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Elizabeth McCaul
Board Member
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Supervising leveraged lending

Speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at AFME’s 17th Annual European Leveraged Finance Conference

London, 20 September 2022


Thank you very much for inviting me to this conference. It is an honour to be with you here today.

Europe – and with it the European banking sector – is facing a unique situation: the pandemic is still with us, and war has returned to European soil. Supply bottlenecks, higher-than-expected inflation, particularly in energy and food prices, as well as geopolitical uncertainty are weighing on the economic outlook. The direct and indirect effects of higher energy and commodity prices warrant particular attention. While some of these factors might be cyclical, the pandemic has also caused structural changes in the economic and financial system.

Today I would like to elaborate on some of the recent developments we have seen in the leveraged finance market, and which we also highlighted in our “Dear CEO” letter published in March[1]. I also want to discuss what we have learnt from the replies we have received so far, and what we expect from banks in terms of “look-through” credit analysis. By that, I mean their ability to properly distinguish between those customers facing cyclical difficulties owing, for example, to temporary supply bottlenecks, and those customers whose repayment capacity is permanently impaired as a result of structural issues.

Ensuring continued lending to the real economy while also upholding robust risk identification, measurement and management practices was at the core of our supervisory response to the coronavirus (COVID-19) pandemic. Although we have now ended all temporary relief measures, the underlying principle remains as valid as ever.

The leveraged finance market

A decade ago, leveraged finance was a specialist market, overshadowed by a much larger high-yield bond market. However, structural changes following the global financial crisis mean that today, leveraged finance has emerged as the market of choice for indebted corporates. This transformation has been closely linked to the rise of private equity firms and the search for yield in the low interest rate environment.

The results have been remarkable: the US leveraged loan market grew by 50% between 2014 and 2018 and by another 50% by 2022. The European market has been playing catch-up, growing at the same pace as the US market between 2014 and 2018 but doubling in size by 2022. In other words, the European market grew twice as fast, but did so from a much lower baseline than the considerably larger US market.

As is usually the case, strong growth in credit issuance entails increasing risks. Leverage levels are higher in Europe compared with the United States, with a higher share of loans rated B and lower issued in primary markets, which in turn reflects a market more dominated by private equity-controlled issuers. Outside the syndicated leveraged loan market, which is primarily accessed by relatively larger corporates, the private debt market also grew significantly. Borrowers in this market tend to be middle market firms with no access to the larger syndicated loan markets. Here, financing is provided by direct lenders such as private credit funds competing with traditional bank lenders. This market has now grown to as much as USD 1.5 trillion globally and, although data are scarce, it is estimated to represent about a third of the amount of leveraged loans held by banks and investors.

To proactively address increased risk-taking in the fast-growing leveraged loan market, the ECB issued guidance on leveraged transactions in early 2017 setting out our supervisory expectations on leveraged finance.[2] This guidance also provided a harmonised definition of leveraged transactions to be applied by banks across all business units and geographical areas.

Before I turn to our most recent supervisory measures, let me briefly focus on market developments during the pandemic.

Leveraged lending and COVID-19

The pandemic was an unprecedented shock that could not have been worse for highly indebted non-financial corporates. For a brief moment, the music stopped. Earnings dried up, particularly in sectors involving human contact such as hospitality and tourism. When revenues halted abruptly, corporates rushed to draw down their credit lines to secure funds to pay expenses – and in some cases service debt. However, comprehensive and swift fiscal and monetary support measures avoided a wave of bankruptcies, leading to much lower default levels than initially expected. This may have bred complacency about the real risks in the market.

In fact, the pandemic has even exacerbated risks, as the economic downturn led to an increase of leverage in some sectors and a persistent deterioration in credit risk. The share of outstanding corporates with a credit rating of B or lower had already risen before COVID-19 but accelerated further during the pandemic. The shock substantially weakened credit profiles, with 70% of the outstanding high-yield issuers in Europe having ratings of B+ and lower, and 30% rated B- and lower.

Worryingly, risks have been developing beneath the surface, with very weak loan and bond documentation. Covenant-lite loans are now the norm in Europe as well, and the quality of other covenants has sharply deteriorated as well, reaching the lowest levels on record in Europe last year. Weak underlying documentation and the emergence of covenant-lite as standard practice reduce banks’ ability to take remediation actions at an early stage when the financial situation of borrowers deteriorates. Technical defaults are avoided at the cost of higher losses down the road. Developments in the private credit markets are even less understood owing to their opacity and the less regulated nature of non-bank lenders. However, there is growing evidence that risks are increasing in lockstep with the public syndication markets, i.e. that smaller corporates are being leveraged up.[3]

We have seen many of these risks reflected in the balance sheets of the banks under our supervision. Significant banks in the euro area now hold more than half a trillion euro of leveraged loans, an increase of 80% increase relative to 2017, when we first issued our guidance. This increase is even more significant if we view it in relation to banks’ capital: in less than four years, significant banks have, on aggregate, reported increased leveraged loan exposures in their hold books from around 40% of Common Equity Tier 1 (CET1) capital to close to 60%. Much of this increase comes from mergers and acquisitions and highly leveraged transactions, i.e. transactions where debt is more than six times annual earnings. These transactions consistently account for around half or more of leveraged loans originated. Furthermore, in recent months we have seen losses on write-downs in banks’ underwriting pipelines as primary markets shut down and leveraged loans and high-yield bonds are sold off.

