The European Central Bank is threatening to impose additional capital requirements on banks that continue to ignore requests to rein in risk in the booming leveraged loan market.
Policymakers are increasingly frustrated by the lack of action to tighten risk controls in the market at some European lenders, which they fear could lead to repayment problems if interest rates rise.
If industry practices do not change, the EU regulator “won’t hesitate to impose capital add-ons” through its annual Supervisory Review and Evaluation Process process, said a person familiar with internal discussions.
Leveraged loans are junk-rated debt usually used to back or refinance private equity takeovers of companies. Banks keep little of the risk on their own balance sheets and sell almost all of the loans on to other investors.
Fierce competition has led to ultra-low pricing, a softening of underwriting standards and increasing leverage in private equity buyout loans. The use of “covenant-lite” structures — which strip out many of the usual protections for investors — has surged.
In response, the ECB is planning more frequent “on-site” visits — performed virtually during the pandemic — to evaluate banks’ risk management procedures on recent and current deals and adjust their capital requirements accordingly, said the person.
“Where banks incur risks in leveraged lending that are not adequately addressed by appropriate risk management practices, ECB banking supervision is considering supervisory actions and measures, including qualitative or quantitative requirements as well as capital add-ons,” the ECB said in a statement.
Last summer, Deutsche Bank received a request to suspend part of its leveraged finance business because of shortcomings in its risk controls but it refused, the Financial Times has reported.
A senior eurozone central banker said the issue would be raised as a key concern in the ECB’s next financial stability review in May.
Banks have become more aggressive in investment banking as income from traditional retail and commercial lending activities has plunged because of negative interest rates. More recently, they have also had to contend with a surge in coronavirus-related loan-loss reserves.
Supervisors’ concerns have been prompted by changing market dynamics, one of the people said. Indicators suggest that inflation is picking up and once interest rates around the world start to rise, repayments on some of the most aggressive deals could become difficult. Many banks have been pricing loans on the assumption that negative rates will persist for a decade or more, the person said.
In 2017, the ECB introduced guidance that defines “high levels” of leverage as deals where total debt — including undrawn credit lines — exceeds six times earnings before interest, tax, depreciation and amortisation.
The regulator said that such transactions and covenant-lite structures “should remain exceptional and [ . . . ] should be duly justified” because very high leverage for most industries “raises concerns”.
Despite these instructions, the ECB found that by 2018 more than half of new leveraged loans by major eurozone banks were already above this threshold.
Deutsche Bank is among banks the ECB has contacted. Despite receiving a letter from the regulator calling its risk management framework for highly leveraged transactions “incomplete,” Germany’s largest lender refused to suspend parts of the business and said it was “impractical” to follow the request. It was not required to do so because the guidance was non-binding.
Deutsche Bank declined to comment.
As it is for many other big lenders, such as BNP Paribas, leveraged finance is a buoyant and lucrative business for Deutsche’s investment bank. It generated €1.2bn of revenues in the first nine months of 2020, an increase of 43 per cent from 2019.
Recent transactions on the riskier end of the scale include a €4.4bn leveraged loan and high-yield bond package for Swedish alarms company Verisure this month. The deal is more than seven times levered, even when using the company’s own heavily adjusted earnings number, and includes a €1.6bn dividend paid out to its private equity owners.
Deutsche is a joint global co-ordinator of the Verisure debt, with BNP Paribas, CaixaBank, Crédit Agricole and Santander also involved.
Another highly leveraged buyout this year is BC Partners’ takeover of US gynaecology company Women’s Care Enterprises. The deal’s overall leverage is more than nine times its ebitda, according to S&P Global Ratings. Deutsche is again a joint bookrunner.