A major risk hangs over European banks: leveraged loans

Although issuance has declined this year due to the war in Ukraine, the European Central Bank estimates that there are over $ 4 trillion in such loans outstanding globally.

Major acquisitions driven by leveraged loans included the $ 9 billion acquisition of British grocery chain Wm Morrison Supermarkets PLC after a bidding war, and a $ 30 billion trade in the United States for medical supply company Medline Industries Inc. France’s BNP Paribas SA was one of the agreements -lending banks in both. A spokeswoman for the bank declined to comment.

The fear is that highly indebted borrowers may start struggling to pay off their debts as the economy slows, they face higher costs for their business due to inflation, and interest rates rise. Leveraged loans typically have liquid borrowing costs, which would make refinancing more expensive.

“Leveraged lending is always risky, but right now we are facing a confluence of factors, from the war in Ukraine to high inflation, that have escalated these risks,” said Trevor Pritchard, CEO of European geared finance at S&P Global Ratings.

Banks in Europe embraced leveraged loans because the region’s negative interest rates have hampered their ability to monetize more banal forms of lending. The market has been overcharged because leveraged loans are also used to pay for private equity buyouts, which reached record levels last year.

Other euro area banks that have provided leveraged loans include Germany’s Deutsche Bank,

France’s Crédit Agricole and Italy’s UniCredit,

according to Dealogic.

Last month, the head of the ECB’s Banking Supervision, Andrea Enria, sent a letter to the banks’ top executives, warning banks that they would take a proactive approach to controlling their appetite for these types of loans, including by forcing them to set aside capital to cover potential losses.

“Excessive risk-taking is of particular concern to the ECB when it comes to inadequate risk management,” he said. Enria.

Last year, Deutsche Bank said it took an additional capital requirement on leveraged lending according to ECB instructions. A spokesman for the bank declined to comment. In its quarterly accounts on Wednesday, the bank said revenue from leveraged loans dragged down the investment banking business.

The ECB says that exposures with leveraged loans from 28 systemically important banks, which it oversees, which include some US banks, rose 80% between 2018 and last year to 500 billion euros, equivalent to 530 billion dollars. It accounts for 60% of their combined key capital buffer ratio, which can begin to evaporate if defaults become widespread.

While banks typically transfer the loans – and the risk – to investors in loan funds, they end up owning some of the credit, while also offering the same borrowers revolving credit facilities. Banks may also find themselves holding on to loan obligations if investor interest declines.

After Russia invaded Ukraine in late February, the leveraged loan market stalled, S&P said in a report. It’s taking over again.

Privately, the banks have refused the ECB’s assessment, saying they are overestimating the problem. For example, it includes unutilized lines of credit in its exposure figures.

The ECB first issued guidance to lenders in 2017, as it sought to limit that type of lending to a maximum of six times the borrower’s earnings. Mr. Enria said the guidance has not been adequately followed. The conditions set by the lender under the loans have meanwhile only become weaker, which means that recovery in case of default may be low.

Fitch Ratings, which tracks leveraged loans for valued companies, said so far that borrowers have shown resilience. It expects default rates to rise to 2.5% in 2022 from 0.5% over the last 12 months to March.

But Ed Eyerman, Fitch’s head of European leveraged finance, said that borrowers with leveraged loans, which the ECB stands for, include undervalued and indebted small businesses and private equity-owned companies that have received credit from banks competing with private debt firms.

“There will definitely be more standards,” Mr. Eyerman.

Write to Patricia Kowsmann at patricia.kowsmann@wsj.com