The European Central Bank is threatening to impose additional capital requirements on banks which continue to ignore demands for risk control in the booming leveraged loan market.
Policymakers are increasingly frustrated by the lack of measures to tighten market risk controls at some European lenders, which they say could lead to repayment problems if interest rates rise.
If the practices of the sector do not change, the European regulator “will not hesitate to impose capital add-ons” through its Supervisory review and assessment process process, said a person familiar with the internal discussions.
Leverage loans are bad debt securities typically used to support or refinance corporate takeovers by private capital. Banks keep little risk on their own balance sheets and sell almost all loans to other investors.
Fierce competition has led to extremely low prices, a relaxation of underwriting standards and an increase in the leverage of private equity buyout loans. The use of covenant-lite structures – which remove many of the usual protections for investors – has increased.
In response, the ECB is planning more frequent “on-site” visits – carried out virtually during the pandemic – to assess banks’ risk management procedures on recent and ongoing transactions and adjust their capital requirements accordingly, said the person.
“When banks run risks in leveraged loans that are not properly addressed by appropriate risk management practices, ECB banking supervision considers supervisory actions and measures, including qualitative requirements or quantitative as well as capital additions, ”the ECB said in a statement.
Last summer, Deutsche Bank received a request to suspend part of its leveraged finance business due to weaknesses in its risk controls, but refuse, reported the Financial Times.
A central banker in the euro area said the issue would be raised as a major concern during the ECB’s next financial stability review in May.
Banks have become more aggressive in investment banking services as revenues from traditional retail and commercial lending activities have fallen due to negative interest rates. More recently, they have also had to deal with an increase in reserves for loan losses related to the coronavirus.
Supervisors’ concerns were sparked 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 of some of the more aggressive transactions could become difficult. Many banks have valued the 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 debt as operations where total debt – including unused lines of credit – exceeds six times earnings before interest, taxes, depreciation and amortization.
The regulator said that these transactions and lean alliance 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 in 2018, more than half of new leveraged loans from large euro area banks already exceeded this threshold.
Deutsche Bank is one of the banks that 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 that it was “impractical” to follow the demand. He was not required to do so because the guidelines were not binding.
Deutsche Bank declined to comment.
As with many other large lenders, such as BNP Paribas, leveraged finance is a dynamic and lucrative business for Deutsche’s investment bank. It generated 1.2 billion euros in revenue in the first nine months of 2020, an increase of 43% from 2019.
Recent deals in the riskiest part of the scale include a € 4.4 billion leveraged loan and a set of high yield bonds for Swedish alarm firm Verisure this month. The deal is more than seven times in debt, even using the company’s sharply adjusted earnings, and includes a € 1.6 billion dividend paid to its private equity owners.
Deutsche is a global Verisure debt co-coordinator, with BNP Paribas, CaixaBank, Crédit Agricole and Santander also involved.
Another very profitable takeover this year is BC Partners’ takeover of US gynecology firm Women’s Care Enterprises. The overall leverage of the agreement is greater than Nine times its ebitda, according to S&P Global Ratings. Deutsche is once again an associate bookrunner.