20 September 2022

SSM's McCaul: Supervising leveraged lending

Speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at AFME’s 17th Annual European Leveraged Finance Conference

Europe – and with it the European banking sector – is facing a unique situation: the pandemic is still with us, and war has returned to European soil. Supply bottlenecks, higher-than-expected inflation, particularly in energy and food prices, as well as geopolitical uncertainty are weighing on the economic outlook. The direct and indirect effects of higher energy and commodity prices warrant particular attention. While some of these factors might be cyclical, the pandemic has also caused structural changes in the economic and financial system.

Today I would like to elaborate on some of the recent developments we have seen in the leveraged finance market, and which we also highlighted in our “Dear CEO” letter published in March^[1]. I also want to discuss what we have learnt from the replies we have received so far, and what we expect from banks in terms of “look-through” credit analysis. By that, I mean their ability to properly distinguish between those customers facing cyclical difficulties owing, for example, to temporary supply bottlenecks, and those customers whose repayment capacity is permanently impaired as a result of structural issues.

Ensuring continued lending to the real economy while also upholding robust risk identification, measurement and management practices was at the core of our supervisory response to the coronavirus (COVID-19) pandemic. Although we have now ended all temporary relief measures, the underlying principle remains as valid as ever.

The leveraged finance market

A decade ago, leveraged finance was a specialist market, overshadowed by a much larger high-yield bond market. However, structural changes following the global financial crisis mean that today, leveraged finance has emerged as the market of choice for indebted corporates. This transformation has been closely linked to the rise of private equity firms and the search for yield in the low interest rate environment.

The results have been remarkable: the US leveraged loan market grew by 50% between 2014 and 2018 and by another 50% by 2022. The European market has been playing catch-up, growing at the same pace as the US market between 2014 and 2018 but doubling in size by 2022. In other words, the European market grew twice as fast, but did so from a much lower baseline than the considerably larger US market.

As is usually the case, strong growth in credit issuance entails increasing risks. Leverage levels are higher in Europe compared with the United States, with a higher share of loans rated B and lower issued in primary markets, which in turn reflects a market more dominated by private equity-controlled issuers. Outside the syndicated leveraged loan market, which is primarily accessed by relatively larger corporates, the private debt market also grew significantly. Borrowers in this market tend to be middle market firms with no access to the larger syndicated loan markets. Here, financing is provided by direct lenders such as private credit funds competing with traditional bank lenders. This market has now grown to as much as USD 1.5 trillion globally and, although data are scarce, it is estimated to represent about a third of the amount of leveraged loans held by banks and investors.

To proactively address increased risk-taking in the fast-growing leveraged loan market, the ECB issued guidance on leveraged transactions in early 2017 setting out our supervisory expectations on leveraged finance.^[2] This guidance also provided a harmonised definition of leveraged transactions to be applied by banks across all business units and geographical areas.

Before I turn to our most recent supervisory measures, let me briefly focus on market developments during the pandemic.

Leveraged lending and COVID-19

The pandemic was an unprecedented shock that could not have been worse for highly indebted non-financial corporates. For a brief moment, the music stopped. Earnings dried up, particularly in sectors involving human contact such as hospitality and tourism. When revenues halted abruptly, corporates rushed to draw down their credit lines to secure funds to pay expenses – and in some cases service debt. However, comprehensive and swift fiscal and monetary support measures avoided a wave of bankruptcies, leading to much lower default levels than initially expected. This may have bred complacency about the real risks in the market.

In fact, the pandemic has even exacerbated risks, as the economic downturn led to an increase of leverage in some sectors and a persistent deterioration in credit risk. The share of outstanding corporates with a credit rating of B or lower had already risen before COVID-19 but accelerated further during the pandemic. The shock substantially weakened credit profiles, with 70% of the outstanding high-yield issuers in Europe having ratings of B+ and lower, and 30% rated B- and lower.

Worryingly, risks have been developing beneath the surface, with very weak loan and bond documentation. Covenant-lite loans are now the norm in Europe as well, and the quality of other covenants has sharply deteriorated as well, reaching the lowest levels on record in Europe last year. Weak underlying documentation and the emergence of covenant-lite as standard practice reduce banks’ ability to take remediation actions at an early stage when the financial situation of borrowers deteriorates. Technical defaults are avoided at the cost of higher losses down the road. Developments in the private credit markets are even less understood owing to their opacity and the less regulated nature of non-bank lenders. However, there is growing evidence that risks are increasing in lockstep with the public syndication markets, i.e. that smaller corporates are being leveraged up.^[3]

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