, it conducts a more detailed review, which may lead to a new or revised guideline.

EPA published its most recent effluent guidelines program planâthe Final 2016 Effluent Guidelines Program Plan âin April 2018. It identified one new rulemaking to revise the Steam Electric Power Generating Point Source Category ELG but concluded that no other industries warrant new ELGs at this time. In its plan, EPA also announced that it is initiating three new studies: a holistic look at the management of oil and gas extraction wastewater from onshore facilities, an industry-wide study of nutrients, and an industry-wide study of PFAS.

Options to Address CECs through Technology-Based Requirements

Both EPA and states have authority under the CWA to address CECs through technology-based effluent limitations using ELGs or by setting technology-based effluent limits in NPDES permits on a case-by-case basis. In addition, the CWA authorizes EPA to add contaminants to the Toxic Pollutant List.

When EPA develops an ELG for a new industrial category or revises an existing ELG, it is for the industrial categoryânot a specific pollutant. However, as evidenced in the agency's most recent effluent guidelines program plan, EPA may initiate a cross-industry review of particular pollutants (such as the agency is doing with PFAS and nutrients). EPA uses such reviews to prioritize further study of the industrial categories that may be candidates for ELG development or revision to control the discharges of those particular pollutants. If EPA were to determine that new or revised ELGs are warranted to control discharges of those pollutants, and the agency had the necessary data to support the development or revision, the agency could initiate a rulemaking process to do so.

Establishing Technology-Based Effluent Limits in NPDES Permits on a Case-by-Case Basis

The CWA also authorizes EPA and states to impose technology-based effluent limits in NPDES permits on a case-by-case basis when "EPA-promulgated effluent limitations are inapplicable." This includes when EPA has not developed ELGs for the industry or type of facility being permitted or pollutants or processes are present that were not considered when the ELG was developed. This provides a means for the permitting authority to restrict pollutants in a facility's discharge even when an ELG is not available. CWA regulations require best professional judgment to set case-by-case technology-based effluent limits, applying criteria that are similar to the analysis EPA uses to develop ELGs but are performed by the permit writer for a single facility.

The CWA also authorizes EPA to designate contaminants as toxic pollutants, which can trigger other actions under the CWA and CERCLA. (For a discussion of the effect of designating a contaminant as a toxic pollutant on the treatment of that contaminant under CERCLA, see " Designating CECs as Toxic Pollutants or Hazardous Substances .") CWA Section 307 authorizes EPA to designate toxic pollutants and promulgate ELGs that establish requirements for those toxic pollutants. Section 307(a)(1) directed EPA to publish a specified list of individual toxic pollutants or combination of pollutants and, from time to time, add or remove any pollutant that possesses certain properties. EPA adopted the initial list of 65 toxic pollutants in 1978, as directed by Congress. Since that time, the list of 65 toxic pollutants has generally not changed.

Section 307(a)(1) directs EPA to "take into account the toxicity of the pollutant, its persistence, degradability, the usual or potential presence of the affected organisms in any waters, the importance of the affected organisms, and the nature and extent of the effect of the toxic pollutant on such organisms" when revising the Toxic Pollutant List. Section 307(a)(2) authorizes EPA to develop effluent limitations for any pollutant on the Toxic Pollutant List based on best available technology. Notably, however, EPA has the authority to develop effluent limitations for any pollutant regardless of whether it is on the Toxic Pollutant List.

Adding a pollutant to the Toxic Pollutant List would trigger an additional requirement for states. Section 303(c)(2)(B) of the CWA requires states, whenever reviewing, revising, or adopting water quality standards, to adopt numeric criteria for all toxic pollutants listed pursuant to Section 307, for which EPA has published water quality criteria under Section 304(a). EPA and states use both the ELGs for industrial categories and state water quality standards in establishing pollutant limits in permits under Section 402. (See Figure 1 .)

Challenges to Addressing CECs through Technology-Based Requirements

EPA and states face a number of challenges in addressing CECs through technology-based effluent limitations. In particular, EPA officials stated that in developing a new ELG or updating an existing ELG, the agency needs to gather extensive supporting information. This effort includes identifying the pollutants of concern; evaluating the levels, prevalence, and sources of those pollutants of concern; determining whether the pollutants are in treatable quantities and whether effective treatment technologies are available; and developing economic data to project the cost of treatment, among other things.

