Credit risk: Emerging challenges for asset quality and leveraged lending

July 2022

The ECB’s recent assessment of the impact of the crisis in Ukraine points towards a potential deterioration in asset quality, as the current situation puts additional pressure on vulnerable sectors and leveraged borrowers. The ECB will continue its focus on credit risks, and expects banks to adequately assess the impacts of the evolving crisis on their loan portfolios. Banks should be aware of the ECB’s expected supervisory focus over the coming months, including a particular emphasis on leveraged transactions.

The ECB recently published its approach to tackling the new challenges posed by the crisis in Ukraine, based on three steps:

The first step, the crisis management structure, is now in place. The ECB has also begun step 2, performing initial assessments of the new and emerging risks from the crisis in Ukraine by:

• Analysing the impact on banks, along with potential systemic risks; and
• Assessing how the new risks created by the conflict may affect its supervisory priorities and focus.
  

At a macro level, European banks’ direct credit exposures to Russian counterparties are manageable, being relatively small (c. 0.3% of total assets according to the latest EBA Risk Dashboard) and mostly concentrated in a handful of banks.

In contrast, the main perceived risks result from second and third order effects on asset quality. The ECB is concerned that new macroeconomic and geo-political challenges will further impact sectors and borrowers already weakened by the pandemic, leading to signs of distress later in the current year.

A broad range of factors could contribute to a possible increase in credit risks, such as increased costs for corporates — including energy and commodities — and disruption in supply chains. A decrease in households' disposable income might also prove very challenging for consumers, especially for low-income families.

The evolving crisis and its uncertainties can make it more complex and challenging for banks to perform precise, granular assessments of the possible impact on asset quality. However, as during the pandemic, the ECB still expects banks to take all necessary measures to evaluate these risks and assess their potential impact on loan portfolios. This includes updating scenarios and analyses, covering the possible direct and indirect effects on asset quality across geographies, sectors and types of borrowers.

Overall, the recent assessment of the ECB has reinforced its focus on the already defined SSM supervisory priorities for 2022 to 2024, which aim to ensure that banks emerge from the pandemic healthy, that structural weaknesses are addressed, and that emerging risks are tackled.

When it comes to credit risks, the ECB has communicated (PDF 622KB) that it will focus its efforts on:

• Maintaining scrutiny of sectors already vulnerable to the pandemic, including supervisory deep dives on commercial real estate (CRE) and residential real estate (RRE).
• Increasing its focus on new conflict-related vulnerable sectors, such as commodity trading and energy utility sectors, where there will be supervisory deep dives.
• Monitoring closely any concentrations for sectors highly dependent on energy and raw materials.
• Continuing to closely monitor and assess banks’ exposures to leveraged transactions.
  

At the end of 2021, the level of leveraged loan issuance was at an all-time high and credit spreads for the riskiest leveraged loans had fallen to the lowest levels since the last global financial crisis. The impact of the pandemic has led to a deterioration in key performance indicators, with more corporate loans qualifying as leveraged transactions. The ECB is now concerned that the worsening macroeconomic environment and rising interest rates may further hit leveraged borrowers and accentuate risks in this segment.

We have already seen the ECB intensify its focus on leveraged transactions this year, including with the Dear CEO letter (PDF 408KB) it sent in March 2022 to significant institutions. This letter reinforced the expectations set out in the ECB Guidance (PDF 256KB) of 2017, highlighting persistent and significant deficiencies in banks’ risk management practices.

The ECB has now entered a second round of on-site-inspections and thematic reviews on this topic. It has also reiterated that failure to remedy the deficiencies identified may result in higher Pillar 2 requirements (P2R) in the future. Based on our discussions with clients across Europe, banks still face several challenges to achieving full compliance with the ECB’s expectations, including:

• The ECB’s definition of leveraged transactions is still a point of divergence with market practices. For example, some banks disagree with including “fallen angels” in the origination definition, and with the lack of consideration given to guarantees (e.g. from public schemes). There are also doubts over how to include as indirect exposures, making it harder to measure leveraged transactions (LT) as expected by the ECB.
• It is unclear what the ECB considers as an acceptable level for high leveraged transactions (HLTs). Banks suggest there are several reasons why the number of leveraged transactions with total debt exceeding 6 x EBITDA does not necessarily constitute an exception. One is that some of the increase is driven by deteriorating macroeconomics conditions.
• The ECB’s greater emphasis on banks’ risk appetite framework (RAF) for LTs is challenging. This requires banks to more precisely define how they manage perceived leveraged lending risks and how they link them to their RAF, ultimately ensuring that increased risk-taking is reconciled with capital and liquidity buffers. Incorporating the relevant metrics and forward-looking perspective is also difficult in these uncertain times.

We understand that European banks have already discussed these supervisory expectations, challenges and implications with Joint Supervisory Teams (JSTs). We expect this to continue given the heightened relevance of any persistent deficiencies on future levels of P2R.

To summarise, the widening effects of the crisis in Ukraine, together with the lagging impacts of the pandemic, are putting additional pressure on asset quality. Credit risks remain at the top of the ECB’s agenda, with a particular focus on vulnerable sectors. Supervisory scrutiny will only increase - especially on leveraged lending, where the ECB has lingering risk management concerns. Banks should engage proactively with JSTs, while remaining alert to further credit risks arising from geopolitical volatility and higher interest rates.