Leveraged transactions: supervisory expectations in the Eurozone

In May 2017, the ECB published its Guidance on Leveraged Transactions, which defines their scope and suggests best practices and procedures for significant institutions (SIs) when outlining and managing their risk appetite and management practices in this area. In the past months, the regulator has been following closely how the market develops in this area through the use of Leveraged Finance Dashboard – a supervisory tool sampling significant institutions’ reports on leveraged finance-related data on a quarterly basis, and through the use of on-site inspections. 

A few weeks ago, the Single Supervisory Mechanism (SSM) sent a Dear CEO letter to the SIs in the Eurozone, noting that the establishment of risk appetite frameworks for leveraged transactions (LT RAF), which follows the ECB guidance, is crucial. Notably, all key risks should be properly captured and managed by the banks. At present, the growth of highly leveraged transactions in a covenant-lite format continues in Europe and the US, leading to a decline in the quality of credit in the banking books.

This extreme risk-taking, when combined with insufficient risk management, could be a reason for the concern of losses for the banks in the case of unexpected market repricing. Not only have banks accelerated their LT exposure, but they have significantly increased the riskiest sub-segment within this asset class – highly leveraged transactions (HLT). These often lack enough subordinated debt cushions, have much lower recovery levels and, when present in high volumes in banks’ hold books, represent a concentration risk. Through its supervisory practices, the ECB has discovered that HLT origination is often unrestricted and the metrics used to capture and manage the risks are insufficient. 

The underwriting and syndication activities covered in chapter five of the guidance on LT have also shown shortcomings following a horizontal exercise organised by the ECB in 2021. The banks could not capture the market value of syndication inventory on time and failed to seize and measure market risk via stress testing adequately. 

Recommendations for the banks outlined by the recent ECB letter:

• All leveraged transactions must be captured as an asset class at a group-wide level, and a comprehensive and effective risk management framework should be in place. Banks’ identification of LT and HLT must always follow the ECB Guidance definition and indirect LT exposures should be identified and included in the LT RAF.
• The metrics applied to LT activities should be linked to group-wide metrics and not be simplistic. Notional limits are risk insensitive and should not be the only limits for the hold book and the underlying pipeline. Credit and market risk metrics must be built to distinguish between expected losses from business as usual and stress periods. Group-wide risk-sensitive measures should be applied to the relevant risks raised by LT – liquidity risks, in particular, should not be restricted to the investment bank units. The funding risks related to corporates drawing before the syndication date committed by banks should be captured and measured.
• The calibration of risk metrics should be linked to the calibration of the same metrics at group-wide levels. In addition, calibration must not be too permissive and allow too much headroom for the risk metrics. Notional metrics should not be calibrated using inconsistent legacy practices, and risk-sensitive metrics should not follow unjustified local limits, which can’t be assessed in terms of group-wide equivalents.
• HLT must be sufficiently covered by risk metrics, and their origination levels should lessen relative to LT origination. The risk of HLT should also be managed at a group-wide level and framed by limits. The SIs should manage high HLT exposure as a concentration risk and subject them to stress testing.
• Risks specific to LT activities must be considered at more granular levels. Metrics which monitor risk development and forward-looking metrics seizing risk growth in the LT portfolio must be used. Leverage of the hold portfolio must be tracked on an ongoing basis. Risks raised by the lowest-rated transactions in the portfolio must be monitored and restricted. Other missing metrics to consider include industry exposure, single name/connected debtor, and level of covenant protection.
• The governance of notional and cascaded metrics must be adequate. Governance provisions regarding metric setup and enforcement should be improved – non-binding metrics’ forms such as thresholds and guidelines do not limit risk, and effective procedures for limit escalation must exist.
• The risks of delayed and failed underwritten transactions should be captured. Banks must implement definitions identifying such transactions in the pipeline and set specific limits. There must be adequate risk management in place, which clearly sets out consequences for overly high stock of delayed and failed transactions while at the same time not restricting the ongoing underwriting of new transactions.
• The market risk of underwriting and syndication activities should be recognised, measured and managed adequately by banks. The underwriting pipeline should be market to market in a timely manner, and the stress testing methodologies should be well developed and incorporated in the LT RAF.

The above points should be considered by all Eurozone banks. Leveraged finance is identified as a crucial vulnerability by the ECB Banking Supervision and is a key supervisory priority for 2022-2024. It will entail increased scrutiny and remedial actions from the supervisor in the future, and banks’ failures to remedy this could lead to increases in Pillar 2 requirements in the annual Supervisory Review and Evaluation Process (SREP).

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