The European Central Bank intends to toughen its stance against lenders overexposed in leveraged finance later this year, according to a person familiar with the situation. The regulator will use its annual Supervisory Review and Evaluation Process, or SREP, to outline stricter capital requirements for leveraged financing, the person said. The ECB issues SREP reports to banks each year outlining key concerns and giving them a specific deadline for action. The aim is to ensure banks have a proper risk appetite for the risk finance and make sure there are internal limits. Then, as part of the SREP letter, the ECB can then impose Pillar 2 requirements — legally binding qualitative requirements. The ECB has already warned Deutsche Bank AG about its leveraged-finance exposure, but other banks could also be affected by the regulator’s actions. The central bank would deploy the full range of tools available to rein in lenders piling on risk. At the same time, the ECB must avoid putting on the brakes too hard to keep loans flowing in Europe’s pandemic-hit economy.
Leveraged finance provides banks with strong returns, in part because the market caters to many highly indebted corporate counterparties of speculative-grade credit quality — below BBB- rating. It has become a valuable income stream to banks facing various pressures on profitability, including negative interest rates, lower deposits and costly restructurings. The ECB has said that as of the end of 2019, the 26 most active directly supervised banks had a total exposure to leveraged loans of €417 billion, or 20% of their corporate loan books on average. More than half of the €165 billion of new transactions underwritten in 2019 were covenant-lite, which entails fewer borrower restrictions or weaker lender protections, or had no covenant at all.