The ECB's guidance on leveraged finance enters force in November 2017, and JSTs will need implementation reports one year later. Meeting this target will pose significant challenges for many banks, partly because some key definitions and requirements appear unclear. Banks need to act fast to clarify uncertainties, achieve successful implementation and avoid any disruption to their lending activities.

Four months have already passed since the ECB published its final guidance on leveraged transactions, link. (PDF 256 KB) The guidance applies to all Significant Institutions, and will enter force in November 2017. It reflects a growing supervisory focus on the size and nature of leveraged lending, and follows a thematic review that identified concerns over weakening credit criteria. The issuance of the final guidance followed a consultation period that generated 445 comments from 24 banks, showing the industry's great interest in this topic.

Taking an EU-wide perspective we expect the identification of leveraged transactions and the need for control adjustments and system adjustments to be the most challenging aspects of the guidance. Given the tight timeline for implementation, it is now crucial for banks to clarify the main areas covered by the guidance. KPMG member firms' conversations with clients suggest that the most challenging topics include:

• Identification/Definitions. Identification is fundamental to proper implementation, but is proving challenging. For example, the guidance appears to cover not only what banks define internally as leveraged finance, but also significant parts of their corporate loan portfolios. The lack of explicit definitions could make processes, procedures and governance particularly difficult.
• Timelines for transaction flagging. The guidance does not have a clear requirement regarding the timeline and timings for transaction flagging. Banks are still seeking clarification on whether they need to identify all relevant outstanding transactions as of November 2017, or if they merely need to start flagging new transactions thereafter - in other words, if grandfathering applies.
• The definition of `total debt'. The final guidance defines total debt as “total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit” ECB Guidance on leveraged transactions May 2017.. Several banks have asked if this includes shareholder loans. In its feedback statement the ECB's answer was clear, saying that Payment In Kind instruments and other shareholder loans are credit facilities paying interest in the form of additional debt or equity rather than cash, and should thus be included in total debt calculations ECB's Feedback statement “Responses to the public consultation on the draft ECB guidance on leveraged transactions”.. This will significantly increase the number of banks' leveraged transactions, posing challenges around proper monitoring and reporting. Another challenge comes from the inclusion of undrawn and incremental loan facilities in `total debt'. Borrowers do not always disclose the size of undrawn loans, making this information hard to acquire and monitor.

It remains to be seen what market impact the guidelines may have. The ECB has stated that their intention is not to prevent credit institutions from providing financing solutions to leveraged borrowers. However, similar guidelines in the US were seen to result in a reduction in leveraged activity amongst banks, with some lending business migrating to non-banks Federal Reserve Bank of New York Staff Reports, no. 815. Link. Time will tell whether the guidance will affect banks' appetite for leveraged transactions.

With the guidance entering force imminently, banks only have until November 2018 to submit internal audit reports on implementation to their Joint Supervisory Teams (JSTs). So it is essential for implementation projects to begin, if they have not already done so. For most banks, gap analysis and benchmarking will be the first steps. KPMG member firms can help to familiarise clients with the requirements and identify the areas requiring most attention. A forward-looking impact analysis will be critical to maintaining uninterrupted lending activities, clarifying areas of uncertainty, and ensuring effective implementation.