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," said the source. The bank-specific Pillar 2 capital requirement is part of the Basel framework and covers risks that are underestimated or not covered by the minimum capital 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. Andrea Enria, chair of the ECB's Supervisory Board, recently said the central bank would deploy the full range of tools available to rein in lenders piling on risk. At the same time, the ECB has to avoid putting on the brakes too hard so as to keep loans flowing in Europe's pandemic-hit economy.

"This is always the balancing act that the regulator has to undertake," said Benjie Creelan-Sandford, an analyst at Jefferies. "It has been very clear about its desire for banks to continue to lend into the real economy to support the economy during COVID-19 but at the same time, there are pockets of activity that it may be concerned about."

Leveraged finance provides banks with strong returns, in part because the market caters to a large number of 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.

'Late-cycle behavior'

The leveraged finance market is growing again after coming to a virtual halt at the start of the COVID-19 pandemic in March 2020. The S&P European Leveraged Loan Index stood at €251 billion in June, up from €235 billion in December 2020. Total leverage for all leveraged loan transactions reached 5.5x annual pro forma debt-to-EBITDA for the year-to-date to June 30, 2021, higher than any year other than 2007, according to LCD.

So far this year, the leveraged finance market has been characterized by late-cycle behavior "with a flurry of sponsor-backed dividend recapitalizations, add-on acquisitions, and new buyouts pushing secured and total leverage higher, as both loan and high-yield investors accepted the risk on offer," according to a July 20 report by S&P Global Ratings.

Ratings noted that leveraged finance structures are more aggressive, with total leverage for sponsor-backed transactions approaching 6x EBITDA and senior secured leverage reaching 5.25x-5.5x EBITDA, on average. Year-to-date dividend recap activity — payouts to owners of issuers funded by new debt taken on by the issuer — is at the highest level recorded since 2007, often featuring an additional 0.5x of senior leverage in comparison to the last time the same issuers approached the market, the report said.

There has also been a steady rise in leverage on European private-equity sponsored acquisitions, according to LCD. The biggest leveraged finance deals, including Swedish buyout firm EQT AB (publ)'s purchase of a majority stake in French medical laboratories' operator Cerba HealthCare SAS for €1.8 billion, have seen the involvement of some of the leading banks in this field. These include Deutsche Bank, The Goldman Sachs Group Inc., HSBC Holdings PLC, JPMorgan Chase & Co., UBS Group AG and Nomura Holdings Inc.

A matter of perspective

The ECB and Deutsche Bank have clashed for several months on the issue of leveraged finance. The regulator has warned the bank that its internal risk management was inadequate and encouraged it to suspend high-risk transactions, according to the Financial Times.

However, the ECB and Deutsche Bank differ over their definition of high levels of leverage. The ECB defines it as deals where total debt, including undrawn credit lines, exceeds 6x EBITDA. Deutsche's definition, reportedly in common with other banks, excludes undrawn credit lines, according to the newspaper.

Deutsche said in a statement that it would not comment on any dialogue it might have with its regulator and noted that leveraged loans were an important business for the bank. "We have a strong track record in the business and we follow a prudent risk management approach in line with regulatory requirements," it said.

In its annual report, Deutsche said its fee-based leveraged loan business is expected to benefit from a further reopening of the loan market this year. The various support measures introduced by central banks and governments in response to the COVID-19 pandemic have helped drive this trend, according to Creelan-Sandford.

"There are pockets of stress in the corporate sector which will remain going forward, but corporate balance sheets have not necessarily deteriorated as much as we might have expected over the past 12-18 months," the analyst said. "More broadly than leveraged finance, in terms of corporate loan demand, that is a potential tailwind for the European bank sector, not least as further support measures kick-in. The next generation of European Union recovery funds are coming later this year and into 2022 to support corporate activity."

LCD is an offering of S&P Global Market Intelligence.