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ECB to crack down on dangerous risks in banks’ leveraged lending

Banks are too complacent about the excessive risks building up in leveraged loan and equity derivative markets and can expect higher capital requirements as a result, the European Central Bank’s head of supervision has warned.

Andrea Enria said on Friday that he was worried about “market complacency and excessive risk-taking” by banks, adding that there were “warning signs of increasing leverage, financial complexity and opacity creating the potential for a dangerous combination of risk factors”.

ECB officials said the speech signalled that the supervisor had lost patience with several larger eurozone lenders, such as Deutsche Bank, which have been rebuffing its calls for them to rein in riskier lending.

“Where we see shortcomings, we will take supervisory actions,” Enria said in an online address to finance and economics graduates at the University of Naples.

“In key areas such as leveraged finance, where previous supervisory guidance has not been sufficiently implemented by banks, we plan to deploy the full range of supervisory tools available to us, including minimum capital requirements commensurate with the specific risk profile of individual banks, should this become necessary,” he said.

The ECB’s head of supervision said earlier this week that it would lift the cap on banks’ dividends and share buybacks later this year. On Friday he said banks “remain resilient” while “uncertainty has abated and, by all indicators, the economic system is on a path to recovery”. The ECB is due to publish the results of its banking stress tests on July 30.

However, despite this more upbeat outlook, Enria said: “Concrete signs of risk build-up have in our view become apparent in the risky asset segments of leveraged debt and equity-related derivatives, which warrant intensified supervision.”

The vast support provided by governments and central banks have shielded the financial system from the fallout of the coronavirus pandemic, he said.

But he said this may have fuelled complacency and warned about the risk of “a sudden correction in asset prices” when this support is withdrawn, especially “if investors expect inflationary pressures to be persistent and revise their expectations regarding the monetary policy stance”.

“Renewed tensions surrounding risky assets would again expose the whole ecosystem of non-bank entities and funds to liquidity risk resulting from investor redemptions as well as credit and valuation losses,” he added.

The US Federal Reserve warned in May that some asset valuations are “elevated relative to historical norms” and “may be vulnerable to significant declines should risk appetite fall”.

Despite the ECB calling since 2017 for banks to rein in their leveraged lending — the practice of financing private equity groups and other buyers of corporate assets — Enria said it had seen a “further deterioration in underwriting standards” by the most active banks in this area.

In the fourth quarter of 2020, he said more than half the leveraged loans from these banks had debt equal to over six times earnings before interest, tax, depreciation and amortisation and were covenant-lite — stripping out the usual protections for investors — or had no covenants at all.

Last year, Deutsche Bank rejected an ECB request to suspend key parts of its leveraged finance operations over concerns it was not properly monitoring risk in that area, where it is one of Europe’s largest lenders. Deutsche declined to comment on Friday.

Enria also expressed concern at how banks were “worryingly” not reining in risks in the eurozone’s €15tn market for equity derivatives that allow investors to take leveraged bets on stock markets. 

He said the risks in this market were underlined by the collapse of Bill Hwang’s Archegos family office in March, which left some banks with “suboptimal margining practices” nursing heavy losses. Credit Suisse lost $5bn on credit given to Archegos and Nomura lost $3bn.

Referring to “the broader problem of the opaqueness of the shadow banking sector and the degree of interconnectedness in financial markets,” Enria said “it is necessary to revamp the regulatory and supervisory dialogue at the global level, as new solutions might be needed”.

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