The ECB picks up dangerous risks in banks’ leveraged loans

Banks are too complacent about the excessive risks that develop in the derivatives markets of loans and stocks and can expect higher capital requirements as a result, warned the head of supervision of the European Central Bank.

Andrea Enria said Friday that he was concerned about “market complacency and excessive risk-taking” by banks, adding that there were “warning signs of growing leverage, financial complexity and opacity that create the potential for a dangerous combination of risk factors. “

ECB officials said the speech signaled that the supervisor had lost patience with several major eurozone financiers, such as Deutsche Bank, which retaliated. their calls for them to enforce riskier loans.

“Where we see shortcomings, we will take surveillance action,” Enria said in an online address to the degrees in finance and economics at the University of Naples.

“In key areas such as leveraged finance, where the previous supervisory orientation has not been sufficiently implemented by banks, we intend to implement the full range of supervisory tools available to us, including proportionate minimum capital requirements. to the specific risk profile of individual banks, this is necessary, ”he said.

The ECB’s chief supervisory officer said earlier this week that he would lift the cap on banks ’dividends and share repurchases later this year. Friday said banks “remain resilient” while “uncertainty is declining and, by all indicators, the economic system is on track to recover.” The ECB will publish the results of its banking stress tests on 30 July.

However, despite this more optimistic outlook, Enria said: “The concrete signs of risk accumulation have become evident in our risky asset segments of leveraged debt and equity-related derivatives, which deserve intensified supervision.” .

The extensive support provided by governments and central banks has protected the financial system from the fall of the coronavirus pandemic, he said.

But he said this could have fueled complacency and warned of the risk of “a sharp correction in asset prices” when this support is withdrawn, especially “if investors expect inflationary pressures to persist and revise. their expectations regarding the position of monetary policy ”.

“Renewed tensions around risky assets again exposed the entire ecosystem of non-bank entities and funds to liquidity risk resulting from investor repayments and from credit and valuation losses,” he added.

The United States Federal Reserve warned of May that some asset valuations are “high relative to historical norms” and “may be vulnerable to significant declines where there is a risk of falling appetite”.

Although the ECB has been calling on banks since 2017 to bolster its leveraged lending – the practice of financing private equity groups and other corporate asset buyers – Enria said it had seen a “further deterioration”. of the underwriting rules “by the most active banks in this area.

In the fourth quarter of 2020, he said more than half of the loans exploited by these banks had a debt equal to more than six times the earnings before interest, taxes, depreciation and amortization and were covenant-lite – eliminating the usual protections for investors – or they had no alliance.

Last year, Deutsche Bank refused a request from the ECB to suspend key parts of its financing operations revealed concerns did not properly address the risk in that area, where it is one of Europe’s largest lenders. Deutsche declined to comment Friday.

Enria also expressed concern that banks were not “concerned” about hedging risks in the 15 eurozone market for equity derivatives that would allow investors to take leveraged bets on the stock markets. .

He said the risks in this market were underlined by the collapse of Bill Hwang’s Archegos family office in March, which left some banks with “sub-optimal marginalization practices” nursing. heavy losses. Credit Suisse lost $ 5 billion to the credit given to Archegos and Nomura lost $ 3 billion.

Referring to “the wider problem of the opacity of the shadow banking sector and the degree of interconnectivity in financial markets”, Enria said “it is necessary to renew the regulatory and supervisory dialogue at the global level, as they could be new solutions are needed “.

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