Andrea Enria, who chairs the European Central Bank’s Supervisory Board, is deeply concerned about lenders’ exposure to highly leveraged companies. Yet a crackdown has limits. Try too hard, and he’ll drain further revenue from already struggling groups like Deutsche Bank and push the problem elsewhere.
Enria said that years of low interest rates have made lenders complacent. His main beef is leveraged finance, where banks arrange funding for buyouts.
Setting priorities
Big players like Deutsche and BNP Paribas would point out that they only hold loans for around a month before selling them to funds and insurers. Even during the Covid-19 crisis last spring, only a handful of loans got stuck on lenders’ books, bankers say, although unprecedented central bank intervention helped.
The sector is certainly getting riskier. The ECB reckons that over half of buyouts in the fourth quarter of 2020 saw the borrowers’ debt surpass 6 times EBITDA, compared with its guidance that transactions with that level should be “exceptional”. Some 97 per cent of deals in the first quarter were “covenant-lite”, meaning they had minimal lender protections, Enria reckons.
And the market is swelling. Outstanding public European leveraged loans were 245 billion euros in May compared with 139 billion euros at the end of 2017, according to the European Leveraged Loan Index compiled by S&P Global’s LCD unit. Including undrawn credit lines, big lenders’ exposure to leveraged finance was equivalent to 50 per cent of common equity tier 1 capital in 2019, the European Banking Authority calculated.
Clamping down
Enria is threatening higher capital requirements unless banks rein in risk. Yet he may struggle to treat miscreants too harshly. Since most deals in the market now breach the ECB’s definition of excessive leverage, Deutsche and others would lose a huge amount of business at a time when low interest rates are hurting profitability. European banks on average earned just a 5 per cent return on equity in the fourth quarter of 2019, according to the ECB, half their likely cost of equity.
A crackdown could push more risk towards private credit funds and other shadow banks, which oversee some $1 trillion of assets, Preqin reckons. Credit Suisse’s Greensill Capital debacle shows that blowups there can find their way back into the banking system if markets are not properly policed. Enria has spotted the right problem, but his bark may end up being worse than his bite.