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Keeping an eye on banks’ leveraged lending

Leveraged lending markets have increased significantly over the past decade, driven by low interest rates and investors’ search for yield. According to the May 2018 ECB Financial Stability Report and based on publicly available data, issuances of leveraged loans in the European Union amounted to just over €300 billion in 2017, in line with previous highs recorded in 2014 and 2007. Data collected by ECB Banking Supervision on the 18 most active supervised banks show that their total exposure reached approximately €321 billion in the fourth quarter of 2018. While in 2017 and the first quarter of 2018 the trend was clearly toward loan refinancing, in the latter half of 2018 it shifted to acquisition financing. This pushed the average loan maturity forward to 2021/2022. The total for newly arranged leveraged transactions for the 18 most active banks declined to €34 billion in the fourth quarter of 2018 from €49 billion in the first quarter.

Against this background, underwriting standards have been loosening further. “Covenant-lite” transactions, which entail fewer borrower restrictions and weaker lender protection, are now the market standard across the US and European markets and may lead to higher than usual losses in an economic downturn. In addition, there has been an overall increase in transaction leverage levels, measured as the ratio of total debt to earnings before interest, taxes, depreciation and amortisation (EBITDA). This raises concerns regarding the capacity of borrowers to repay their debt.

ECB Banking Supervision continues to be vigilant about developments in leveraged lending markets. High corporate leverage can increase borrowers’ sensitivity to default in an adverse economic scenario and ultimately lead to lower recovery rates.

In the light of these market developments and the shortcomings identified in supervised banks’ risk management and monitoring frameworks, in May 2017 the ECB published its guidance on leveraged transactions. The guidance applies to all banks supervised by the ECB and has two main objectives: to facilitate the identification and monitoring of leveraged loans and to foster sound origination and risk management practices for these transactions. It also provides a single definition of leveraged transactions to be applied by supervised banks across all business units and geographical areas. This definition makes it easier to identify leveraged transactions so that a bank’s senior management can have a clear overview of its lending activities. Finally, the guidance establishes a comprehensive set of quantitative and qualitative supervisory expectations. This applies to origination, underwriting criteria and risk management and reporting requirements.

The ECB’s Joint Supervisory Teams (JSTs) have been closely monitoring banks’ practices since the guidance entered into force in November 2017. In November 2018 the banks themselves were also required to provide an internal assessment of their implementation of the guidance expectations. Also in 2018 the ECB started collecting quarterly data from the 18 most active supervised banks in order to monitor their loan underwriting activity and the quality of newly originated loans. A multi-year programme of on-site inspections was launched in January 2019.

The ECB sees good progress in supervised banks’ efforts to implement its expectations in the areas of defining leveraged transactions, risk appetite and governance, monitoring, and risk management practices for loan syndication and credit approval processes. More than 30 supervised banks have launched group-wide projects aimed at implementing guidance expectations and have established dedicated risk management frameworks for leveraged transactions. Senior management awareness has been strengthened significantly.

However, some improvements are still necessary to achieve full compliance with certain risk management expectations. These include the consistent implementation of the ECB’s definition requirements across business units, internal stress testing frameworks to address direct and indirect risks, and underlying management information reports which often rely too much on manual treatments. In particular, compliance with quantitative supervisory expectations shows room for improvement. While the guidance considers that the most highly leveraged transactions (leverage levels exceeding six times total debt divided by EBITDA) should remain exceptional and be duly justified, the share of newly originated loans posting such levels increased to above 50% in 2018. Although the ECB did not set quantitative thresholds, it regards excessive leverage as a key supervisory concern and expects banks to put in place more stringent risk management practices.

According to the charts below, newly originated leveraged transactions show high leverage levels and weak covenant protection.

Percentage breakdown of total notional of leveraged transactions originated by 18 supervised banks in each quarter – by leverage

Percentage breakdown of total notional of leveraged transactions originated by 18 supervised banks in each quarter – by covenant protection

Source: ECB internal data.

The market for leveraged transactions continues to be supported by strong, albeit evolving, demand. Against the background of increasingly aggressive structuring and loosening credit standards in new loan origination, ECB Banking Supervision will continue to closely monitor supervised banks’ direct and indirect exposure to leveraged transactions as well as their origination activity.

More stringent risk management of these exposures will strengthen banks’ ability to operate during an economic downturn and ultimately facilitate lending to leveraged borrowers throughout the business cycle. Safe and sound origination practices enable banks to contribute to the smooth financing of the real economy.

The ECB will continue to promote its guidance through the ongoing supervision of banks by JSTs and through dedicated and coordinated on-site investigations based on a common methodology. Shortcomings in supervised banks’ risk management practices will be taken into account in the Supervisory Review and Evaluation Process. The most highly leveraged transactions will be placed under increasing scrutiny in the assessment of compliance with the guidance. ECB Banking Supervision will continue to engage with all relevant stakeholders, including in other jurisdictions, and assess the potential need for further action.

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