The pandemic has led to structural changes in the economy. While some companies may recover their earnings once the supply bottlenecks are resolved, others may turn out to be non-viable. This is particularly true for firms which have been unable to recover their revenues after the pandemic and are now being hit by high energy costs that they are unable to pass on to their customers. Thus, there is a risk that some companies may struggle to service debt or refinance owing to higher interest rates and wider credit spreads.[4] From a supervisory perspective, we are particularly concerned about banks that are heavily exposed to highly vulnerable corporates with a weak debt servicing capacity.

Overall, the vulnerabilities in the leveraged loan market are greater now than they were when we published our guidance. However, European banks are in a robust position. The aggregate CET1 capital ratio of significant banks stood at 15% in the first quarter of 2022. Moreover, expectations so far point to only a moderate rise in default rates as a result of the increasingly challenging macroeconomic outlook. And some corporates have taken advantage of the highly accommodative environment of recent years to refinance and extend the maturity of their outstanding loans, making them less vulnerable in the near term.

But this does not mean that risk-taking should continue unabated. Markets should not operate in the belief that the official sector will step up and support the corporate sector every time a shock occurs. In just two years markets have experienced two unexpected shocks – first the pandemic and now the war in Ukraine. And other unexpected shocks may come, bringing their own challenges.

Our supervisory expectations

As supervisors, we are following these developments with concern. It is against this background that we have identified leveraged finance as a key vulnerability that will require increased scrutiny and remedial actions. Addressing weaknesses in leveraged lending is one of our supervisory priorities for 2022-24.[5]

I would now like to return to our 2017 guidance. Overall, the way banks have implemented this guidance has been rather disappointing. While banks did follow our guidance nominally, in practice its implementation was shallow and thus severely deficient. Therefore, we followed up with a letter to banks earlier this year. The letter is centred on a key area of our guidance – the risk appetite framework. This sets out the type and amount of risk a bank is willing to take on, and how it should be monitored and managed. In essence, this letter operationalises our earlier guidance.

We expect banks’ risk appetite frameworks to properly identify, quantify and limit risks, to reduce risk-taking and to ensure robust stress testing of portfolios. Highly leveraged transactions warrant particular attention because they are a key risk driver, both for underwriting activities and for the portfolios in banks’ hold books. Therefore, we expect banks to reduce the origination of highly leveraged transactions over time.

Let me clarify this point. Highly leveraged transactions are risky transactions that create significant vulnerabilities on banks’ balance sheets. As supervisors, we want to make sure that banks do not allow such vulnerabilities to build up. However, this does not mean that banks should stop financing strong, fundamentally sustainable corporates in case they face temporary difficulties, such as supply chain bottlenecks. Instead, we expect banks to be able to explain why they have exceeded the limits on highly leveraged transactions. If it is because revenues are simply delayed owing to temporary difficulties, we will consider the specific characteristics of the transactions to prevent any supervisory action from having procyclical effects and hampering sound lending to the real economy. Our supervisory dialogue with individual banks is an essential element of our supervisory approach.

The second important issue that we addressed in our letter concerns market risk. We expect banks to adequately recognise and manage the market risk arising from leveraged finance underwriting and syndication activities. In addition, banks should carry out robust stress testing to assess potential losses under stressed conditions.

Stocktake after “Dear CEO” letter and next steps

Having explained our main supervisory expectations, I would now like to share some of the insights we have gained from the banks’ responses to our letter. We asked the banks engaging in leveraged lending activities to respond to our letter in two stages. Around ten banks have replied already as part of the first stage, and the remainder are mostly expected to reply by the end of this month.

The responses confirm that there are significant deficiencies in both the robustness of banks’ overall risk appetite frameworks and their management of market risk.

We have found that, by and large, banks’ risk appetite frameworks are overly simplistic, insufficiently granular, and the risks posed by leveraged transactions are inadequately captured, understood and managed. For example, risk-sensitive metrics measuring losses arising from credit and market risk under stress are often missing. Banks set no or overly permissive limits on highly leveraged transactions. For market risk, we have seen that many banks do not mark to market their underwriting inventories, meaning that both their recognition and management of market risk are severely deficient.

These findings confirm that greater risk-taking has not been matched by stronger risk management. Banks’ risk management practices should be commensurate with their risk-taking. This includes proper risk identification, measurement, management and mitigation, including limits on overly risky transactions.

The Joint Supervisory Teams will work closely with individual banks to discuss how they can close the identified gaps relative to our expectations. The responses feed into our qualitative and quantitative assessments of the risks that leveraged lending activities pose to banks. These include assessments of the level of exposure and of the quality of banks’ risk management.

Depending on the outcome of these assessments, we will start to apply capital charges if we see that the risks associated with leveraged lending activities are too high – either because of the level of very high-risk exposures, weaknesses in risk management practices, or both. We will apply the charges via the Supervisory Review and Evaluation Process. These charges reflect the insufficient progress made by banks in meeting the expectations set out in our 2017 guidance and will only apply as long as the identified deficiencies persist.


Let me conclude.

Risk-taking is an essential part of banking. However, it needs to be accompanied by appropriate risk management. Looking at the leveraged lending market in recent years, it is clear that banks need to step up their game to strike the right balance and to align their practices with our guidance.

Thank you very much for your attention.

  1. ECB Banking Supervision (2022), “Leveraged transactions - supervisory expectations regarding the design and functioning of risk appetite frameworks and high levels of risk taking”, 28 March.

  2. ECB (2017), “Guidance on leveraged transactions”, 4 May.

  3. See Moody’s Investors Service (2022), Private credit opportunity for lenders comes with opaque, systemic risks, 4 May.

  4. See also Basel Committee on Banking Supervision (2022), “Newsletter on credit risk: real estate and leveraged lending”, August.

  5. ECB (2021), “ECB Banking Supervision – Supervisory priorities for 2022-2024”, December.


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