ECB warns banks that failure to comply with leveraged lending guidance may result in capital charges

Background

The European leveraged lending market, which has already been growing steadily in recent years, has received another enormous boost in the wake of the Covid-19 pandemic and the accompanying economic downturn. Additionally, covenant-lite structures are now the norm with loans being supported by very weak documentation that reduces banks’ ability to act when a borrower experiences financial difficulties.  

According to Ms McCaul, significant institutions (SIs) in the euro area hold more than half a trillion euros in leveraged loans, an 80% increase from five years ago. Leveraged loan exposures in SIs’ books increased from about 40% of Tier 1 capital to about 60%. 

Against this background, the ECB published its first guidance on leveraged transactions in 2017 (2017 Guidance) and has since repeatedly criticised banks for their failure to meet supervisory expectations. While banks have gone some way towards addressing these, deficiencies have persisted.

Leveraged finance features prominently in the ECB’s 2022-24 Supervisory Priorities as an area of increased scrutiny and supervisory action. In March 2022, the ECB followed up on their 2017 Guidance with a ‘Dear CEO letter’ that operationalises that guidance and calls on banks to remedy ongoing deficiencies (Dear CEO Letter). 

The ECB’s supervisory expectations on leveraged lending 

ECB’s definition of ‘leveraged transactions’ 

As set out in the 2017 Guidance, the ECB defines “leveraged transaction” as one where the total debt to EBITDA ratio exceeds 4.0 or where the borrower is owned by one or more financial sponsors. Excluded from this are inter alia loans to SMEs, specialised lending, trade finance and investment grade loans. 

The ECB is particularly concerned with the increase in the number of “highly leveraged transactions” (HLTs) that make up about half of newly originated leveraged transactions. The definition of HLTs includes exposures where the debt to earnings ratio exceeds 6.0 times and has been agreed by supervisors at a global level. 

2017 Guidance

The 2017 Guidance called on banks to have a comprehensive internal risk appetite framework in place that includes “acceptable limits” leveraged transactions and over which senior management has oversight. SIs are also expected to have robust policies and procedures for credit approval and ongoing monitoring of their leveraged lending portfolio. 

Dear CEO Letter

In her speech, Ms McCaul criticised banks' practical implementation of the 2017 Guidance as being too shallow and severely deficient. Therefore, the ECB followed up with the Dear CEO Letter earlier this year by focussing in particular on banks’ risk appetite framework and the management of the market risk arising from leveraged finance. 
While the Dear CEO Letter was addressed to all Sis, it stressed that it particularly applied to a subset of banks with significant exposures in this area.   

Risk appetite framework 

The ECB expects banks to have robust risk appetite frameworks in place that not only identify but effectively limit risks and also include stress testing of banks’ leveraged finance portfolios. The metrics banks have applied to capture the risk of leveraged transactions are overly simplistic and not sufficiently risk sensitive. 

In particular, the Dear CEO Letter explicitly called on banks to reduce their HLT origination without however defining an upper limit. Ms McCaul reiterates the need for such reduction in her speech but does not go into detail as to the maximum share of an institution’s hold book that may consist of HLTs.  The Dear CEO Letter makes clear that the risk appetite framework should test against stress conditions and must encompass the risk of concentration of leveraged finance at a group-wide level. 

Market risk 

The letter also calls out deficiencies in the management of market risk that arise out of banks’ underwriting and syndication activities. In particular, the ECB observed insufficiently robust market pricing mechanisms at a number of SIs. It expects banks to mark to market their inventories in a timely manner and implement appropriate stress tests to estimate market losses realistically.  

ECB’s current stocktaking exercise 

According to Ms McCaul, the banks’ responses to the Dear CEO Letter confirm that, despite an increase in exposures to leverage loans, banks’ risk management has not kept pace. In response, the Joint Supervisory Teams (JSTs) will work closely with individual banks to discuss how they can close the identified gaps. 
She also repeated the warning that, depending on the outcome of the upcoming assessments, the ECB would be applying capital charges where it sees banks’ risk taking as excessive in terms of level of exposure, weak risk management or both.  

Next steps 

It looks like the ECB will be starting to use the “capital stick” (as Andrea Enria put it earlier this year)  to enforce the requirements set out in the 2017 guidance, as it has been warning banks for some years now. 

Banks with high levels of leveraged lending exposures will hear from the relevant JST and should prepare to be in close contact with them to discuss their position and how to remedy deficiencies. Banks are required to discuss the Dear CEO Letter with their supervisory boards. The identification of specific “Sound policies and practices” in the annexes to the letter may facilitate these reflections.

One sticking point will be how to navigate the broad scope of the ECB’s definition of “leveraged transactions” and the uncertainty surrounding the acceptable level of HLTs. Ms McCaul’s speech hinted as much and opened the door to dialogue on justifying higher levels of HLTs, which is particularly important in a deteriorating economy. Two elements are important here: (i) proportionality and an institution-specific approach, and (ii) the avoidance of a pro-cyclical approach. 

At the same time, it remains possible that the ECB will introduce a quantitative restriction on HLTs as part of the SREP going forward. 

The supervisory dialogue will be the basis of the ECB’s further assessment and the annual SREP that could result in higher capital charges so long as the ECB continues to be dissatisfied with banks’ progress in addressing deficiencies.  

This hardened stance on leveraged transactions has been a long time coming and has been foreshadowed by the Supervisory Priorities 2022-2024 that have the explicit aim of fostering compliance with the 2017 Guidance. 

Further Reading