Also, EPA and state officials have asserted that it is difficult for the agency and its CWA programs to keep pace with the growth of new chemicals in commerce. Accordingly, the agency is generally reactive rather than proactive in addressing CECs. EPA officials stated that identifying demonstrated treatment technologies and documenting their efficiency is especially challenging. The officials further stated that the most difficult task is showing that any technology selected as the basis for an ELG is economically achievable for the industry.

In addition, EPA and states often lack analytical methods to measure an emerging contaminant. Even where analytical methods are available, there is still often a lack of data on the levels of the contaminant in dischargers' effluent and/or in the receiving surface waters. The two sources of data most readily available to EPAâdischarge monitoring report data and toxic release inventory dataâare limited to specific contaminants on which industry is required to report. EPA stated that the agency's capacity to collect dataâincluding obtaining clearance to request and collect the data and undertaking the extensive effort to do soâis limited in light of their staffing levels and resources.

Should EPA have enough data to determine that a new or revised ELG is warranted and announce its intent to do so in an effluent guidelines program plan, the time it takes to issue the regulation varies, according to EPA officials. CWA Section 304(m) establishes a three-year time limit for new ELGs. For revised ELGs, the EPA officials stated that the time can vary depending upon the availability of data and the level of complexityâsome may be very technical and involve many wastestreams. Two of the more recently issued ELGsârevisions of the oil and gas extraction and steam electric power generating categoriesâtook five and six years, respectively.

Under the CWA, water quality standards translate the goals of the act (e.g., fishable and swimmable waters, no toxic pollutants in toxic amounts) into measurable objectives to protect or improve water quality. States, territories, and authorized tribes (hereinafter referred to collectively as states) are required to adopt water quality standards for waters of the United States, subject to EPA approval. They may also adopt standards for additional surface waters if their own state laws allow them to do so.

Water quality standards consist of three key required components:

1. Designated uses for each water bodyâfor example, recreation (swimming or boating), aquatic life support, fish consumption, public water supply, agriculture; 2. Criteria , which describe the conditions in a water body necessary to support the designated usesâexpressed as concentrations of pollutants or other quantitative measures or narrative statements; and 3. An antidegradation policy for maintaining existing water quality.

States have the primary authority to adopt, review, and revise their water quality standards and implementation procedures. The CWA requires states to review their water quality standards at least once every three years. EPA is required to review the states' water quality standards.

Water quality criteria prescribe limits on specific contaminants or conditions in a water body that protect particular designated uses of the water body. Both the EPA and states have roles in establishing water quality criteria under CWA Section 304(a) and 303(c)(2), respectively.

CWA Section 304(a) requires EPA to develop and publish and "from time to time thereafter revise" criteria for water quality that accurately reflect the latest scientific knowledge. These criteria are recommendations to states for use in developing their own water quality standards. EPA has developed several different types of criteria, including human health criteria, aquatic life criteria, and recreational criteria. EPA has also published guidelines for deriving water quality criteria, which the agency uses to develop new criteria under Section 304(a). These guidelines also serve as guidance to states as they adjust water quality criteria developed under Section 304(a) to reflect local conditions or develop their own scientifically defensible water quality criteria.

EPA most recently updated its human health criteria in 2015, revising 94 of the 122 existing human health criteria. EPA last updated its methodology for deriving human health criteria in 2000, incorporating "significant scientific advances in key areas such as cancer and non-cancer risk assessments, exposure assessments, and bioaccumulation in fish."

EPA's national recommended aquatic life criteria table currently includes 58 criteria. Many of these criteria were published prior to 1990. In the past 10 years, EPA has published two new criteria. EPA has not updated its guidelines for deriving aquatic life criteria since 1985. According to EPA, however, the guidelines allow for best professional judgment, which they have used in more recent criteria development and updates. The agency recognizes that since 1985, there has been substantial scientific advancement that warrants updating these guidelines. EPA formally initiated the guidelines revision process in 2015. However, according to EPA officials, the agency has shifted its focus from updating the guidelines to determining whether available data and research support development of human health criteria for PFAS. In doing so, EPA officials indicated they plan to use information gathered for the guidelines revision and also noted that they are not tied to the 1985 guidelines due to the best professional judgment clause included therein.

