Europe’s top financial supervisor has warned banks it will raise capital requirements unless they reduce their exposure to risky loans to private equity acquisitions and other highly indebted borrowers.
Andrea Enria, chair of supervision at the European Central Bank, said he planned to send a “Dear CEO” letter to the heads of the banks that provide most European leveraged loans to remind them of the regulator’s recommendation.
“We notice some reluctance of banks to follow our guidelines,” he said during a press conference on Thursday. “If eventually we are not satisfied with progress, it is the capital stick that will be used.”
The eurozone-based banks that were most active in providing European leveraged loans last year were BNP Paribas, Deutsche Bank and Crédit Agricole, according to Dealogic data. The ECB intends to also send the letter to US-based lenders active in the eurozone, including JPMorgan, Goldman Sachs, Barclays and Bank of America.
The initiative marks an escalation of the ECB’s efforts to rein in risk-taking with this type of lending in the eurozone. Leveraged loans typically finance companies with high debt levels and poor credit ratings.
The Frankfurt-based regulator issued guidance in 2017 calling on lenders to limit the number of leveraged loans exceeding six times the borrower’s earnings, or without some of the traditional covenants granting lenders the right to get some of their money back or renegotiate the terms of the loans if a borrower misses certain profit targets.
Since then, the average debt level in the European leveraged loan market has risen to five and a half times earnings, from five times in 2017, while the proportion of so-called “cov-lite” loans with reduced lender protection has risen from half to 97 per cent.
Ultra-low interest rates have fuelled a surge in leveraged loans in recent years, many of them given to finance takeovers backed by private equity groups.
Regulators are worried that if economic growth disappoints, or borrowing costs rise sharply, large debt loads could become unmanageable, accelerating the decline of heavily indebted companies and potentially exposing banks to losses.
The ECB said on Thursday that disruption caused by a potential rise in interest rates was one of its main concerns, as it published the results of its annual assessment of capital requirements for the 115 eurozone lenders it supervises.
Enria said that while rising interest rates were usually positive for banks, allowing them to increase their profit margins by lending at a higher rate, he was concerned about the potential for “sudden shocks” to hit “the fringe areas of banks’ balance sheets where they may have taken excessive risks”.
On a more positive note, the central bank said six banks were below its minimum capital guidance at the end of last year, down from nine a year earlier.
It said the six lenders had fallen below their minimum capital guidance “because of structural issues that predated the pandemic” and they would have to rebuild their equity buffers by the end of this year, when the ECB’s temporary relaxation of rules because of the Covid crisis would expire.
Overall, the central bank said non-performing loans declined last year and banks maintained “solid” capital and liquidity positions. But it added that there was still uncertainty about the “future trajectory” of the pandemic and other risks included cyber attacks, climate change, downward pressure on profitability and disruption from rising interest rates.
The ECB said “risk management practices for counterparty credit risk are a specific source of concern” after the collapse of the Archegos family office left its lenders nursing big losses last year. As a result, “several banks were subject to measures requiring them to revise their methodologies for quantifying risks and their broader risk control frameworks”, it added.
Deutsche Bank declined to comment about its leveraged loan activities. BNP Paribas and Crédit Agricole did not immediately respond to requests for comment.