30 March 2022

SSM/Bank of England: Financial leverage and banks’ risk controls

Opinion piece by Andrea Enria, Chair of the Supervisory Board of the ECB, and Sam Woods, Deputy Governor for Prudential Regulation and Chief Executive Officer of the Prudential Regulation Authority, published on Bloomberg on 30 March 2022

In the global financial crisis, we learned the hard way that excessive leverage can bring down the economy — even if it doesn’t sit directly on the balance sheets of systemic banks. We also learned the importance of robust governance, risk management and controls. Unfortunately, we are seeing evidence that, in some parts of the banking and wider financial system, these lessons are being forgotten.

We should be clear: 2022 is not 2006. Since the global financial crisis, the regulatory framework has been overhauled, supervision has become stronger and more extensive, major banks’ capital levels have increased substantially, and their risk management practices have improved.

However, despite the COVID-19 pandemic, recent times have seen renewed complacency within some financial markets, where risk-taking is high by historical standards. As we go through a period of significant economic and geopolitical uncertainty, with inflation challenges and the Russian invasion of Ukraine slowing economic growth and increasing volatility, more vigilance and caution is required.

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

The global leveraged lending market came through the pandemic largely unscathed, but banks should be careful not to conclude from this episode that the current high levels of leverage and weak loan documentation are prudent. In our view, they are not; and without the widespread pandemic-related support of economies from public authorities, losses would likely have been substantial.

Risks in the leveraged lending market continued to increase last year. Global primary issuance in 2021 set a new full year record, bringing the global stock of leveraged loans to more than $4 trillion for the first time. In parallel, underwriting standards and lender protection safeguards have continued to deteriorate. Our work has found that banks have increased their risk-taking in the sector, in line with market developments, even as their overall risk appetite and risk-management frameworks lagged behind.

Furthermore, we are concerned that the leveraged lending market remains opaque: its size is subject to considerable uncertainty and the ultimate risk holders remain largely unknown. Risk trends may not be well-captured in the data and risk building may consequently not be well understood. For example, market data may underestimate leverage levels as they rely on borrower earnings inflated by what are known as “add-backs” for future cost-cutting and synergies that may not be achieved.

The ECB is this week addressing the chief executive officers of banks active in this business, asking them to define robust risk appetite frameworks and reduce the origination of highly leveraged transactions in order to adhere to supervisory guidance that has been in place since 2017. The ECB is also considering the application of specific Pillar 2 capital charges to address individual cases of persistent deviation from the guidance. The BOE also monitors U.K. banks’ involvement in this business closely, stress tests banks’ leveraged lending portfolios and applies capital charges where needed.

Following a liquidity “run” on the prime brokerage businesses of multiple firms during the global financial crisis, banks have invested considerably in their liquidity risk management. However, the failure of the family office Archegos in March 2021 highlighted that, besides the liquidity risks of the business, counterparty credit losses can also be highly damaging, especially in a highly leveraged and concentrated environment. The episode showed that in the absence of sufficiently strong governance, risk culture, business strategy and risk management frameworks, banks’ exposures to hedge funds and other non-bank financial intermediaries can leave lenders with severe scars. Last December, following a review of banks’ prime brokerage businesses, the U.K.’s Prudential Regulation Authority wrote to lenders’ CEOs identifying several deficiencies and required executives to take remedial action. In the same vein, the ECB has clarified its expectations with relevant banks and will follow up with targeted reviews and on-site inspections in the areas of counterparty credit risk governance and management — including of prime brokerage — to identify any relevant deficiencies. More widely, banks should apply lessons learned to other areas where they are exposed to trading counterparties — most obviously in energy and commodities markets.

Excessive or poorly-managed risk-taking today sows the seeds of financial instability tomorrow, ultimately threatening the economic recovery. Banks can expect supervisors to engage with them on how they are managing these risks. The ECB and the BOE stand ready to do what’s needed to ensure that the lessons of the global financial crisis aren’t forgotten even as we go through other crises like Covid-19 and Russia’s invasion of Ukraine, so that the financial system can continue to serve the rest of the economy.

SSM/Bank of England

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