EPA's recreational water quality criteria are national recommendations for all inland and coastal waters that have a primary contact recreation (i.e., swimming) designated use. EPA establishes recreational water quality criteria to help protect against illness caused by organismsâsuch as viruses, bacteria, and their associated toxinsâin water bodies. In 2012, EPA updated its recreational water quality criteria, which it had last issued in 1986. Additionally, in June 2019, EPA published final recreational water quality criteria for two algal toxins, which are commonly present in harmful algal blooms, to supplement the 2012 recreational water quality criteria. In addition, EPA is currently developing recreational water quality criteria for coliphage, a viral indicator of fecal contamination.

States use EPA's criteria as guidance in developing their own water quality standards. CWA Section 303(c)(2) requires states to adopt criteria to protect the designated uses of their water bodies and to also adopt criteria for all toxic pollutants listed pursuant to Section 307(a)(1), for which EPA has published criteria under Section 304(a). States' water quality criteria must be based on sound scientific rationale, contain sufficient parameters or constituents to protect the designated uses, and support the most sensitive use for water bodies with multiple designated uses. EPA regulations further require that states should establish numeric criteria based on CWA Section 304(a) guidance, CWA Section 304(a) guidance modified to reflect site-specific conditions, or other scientifically defensible methods. Where numeric criteria cannot be established, states are required to establish narrative criteria or criteria based on biomonitoring methods. States may adopt more stringent criteria than what EPA recommends, including for pollutants or parameters for which EPA has not promulgated 304(a) criteria.

Options to Address CECs through Water-Quality-Based Requirements

EPA and states may establish water quality criteria for CECs. If EPA were to establish criteria under CWA Section 304(a) for a CEC, that action alone would not necessarily require states to adopt criteria for that contaminant. As explained above, the CWA requires that states adopt criteria to protect their designated uses into their water quality standards. EPA's regulations provide that if a state does not adopt new or revised criteria for parameters for which EPA has published new or updated recommendations, then the state shall provide an explanation. States are explicitly required, as explained above, to adopt criteria for a contaminant if EPA designates it as a toxic pollutant under CWA Section 307 and publishes criteria for that contaminant under Section 304(a).

Once a state has adopted water quality criteria for a contaminant as part of its state water quality standards and those standards have been approved, several CWA tools are available for achieving those standards. The primary tool is to limit or prohibit discharges of the contaminant in NPDES permits. In some cases, the technology-based effluent limits may already enable attainment of state water quality standards. In instances where they do not, the permit writer is required to establish water-quality-based effluent limitations. If a water body is not attaining its designated use (i.e., is "impaired" for that use), the Total Maximum Daily Load (TMDL) may also be used. A TMDL, essentially a "pollution diet" for a water body, is the maximum amount of a pollutant that a water body can receive and still meet water quality standards and an allocation of that amount to the pollutant's sources (including a margin of safety). TMDLs consider point sources, which can be addressed through permits, as well as nonpoint (diffuse) sources, which are more often addressed through best management practices and related efforts under CWA Section 319 nonpoint source management programs.

Challenges to Addressing CECs through Water-Quality-Based Requirements

A key challenge is often a lack of data about the occurrence, concentration, and persistence of CECs in the environment, as well as the effects on human health and aquatic life. Detection of a contaminant does not necessarily trigger regulatory measures. Information on the potential for the contaminant to adversely affect human health and aquatic life, potential exposure pathways, and other data would also be needed to inform such decisions.

Developing new water quality criteria or updating existing criteria can often be time intensive, particularly in cases where data are limited. The general process for developing criteria involves a number of steps, including problem formulation and developing an analysis plan; gathering data and analyzing relevant studies; drafting the criteria document; a rigorous review process (e.g., branch level, office level, interagency, and independent external peer review); public notice and comment, and revising and publishing the criteria. According to EPA officials, the time it takes to develop or update criteria is often a function of the data that are available. EPA officials noted that developing criteria can take several years or longer. For example, the 2016 update for the aquatic life water quality criteria for seleniumâan effort characterized by EPA as complicated, in part because of the contaminant's bioaccumulative propertiesâtook 10 years to complete. In other cases, such as when a contaminant has an existing EPA Integrated Risk Information System value, developing or updating the human health water quality criteria for that contaminant may take less time, according to EPA officials.

