ECB and BOE issue joint warning on excessive leverage

Let’s be clear: 2022 is not 2006. Since the global financial crisis, the regulatory framework has been overhauled, supervision has strengthened and expanded, the capital levels of major banks have increased significantly and their risk management practices have improved. However, despite the COVID-19 pandemic, recent times have seen a resurgence of complacency in some financial markets, where risk taking is high by historical standards. As we navigate a period of significant economic and geopolitical uncertainty, with inflation concerns and the Russian invasion of Ukraine slowing economic growth and increasing volatility, increased vigilance and caution are warranted.

The European Central Bank and the Bank of England have recently flagged two specific areas of concern: leveraged lending and prime brokerage. These two segments of the banking business are global in nature, which is why the two authorities continue to exchange information on banking practices and act in as close alignment as possible with each other.

The global leveraged loan market emerged largely unscathed from the pandemic, but banks should be careful not to conclude from this episode that the current high levels of leverage and poor loan documentation are prudent. In our opinion, they are not; and without the widespread support of economies by public authorities linked to the pandemic, the losses would probably have been substantial.

Risks in the leveraged loan market continued to rise last year. Global primary issuance in 2021 set a new full-year record, bringing the global stock of leveraged loans to over $4 trillion for the first time. At the same time, underwriting standards and lender protection guarantees continued to deteriorate. Our work revealed that banks have increased their risk taking in the sector, in line with market developments, even though their overall risk appetite and risk management frameworks have lagged.

Furthermore, we are concerned that the leveraged loan market remains opaque: its size is subject to considerable uncertainty and the ultimate risk holders remain largely unknown. Risk trends may not be captured well in the data and the risk construct may therefore not be well understood. For example, market data may underestimate debt levels because it relies on inflated borrower income by so-called “add-ons” for future cost reductions and synergies that may not be carried out.

The ECB is addressing the CEOs of banks active in this sector this week, asking them to define robust risk appetite frameworks and reduce the origination of highly leveraged transactions in order to meet prudential guidelines in in place since 2017. The ECB is also considering the application of specific Pillar 2 capital requirements to address individual cases of persistent deviation from guidance. The BOE is also closely monitoring the involvement of UK banks in this activity, performing stress tests on banks’ leveraged loan portfolios and applying capital charges if necessary.

Following a “rush” of liquidity on prime brokerage businesses of several firms during the global financial crisis, banks invested heavily in their liquidity risk management. However, the bankruptcy of the family office Archegos in March 2021 highlighted that, in addition to the liquidity risks of the company, counterparty credit losses can also be very damaging, especially in a highly indebted and concentrated environment. The episode showed that in the absence of sufficiently robust governance, risk culture, business strategy and risk management frameworks, banks’ exposures to hedge funds and other non-financial intermediaries banks can leave serious scars for lenders. Last December, following a review of banks’ prime brokerage business, the UK’s Prudential Regulation Authority wrote to lender CEOs identifying several shortcomings and asking executives to take corrective action. In the same vein, the ECB has clarified its expectations with the banks concerned and will continue with targeted reviews and on-site inspections in the areas of governance and management of counterparty credit risk — including premium brokerage — to identify any relevant gaps. More broadly, banks should apply the lessons learned to other areas where they are exposed to commercial counterparties – most obviously in energy and commodity markets.

Excessive or poorly controlled risk-taking today sows financial instability tomorrow, ultimately threatening economic recovery. Banks can expect supervisors to discuss with them how they manage these risks. The ECB and the BOE are ready to do what is necessary to ensure that the lessons of the global financial crisis are not forgotten even as we go through other crises such as Covid-19 and Russia’s invasion of Ukraine, so that the financial system can continue to serve the rest of the economy.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Andrea Enria is Chair of the Supervisory Board of the European Central Bank. He was previously Chairman of the European Banking Authority.

Sam Woods is Deputy Governor for Prudential Regulation at the Bank of England and Managing Director of the Prudential Regulation Authority.