On 28 March 2022, the European Central Bank (ECB) published a letter that it had sent to CEOs of significant institutions that specifies its expectations regarding leveraged transactions. The letter includes an annex setting out the ECB’s observations on the overall leveraged transaction risk appetite framework design and functioning.

Key points in the letter include:

  • Significant institutions have, on aggregate, significantly increased their exposure to leveraged transactions over the past few years and accelerated their leveraged lending activities in 2021.
  • On aggregate, highly leveraged transactions (HLT) accounted for around half of all new leveraged transaction volumes originated in 2019 and 2020, with that figure rising to more than 60% in the first and second quarters of 2021.
  • Excessive risk taking is of particular concern to the ECB when it is coupled with inadequate risk management.
  • The ECB has found that risk management for HLTs remains highly deficient. HLT origination is often unrestricted, with no limits on origination activities or HLT levels in the hold book, and where restrictions are imposed, they are overly permissive.
  • ECB Banking Supervision has identified leveraged finance as a key vulnerability of significant institutions that requires increased scrutiny and remedial actions going forward. The ECB has made leveraged finance a key supervisory priority for 2022-24 in order to ensure that banks manage the associated risks in an appropriate manner.
  • The ECB expects significant institutions to pay particular attention to what it regards as sound credit risk management policies and procedures.
  • These include a risk appetite framework for leveraged transactions (LT RAF) that identifies, quantifies and limits risks in an appropriate manner, a reduction in risk taking and robust stress testing for the leveraged transaction portfolio. In particular, HLTs represent a key risk driver, both for underwriting activities and for the portfolios in banks’ hold books.

The ECB expects all significant institutions that engage in leveraged transactions to take note of its letter and take steps to comply with the expectations set out in it.

Leave a Reply

Your email address will not be published. Required fields are marked *