In May 2019, a report from the Contaminants of Emerging Concern Workgroup, convened by the Association of State Drinking Water Administrators and the Association of Clean Water Administrators, provided recommendations from state regulators regarding the ways state and federal agencies could improve the management of CECs. The report stated the following:

The use of existing authorities and processes under the CWA and [Safe Drinking Water Act] to establish new criteria or standards is onerous, can take decades to implement, and does not meet public expectations for timely identification and prioritization of CECsâ¦. However slow these federal processes are, many state agencies do not have the infrastructure (i.e., sufficient funds and/or staffing levels), regulatory authority, or technical expertise to derive their own criteria or set their own standards for drinking water, surface water, groundwater, and fish tissue.

Among numerous other recommendations provided in the report, the CEC workgroup recommended that EPA work with states to generate a list of priority CECs. To that end, EPA officials stated that they are developing a more formalized prioritization process for determining which contaminants warrant criteria development that will incorporate input from multiple stakeholders (including states), leverage information collected under the Safe Drinking Water Act, and incorporate monitoring and other data (e.g., ambient water concentrations).

Designating CECs as Toxic Pollutants or Hazardous Substances

Two sections of the CWAâSections 307 and 311âauthorize EPA to designate contaminants as toxic pollutants and hazardous substances, respectively. Designating a contaminant under Section 307 or Section 311 of the CWA has implications for how the contaminant is treated under CERCLA. CERCLA defines the term hazardous substance to include toxic pollutants designated under CWA Section 307 and hazardous substances designated under CWA Section 311 (as well as substances designated under certain other statutes and other chemicals that EPA may designate as hazardous substances).

EPA's authority to designate contaminants under CWA Section 307 as toxic pollutants and the CWA-related implications of that designation are discussed above under " Toxic Pollutant List ."

CWA Section 311(b)(2)(A) authorizes EPA to promulgate a rule designating as a "hazardous substance" any element or compound that, when discharged as specified under the section, would present an imminent and substantial danger to public health or welfare, including but not limited to fish, shellfish, wildlife, shorelines, and beaches. EPA is authorized to revise the list of hazardous substances subject to these criteria as may be appropriate. EPA finalized the initial list of hazardous substances in 1978 and thereafter revised the list in 1979, 1989, and 2011.

Pursuant to Section 311(b)(4), EPA established "harmful" quantities for these substances that are subject to the reporting of discharges prohibited under Section 311(b)(3). Section 311(b)(5) requires a person in charge of a vessel or facility to notify the National Response Center, administered by the U.S. Coast Guard, as soon as that person has knowledge of a discharge. Discharges permitted under other provisions of the CWA or otherwise allowable under certain other federal, state, and local regulations are excluded from reporting under CWA Section 311.

CWA Section 311(c) authorizes federal actions to remove a prohibited discharge of a hazardous substance (or oil). CWA Section 311(f) establishes liability for the recovery of removal costs, including restoration of damaged natural resources. Section 311(e) authorizes enforcement orders to require a responsible party to abate an imminent and substantial threat to public health or welfare from a prohibited discharge, or threat of a harmful discharge, of a hazardous substance (or oil).

Implications of CWA Designations on CERCLA

If EPA were to designate a CEC, or any contaminant, as a toxic pollutant or hazardous substance under the CWA, that contaminant would, by statutory definition, be defined as a hazardous substance under CERCLA. CERCLA authorizes federal actions to respond to a release, or substantial threat of a release, of a hazardous substance into the environment in coordination with the states. CERCLA similarly authorizes response actions for releases of other pollutants or contaminants that may present an imminent and substantial danger to public health or welfare. CERCLA also establishes liability for response costs and natural resource damages but only for hazardous substances and not for other pollutants or contaminants.

