A Big Risk Hanging Over European Banks: Leveraged Loans

Europe’s banking regulator is growing antsy about a booming market for banks: loans that fuel riskier borrowers and the global deal-making machine.

That corner of banks’ business, called leveraged financing, has skyrocketed in Europe and elsewhere over the past years as central banks unleashed cheap money to propel economic growth. 

Although issuance has slowed down this year because of the war in Ukraine, the European Central Bank estimates there are over $4 trillion in such loans outstanding globally. 

Big buyouts fueled by leveraged loans included the $9 billion purchase of U.K. grocery chain Wm Morrison Supermarkets PLC following a bidding war, and a $30 billion deal in the U.S. for medical-supply company Medline Industries Inc. France’s BNP Paribas SA was one of the deal-lending banks in both. A spokeswoman for the bank declined to comment.

The fear is that highly indebted borrowers could start struggling to pay off their debt as the economy slows down, they face higher costs for their business because of inflation, and interest rates increase. Leveraged loans typically have borrowing costs that float, which would make refinancing more costly.

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

Banks in Europe embraced leveraged loans because the region’s negative interest rates have hampered their ability to make money off more mundane types of lending. The market has been supercharged because leveraged loans are also used to pay for private-equity buyouts, which reached record levels last year. 

Other eurozone 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 ECB’s banking supervision,

Andrea Enria,

sent a letter to banks’ chief executives warning banks it would take a proactive approach in 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 is coupled with inadequate risk management,” Mr. Enria said. 

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

The ECB says leveraged-loan exposures at 28 systemically important banks it supervises, which include some U.S. banks, rose 80% between 2018 and last year to €500 billion, the equivalent of $530 billion. That accounts to 60% of their combined key capital-buffer ratio, which could start evaporating if defaults become widespread.

While banks typically pass on the loans—and the risk—to investors in loan funds, they end up holding some of the credit while also offering the same borrowers revolving credit facilities. Banks might also find themselves stuck holding the loan commitments if investor interest fades.

After Russia invaded Ukraine in late February, the leveraged-loan market came to a halt, S&P said in a report. It is picking up again.

Privately, banks have balked at the ECB’s assessment, saying it is overestimating the problem. For instance, it includes undrawn credit lines in its exposure figure.

The ECB first issued guidance to lenders in 2017, when it tried to limit that type of lending to no more than six times the borrower’s earnings. Mr. Enria said the guidance hasn’t been sufficiently followed. Conditions set by the lender under the loans, meanwhile, have only grown weaker, which means recovery in case of defaults could be low. 

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

But Ed Eyerman, Fitch’s head of European leveraged finance, said leveraged-loan borrowers the ECB accounts for include unrated and indebted small firms and private equity-owned companies that have been getting credit from banks competing with private debt firms. 

“There will be absolutely more defaults,” Mr. Eyerman said. 

—Ben Dummett contributed to this article.

Write to Patricia Kowsmann at [email protected]

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