European banks face increased leveraged lending risks, says Enria

European banks have increased their leveraged lending, which could expose them to higher risks if central banks increase interest rates, the European Central Bank’s chief supervisor warned.

Single Supervisory Mechanism chair Andrea Enria said today (February 10) banks have breached their expectations regarding the amount of risky lending they would engage in.

Presenting the results of the annual Supervisory Review and Evaluation Process (SREP), Enria warned cyber security and climate change are also becoming increasingly important risk factors.

“Lending to structurally riskier counterparties has progressively increased as leverage limits were lifted and investor protection covenants progressively lowered or disregarded,” he said. “This runs totally counter to our publicly disclosed supervisory expectations.”

As a result, the SSM is preparing a letter to banks that are particularly active in the leveraged lending market to clarify its expectations. The supervisory could consider quantitative requirements in the 2022 cycle if banks failed to meet these expectations.

These riskier operations could become more expensive if central banks increase interest rates in the months ahead. The tightening process “may be bumpy, and characterised by sudden corrections in asset prices and spreads, costly deleveraging and unexpected channels of direct and indirect contagion”, said Enria in his introductory statement.

Due to rising above-target inflation in the US and Europe, the Federal Reserve has accelerated plans to stop net asset purchases in March. In its January policy meeting, the Fed indicated a rate hike will “soon be appropriate”. At the ECB’s last policy meeting, president Christine Lagarde abandoned the previous forward guidance, refusing to rule out a hike in the eurozone in 2022.

Since Lagarde’s intervention on February 3, sovereign debt markets have experienced meaningful changes. For instance, Italy’s 10-year bond yields have increased from 1.4% to 1.8% over the last week, its highest level since May 2020.

Enria acknowledged that an exit from the low interest rate environment would be generally positive for banks, especially if coupled with strong and continued growth. “That would imply higher interest margins from a steeper yield curve, and greater lending volumes from increased demand,” he said.

But he pointed out the impact of higher interest rates may vary across banks depending on their business models. Some will be particularly affected by falls in asset valuations, while others may be more exposed to customers struggling to repay debts.

“The risk of unexpected, material increases in interest rates or credit spreads is a cause for concern in the light of the search for yield strategies some banks have been pursuing in recent years, including throughout the pandemic,” said Enria.

Partly due to higher debt levels in the private sector during the pandemic, banks have increased their indirect exposures to leverage through non-bank financial institutions. Banks seeking higher returns than in traditional banking operations have increased their dealings with firms such as private equity-owned credit funds.

In addition to tighter financing conditions, these practices contribute to higher risk levels due inconsistent risk management practices, the SSM said. For instance, they do not follow a unified criteria when assessing counterparty credit risk, it argued.

“Weak client management principles and insufficient transparency clearly emerged as sources of global concern in this area,” said Enria. “Vulnerabilities stemming from the interplay between credit, market and counterparty risks showed their negative potential in the Archegos case and will attract enhanced supervisory attention.”

Archegos Capital Management was a US-based private investment manager that defaulted in several large margin calls from banks in March 2021. The losses suffered by banks from their exposure to Archegos are unclear but have been estimated in the billions of dollars.

Russia and cyber risks

Enria also said banks need to revamp their efforts to count with adequate technology, staff and procedures to prevent the worst effects of cyber attacks.

This threat has gained increasing attention over the last few weeks as Russia has massed over 100,000 troops on Ukraine’s border. “When there are tensions, when there’s the possibility of sanctions floated, of course this is an issue which raises concern and we need banks to prepare,” said Enria.

On February 9, news agency Reuters reported US and European regulators have told banks to prepare against cyber attacks stemming directly from the Russian state or hackers sponsored by it.

“The concerns from a supervisory perspective in case of deterioration, of tensions between Russia and Ukraine, is more in potential sanctions and the role banks might have in ensuring that these sanctions are properly enforced and in possible broader turbulence in financial markets,” added Enria.

The SSM said today that after detecting security vulnerabilities it has requested banks to draft and implement remediation plans. The supervisor has also asked lenders to establish and document their IT strategy, and to make sure they count with adequate staff capabilities in critical IT functions.

“The recent increase in IT spending that has accompanied the increased reliance on digital strategies has often taken the form of increased reliance on outsourcing, which may raise issues around the continued availability of critical functions if third-party providers suspend their services,” warned Enria.

In fact, despite the emphasis made over the last years on cyber security, the SSM has identified structural deficiencies in the financial sector IT infrastructure and risk data architecture. “For example, we often see different IT systems being used to perform the same or similar tasks across banking groups,” said Enria.

Climate change

The SSM pointed out as a third rising threat: climate change. It said physical as well as transition risks “are already materialising and having a direct impact on banks”.

Physical risks manifest through, for instance, extreme weather events that can prevent borrowers from repaying their loans. They can also reduce the value of the assets posted as collateral against bank loans.

Transition risks can stem from legislation and policies aimed at reducing CO₂ emissions. These include the introduction of carbon-pricing schemes or the banning of carbon-intensive activities.

“Together with shifting consumer preferences towards goods and services that are more sustainable, will have a significant impact on climate-sensitive economic sectors and the broader economy, particularly in the case of an abrupt transition,” said Enria.

The SSM head said the institution will carry out an assessment of the progress banks have made to identify, measure and manage climate and environmental risks. Additionally, the supervisor will run its first climate stress-test exercise in 2022. The outcome will not directly impact banks’ capital requirements.

Nonetheless, Enria warned the SSM “will gradually start treating climate-related risks just like any other risk, meaning they will be reflected in all relevant supervisory requirements”.