CERCLA response authority is available for releases of pollutants or contaminants but without liability to require a potentially responsible party to perform or pay for response actions. Designating a CEC as a toxic pollutant or hazardous substance under the CWA would have the effect of establishing liability for their release as a hazardous substance under CERCLA. However, releases in compliance with a CWA permit would be exempt from liability under CERCLA as a "federally permitted release" based on the premise that the permit requirements would mitigate potential risks.

CWA Section 311 also establishes liability for releases of hazardous substances, but CERCLA liability and enforcement mechanisms are broader than the CWA. In practice, CERCLA has been the principal federal authority used to respond to discharges of hazardous substances into surface waters and to enforce liability, although the enforcement authorities of CWA Section 311 remain available to EPA. For a broader discussion of CERCLA, see CRS Report R41039, Comprehensive Environmental Response, Compensation, and Liability Act: A Summary of Superfund Cleanup Authorities and Related Provisions of the Act , by David M. Bearden.

Recent congressional interest in CECs has largely focused on addressing one particular group of CECsâPFASâand addressing them through several statutes, such as the Safe Drinking Water Act. However, legislation in the 116 th Congress proposes to address PFAS using CWA authorities. H.R. 3616 âthe Clean Water Standards for PFAS Act of 2019âand Section 330A of H.R. 2500 , the House-passed version of the NDAA for FY2020, would direct EPA to add PFAS to the CWA Toxic Pollutant List and publish ELGs and pretreatment standards for PFAS within specified time frames. In addition, Section 330G of the House-passed version of the NDAA bill, Sections 6731-6736 of S. 1790 (the Senate NDAA bill), H.R. 1976 , and S. 950 would direct the U.S. Geological Survey (USGS) to carry out nationwide samplingâin consultation with states and EPAâto determine the concentration of perfluorinated compounds in surface water, groundwater, and soil. These bills would also require USGS to prepare a report for Congress and provide the sampling data to the EPA as well as other federal and state regulatory agencies that request it. Additionally, the bills would require the data to be used to "inform and enhance assessments of exposure, likely health and environmental impacts, and remediation priorities." Some Members have also introduced legislation to require comprehensive PFAS toxicity testing ( H.R. 2608 ).

In addition to focusing on PFAS, several bills proposed in the 116 th Congress look more broadly at how to address CECs. For example, some aim to improve federal coordination and research and support states in addressing emerging contaminants. S. 1507 , S. 1251 , and Sections 6741-6742 of S. 1790 would direct the White House Office of Science and Technology Policy to establish a National Emerging Contaminant Research Initiative. The bills would also direct EPA to develop a program to provide technical assistance and support to states for testing and analysis of emerging contaminants and establish a database of resources available through the program to assist states with testing for emerging contaminants. While these efforts are more focused on CECs in drinking water, the bill directs the EPA to ensure that the database is available to groups that have interest in emerging contaminants, including wastewater utilities.

While Congress is currently debating how to best address the concerns related to widespread detections of PFAS, attention to other emerging contaminants (e.g., microplastics and algal toxins) has also increased with the availability of new detection methods and increased monitoring. Observers note that in the coming years, other CECs will likely emerge and prompt similar calls for immediate action to protect public health and the environment. Many observers argue that federal actions to address CECs currently tend to be reactive rather than proactive. Many of these observers assert that more focus and attention is needed on assessing the toxicity of chemical substances before they are introduced into commerce. Congress is currently considering legislation to improve federal coordination and responses to CECs.

Specific to the CWA, some observers advocate for oversight to identify and address potential gaps or barriers in CWA authorities and processes that make it difficult for EPA and states to quickly respond when CECs are detected. Other observers assert that EPA could better use its existing authorities to address CECs. For example, EPA has not updated its ELGs for certain industrial categories in decades. Accordingly, some observers assert that various ELGs do not reflect advancements in science or technology that could lead to new effluent limitations for CECs. Similarly, some stakeholders assert that EPA could better prioritize which CECs warrant water quality criteria development. EPA's ability to address these and other recommendations depends on the availability of resources, treatment technologies, and scientific and economic data. Moving forward, Congress may be interested in evaluating EPA appropriations for the CWA programs that support EPA's efforts to address discharges of CECs. Congress may also be interested in overseeing the Administration's implementation of these programs.