Let’s be clear: 2022 is not 2006. Since the global financial crisis, the regulatory framework has been revised, supervision has become stronger and more comprehensive, the capitalization of big banks has increased significantly and their risk management practices have improved. Recently, however, despite the COVID-19 pandemic, there has been renewed complacency in some financial markets where risk appetite is historically high. As we live through a period of significant economic and geopolitical uncertainty, with inflation concerns and the Russian invasion of Ukraine slowing economic growth and increasing volatility, more vigilance and caution is warranted.
The European Central Bank and Bank of England recently highlighted two areas where they have particular concerns: leveraged lending and prime brokerage. Both segments of banking are global in nature, so the two authorities continue to share information on banking practices and act in concert as closely as possible.
The global leveraged lending market has come through the pandemic largely unscathed, but banks should be careful not to draw the conclusion from this episode that current high leverage and weak credit documentation are cautious. In our view, they are not; and without widespread pandemic-related support from public authorities to economies, the losses would likely have been significant.
Risks in the leveraged lending market have continued to rise over the past year. Global primary issuance in 2021 set a new full-year record, taking the global stock of leveraged loans to more than $4 trillion for the first time. In parallel, underwriting standards and lender protection have continued to deteriorate. Our work has found that banks have increased their risk appetite in this sector in line with market developments, although their overall risk appetite and risk management framework have lagged behind.
In addition, we fear that the leveraged lending market remains opaque: its size is subject to significant uncertainty and the ultimate risk takers remain largely unknown. Risk trends may not be well captured in the data and risk formation may not be well understood as a result. For example, market data may underestimate leverage levels because it relies on borrower returns inflated by so-called “add-backs” for future cost reductions and synergies that may not be achieved.
The ECB is addressing chief executive officers of banks involved in this business this week, urging them to define sound risk-taking frameworks and reduce the emergence of highly leveraged transactions in order to comply with prudential guidance that has been in place since 2017 to comply with The ECB is also considering the application of specific Pillar 2 capital requirements to address individual instances of persistent non-compliance. The BOE also closely monitors UK banks’ involvement in this deal, testing banks’ leveraged lending portfolios and imposing capital requirements where necessary.
Banks have invested heavily in their liquidity risk management following a liquidity “run” on several firms’ prime brokerage deals during the global financial crisis. However, the collapse of family office Archegos in March 2021 made it clear that alongside the company’s liquidity risks, counterparty credit losses can also be very damaging, especially in a highly leveraged and concentrated environment. The episode demonstrated that in the absence of a sufficiently strong governance, risk culture, business strategy and risk management framework, banks’ exposure to hedge funds and other non-bank financial intermediaries can leave lenders with severe scars. Last December, following a review of banks’ prime brokerage operations, the UK’s Prudential Regulation Authority wrote to lender CEOs, noting several shortcomings and urging executives to take corrective action. Similarly, the ECB has clarified its expectations with the relevant banks and will conduct targeted reviews and on-site inspections in the areas of counterparty credit risk monitoring and management – including prime brokerage – to identify relevant deficiencies. More broadly, banks should apply the lessons learned to other areas where they are exposed to trading counterparties – most obviously in the energy and commodity markets.
Excessive or poorly managed risk-taking today sows the seeds of tomorrow’s financial instability and ultimately threatens economic recovery. Banks can expect regulators to engage with them on how they manage these risks. The ECB and BOE stand ready to do whatever is necessary to ensure that the lessons of the global financial crisis are not forgotten even as we go through other crises such as Covid-19 and Russia’s invasion of Ukraine, so that the financial system can continue to serve the rest of the economy.
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Andrea Enria is Chair of the Supervisory Board of the European Central Bank. Previously he was Chairman of the European Banking Authority.
Sam Woods is Deputy Governor for Prudential Regulation at the Bank of England and Chief Executive Officer of the Prudential Regulation Authority.