The wrong time to restrict leveraged loans
The ECB’s attempts to reduce leveraged lending are damaging, inconsistent, and come at exactly the wrong time
The supervisory arm of the European Central Bank is looking for ways to deter banks from turning to the riskier end of leveraged loans, according to the Financial Times, demanding banks hold additional capital.This is bad news for the European economy and runs counter to other central bank initiatives.
As the Covid-19 vaccination programs are rolled out and lockdowns are lifted, the credit taps for distressed borrowers need to be turned on as much as possible, with banks in a position to comment on the outlook for recovery of damaged industries. It will be crucial, in the coming months, that airlines, hotels, cruise lines, ferry companies and restaurant chains are able to refinance, return emergency funds and prepare for get out of the 2020 profit black hole.
Right now, it is quite on the table. Some companies will have to restructure their liabilities and probably look outside the banking market for the new money to help them do it. But many companies in the “stressed but not distressed” camp will look to the financial markets – taking “Bs” guaranteed term loans or gateways to high yield bonds.
At that point, the credit committees of European investment banks will not want to question their supervisor. There will be a lot of credit work to be done on their own, without trying to determine if a particular position will result in a series of death sentences on top of the existing underwriting risk.
The situation will be particularly dire if supervisors adopt a leverage-based risk analysis approach. This was roughly the treatment of leveraged loans that the Federal Reserve and the Office of the Comptroller of the Currency used in the United States prior to 2017. It is also included in the existing, but ineffective, guidelines on debt lending. leverage of the ECB.
In both cases, six times leverage was considered a normal maximum, with explanations required for more aggressive trades. The ECB was very strict in allowing Ebitda additions, which reduce the leverage levels of securities, while the Fed, which had more enforcement powers, was more lenient.
Using gross leverage based on the previous 12 months, as in the past, will be a disaster for precisely the stressed companies that need access to credit the most. The Ebitda figures for locked-in companies will be shocking, which means the leverage levels of securities will be stratospheric this year.
The market has already recognized this in most cases, with banks granting waivers on leverage covenants, often replacing them with minimum liquidity restrictions.
An attack on leveraged loans also fits uncomfortably with other ECB initiatives.
In adjacent corporate credit markets, such as the investment grade bond market, the central bank has come to the fore, pushing policy rates to 0% for the strongest companies and compressing credit differentiation.
Investment grade bonds usually don’t hit the banking market – so don’t worry about banking supervisors – but pricing affects bank loan prices there, and the tightening of grade markets first to second into second. pursuit of yield.
With regard to SME lending, banking supervisors in Europe have for many years challenged the Basel Committee to keep in place the ‘SME Support Factor’, which reduces the requirements for payment by almost a quarter. equity for loans to SMEs, compared to other assets with the same expectation of loss.
It is a simple capital grant for loans to SMEs. During the Covid-19 crisis, government guarantee systems and enthusiastic encouragement from policymakers kept banks lending. Unlike leveraged finance, small business loans are seen as mission-critical to European economies – something to be preserved at all costs, rather than criticized.
Supervisors will always want to supervise and naturally worry about the disadvantages rather than the advantages, which accrue to the banks themselves. Leverage loans can be risky, and banks can make big losses by messing it up. This should be taken seriously and it is reasonable for a supervisor to want reassurance.
But if they want some solace, last year should help them.
The March chaos and market shutdown left banks stuck with huge positions in sectors heavily affected by Covid – a loan to buy Stonegate, a chain of pubs, for example, or one of the biggest LBOs in the world. ‘Europe, ThyssenKrupp Elevator funding.
Almost all had been cleaned by the end of the year, and most by the end of July. Banks have proven to be firm holders of their subscriptions, able to choose their exit points. Margins and discounts were high, at least initially, but it wasn’t a bloodbath and there was no hard sell. Funds that thought some of the suspension bridges would come out at rock bottom prices have been disappointed.
These exits, to be sure, were achieved in part thanks to colossal amounts of central bank intervention in other parts of the capital markets, but provide a real, recent and far-reaching stress test – and that the leveraged finance has been successful.
If banks face regulatory restrictions on their ability to take out leveraged loans, the market will adapt. Non-banks and direct lenders will carry out more complex or more leveraged transactions, European investment banks will lose even more market share, and some kind of market will persist.
But the real losers, in the short term, will be the midsize companies hoping to raise funds to finance their return to normal trade that policymakers have pledged to support. Regulate, if you must, but it would be wrong to strangle recovery now.