Zooming in on leveraged finance

14 August 2024

Since the publication of its Guidance on leveraged transactions in 2017, the ECB has been expecting banks to improve the risk management of leveraged loans. An example of this was the dedicated letter to banks setting out expectations on the risk appetite framework for leveraged finance (LF), issued in 2022. Off-site assessments were performed to identify shortcomings and banks were requested to address risk management weaknesses related to the risk appetite framework. In the annual Supervisory Review and Evaluation Process, dedicated capital requirements have been applied to banks that are highly exposed to leveraged loans, or when their risk management practices are not sound enough.

To complement the above off-site activities and given the significant growth in European bank lending to the LF sector, in 2023 the ECB decided to conduct a comprehensive LF portfolio review for a set of banks. Between the first quarter of 2018 and the first quarter of 2023, European banks’ LF exposures increased by 59%. Moreover, significant changes in the macroeconomic environment had led to a rise in interest rates, which further increased already high refinancing risks, especially for highly leveraged companies. These developments strengthened the need for additional actions in line with the ECB’s supervisory responsibilities, which ultimately aim to maintain the safety and soundness of credit institutions and the stability of the financial system. The main objectives of the review are to ensure that banks overcome weaknesses in their risk management frameworks for LF portfolios and properly consider the underlying risks of LF transactions.

The review entailed on-site inspections of credit files at 12 banks under European banking supervision. The banks in scope were selected based on a set of criteria such as their exposure to LF in absolute or relative terms to their overall portfolio. The granular credit file reviews covered a large share (or the entirety) of the banks' LF portfolios, about three times more than during regular on-site missions. A larger share of individual portfolios provides an appropriate risk overview, both in the context of the macroeconomic changes and the nature of the LF portfolios, which are not structured to provide for random sampling and meaningful extrapolation. The review was coordinated by a central team of subject matter experts, pooling information from the banks and carrying out benchmark analysis to ensure a level playing field. The on-site teams relied on resources from the ECB, national supervisory authorities and external consultants for the investigation phase, in line with standard practice for on-site missions with a large scope.

The review is based on the ECB’s Guidance on leveraged transactions and its Asset Quality Review methodology. It applies a consistent approach across all banks in scope by using the same methodology at the same reference date. Ultimately, the purpose of the review is to provide a quantitative risk estimation at the portfolio level, determined by both the individually and collectively assessed credit risk stemming from LF transactions.

In terms of results, the ECB distinguishes between quantitative and qualitative findings. From a quantitative perspective, the review focused on the correct identification of leveraged loans, which could lead to a broadening of the existing LF portfolio scope where warranted, and whether the treatment of loans in terms of risk classification and measurement were appropriate. From a qualitative perspective, the review aims to identify deficiencies in risk identification and management. This bottom-up approach complements the earlier off-site work performed on LF risk management weaknesses.

Preliminary quantitative results of the review have been shared with the banks to allow them to clarify processes and provide further information on specific credit files. The review entails the usual rigorous internal quality assurance processes before findings are discussed with the individual banks. The review, which is planned to conclude later this year, can result in adjustments in risk classification and measurement at an individual bank level, depending on the findings. Any adjustments will be defined as part of ongoing supervision during the regular interaction between banks and Joint Supervisory Teams.

The prudent risk management of leveraged loans is of fundamental importance to the ECB, as highly leveraged corporates are particularly vulnerable to market volatility, economic cycles and revenue swings. Banks should maintain capital levels commensurate with the level of risks associated with their LF portfolios and should implement the appropriate governance arrangements and internal control mechanisms, including accounting practices and policies.