Europe’s banking regulator is increasingly worried about a booming market for banks: the loans that feed the riskiest borrowers and the global deal-making machine.
This line of business for banks, called leveraged finance, has exploded in Europe and elsewhere in recent years as central banks free up cheap money to propel economic growth.
Although issuance has slowed this year due to the war in Ukraine, the European Central Bank estimates that there is more than $4 trillion in loans outstanding worldwide.
Big buyouts fueled by leveraged loans included the $9bn purchase of UK grocery chain Wm Morrison Supermarkets PLC following a bidding war, and a $30bn deal in the United States for the medical supply company Medline Industries Inc. -loan banks in both. A bank spokeswoman declined to comment.
The fear is that heavily indebted borrowers will begin to struggle to repay their debt as the economy slows, they face higher costs to their business due to inflation and interest rates interest increases. Leveraged loans usually have floating borrowing costs, which would make refinancing more expensive.
“Leveraged lending is always risky, but we are currently facing a confluence of factors, from the war in Ukraine to high inflation, which have compounded these risks,” said Trevor Pritchard, chief financial officer at European leverage at S&P Global Ratings.
Banks in Europe embraced leveraged lending because the region’s negative interest rates hampered their ability to make money with more mundane types of lending. The market has been overfed because leveraged loans are also being used to pay for private equity buyouts, which hit record highs last year.
Other eurozone banks that have provided leveraged loans include Germany’s Deutsche Bank,
French Crédit Agricole and Italian UniCredit,
according to Dealogic.
Last month, the head of banking supervision at the ECB, Andrea Enria, sent a letter to bank chief executives warning banks that they would take a proactive approach to controlling their appetite for these types of loans, including forcing them to set aside capital to cover possible losses.
“Excessive risk-taking is of particular concern for the ECB when combined with inadequate risk management,” Mr Enria said.
Last year, Deutsche Bank said it had taken an additional capital charge on leveraged loans in line with ECB instructions. A bank spokesperson declined to comment. In its quarterly results on Wednesday, the bank said revenue from leveraged loans drove down its investment banking business.
The ECB reports that the leveraged loan exposures of 28 systemically important banks it supervises, including some US banks, increased by 80% between 2018 and last year to reach 500 billion euros, or the equivalent of 530 billion dollars. This represents 60% of their combined capital and cushion ratio, which could start to evaporate if defaults become widespread.
While banks generally transfer the loans – and the risk – to the investors in the loan funds, they end up holding some of the credit while offering the same borrowers revolving credit facilities. Banks could also find themselves stuck holding onto loan commitments if investor interest wanes.
After Russia invaded Ukraine in late February, the leveraged loan market came to a halt, S&P said in a report. It resumes.
Privately, banks balked at the ECB’s assessment, saying it overestimated the problem. For example, it includes undrawn credit lines in its exposure.
The ECB first issued guidelines to lenders in 2017, when it tried to limit this type of lending to a maximum of six times the borrower’s income. Mr Enria said the guidelines had not been sufficiently followed. Meanwhile, the lender’s terms on the loans have only weakened, meaning recovery in the event of default could be low.
Fitch Ratings, which tracks leveraged loans to rated companies, said borrowers have shown resilience so far. He expects default rates to rise to 2.5% in 2022 from 0.5% in the past 12 months to March.
But Ed Eyerman, head of European leveraged finance at Fitch, said the leveraged borrowers the ECB counts on include unrated, debt-laden small businesses and private equity firms that have secured credit from banks. in competition with private debt companies.
“There will absolutely be more flaws,” Mr. Eyerman said.
—Ben Dummett contributed to this article.
Write to Patricia Kowsmann at email@example.com
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