(Bloomberg) -- Supervisors at the European Central Bank were in a bind.
They were sure interest rates would eventually rise, ending a decade of ultra-loose monetary policy after the global financial crisis that had encouraged risk-taking. Yet banks were largely ignoring their guidance to curb lending to highly indebted companies, challenging the institution’s authority.
The regulators considered three options: They could enforce the guidelines, amend them, or repeal them, as some recall. Led by then-Chairman Andrea Enria, they agreed to enforce.
The decision set the ECB on a collision course with some of the region’s largest lenders that, almost five years later, threatens the hard-earned credibility the watchdog built by shoring up the industry after multiple crises. With interest rates falling again and politicians shifting their priorities toward promoting growth, banks have been emboldened to step up their lobbying -- leaving the ECB on the back foot.
Crucially, the way the watchdog conducted an in-depth review of leveraged lending this year has raised serious questions about its approach. Banks, spooked by initial demands that they set aside billions in additional reserves, are criticizing everything from the methodologies and models to the use of outside consultants, who outnumbered ECB staffers more than ten to one. The ECB at one point even got into a debate over the proper collateral value of cows.
In Frankfurt, some officials at the ECB share that view, criticizing in private how their colleagues in the supervisory arm conducted one of the larger probes euro-zone watchdogs have undertaken so far. The row has turned public, with Belgium’s Tom Dechaene — a member of the central bank’s supervisory board — telling Bloomberg the ECB should “correct” its work if it wasn’t sophisticated enough, a rare admission that the ECB’s regulatory arm can make mistakes.
The ECB is seeking to contain the fallout by telling banks it will weigh their feedback and has escalated the probe to Enria’s successor Claudia Buch. Officials have already more than halved their initial estimate of the extra provisions they want banks to make. Just nine months into her term, Buch — a former Bundesbanker known for being tough on banks — now finds herself in the uncomfortable position to decide how much more the watchdog will walk back its demands.
“Having an uninformed precautionary review and throwing the baby out with the bathwater comes at a cost,” said Michael Koetter, vice president of the Halle Institute for Economic Research. “You trade in future credibility, and this is a serious problem.”
Through interviews with more than a dozen people involved in the work, Bloomberg has pieced together an account of how the ECB found itself in a predicament that's weighing on the supervisor as it approaches its 10-year anniversary. The people spoke on condition of anonymity to discuss internal matters.A spokesperson for the ECB declined to comment on the details as the review is still ongoing.
European banks have been complaining about the ECB’s approach to leveraged finance since 2017, when the watchdog published 14 pages of guidance on how loans to heavily indebted borrowers should be handled. Leveraged finance is often thought about as syndicate deals that a group of banks book together for a heavily indebted borrower, or one with a non-investment grade credit rating.
Read more about the ECB’s leveraged finance probe:
ECB Defends Probe of a Dozen European Banks’ Riskiest Loans
ECB Weighs Halving Demand in Risky Loan Probe to €7 Billion
ECB Set to Delay Risky Loans Probe Findings on Bank Backlash
Banks’ ECB Resentment Flares Up Again in Leveraged Loan Probe
The ECB wanted extra monitoring and governance of any business or commercial loans where the total debt of a corporate, non-investment-grade borrower exceeded four times earnings before tax, interest, depreciation and amortization, or where the borrower was owned by a private equity firm. If their indebtedness exceeded six times earnings, loans were considered “exceptional” and needed to be “duly justified.”
Classifying a loan as “leveraged” did not in itself lead to higher loss reserves for the exposure, but banks argued the guidance put extra monitoring requirements on too broad a group of companies. Based solely on the earnings multiple, around 400 companies in the roughly 2,400-member Stoxx All Europe Total Market Index would currently meet the definition of “leveraged” borrowers, and about half that group would qualify as “highly leveraged.” Still, many of them have investment grade credit ratings, meaning they wouldn’t be subject to the classification.The European approach also meant a loan could be moved into the leveraged finance category if a borrowers’ earnings fell at any time after its inception, although the ECB offered some flexibility. In the US, “fallen angels” whose financial performance deteriorated after a loan’s inception are not put into that category unless the loan is modified, extended or refinanced, according to the interagency guidance from the three federal supervisors of America’s top banks.
Rather than impose restrictions and extra monitoring on a broad group of clients, the banks mostly ignored the guidelines when they came out, people involved in the ECB’s discussions on the topic told Bloomberg.
By 2020, the topic had made its way to the board of the ECB’s supervisory mechanism, which includes representatives from each of the euro zone’s national regulators alongside ECB officials. Views were divided, but the ultimate call was that a decade into the era of ultra low rates was not the right time to ease up on banks’ riskiest loans, the people said. Supervisors could use their discretion to suspend the leveraged finance designation for borrowers whose profitability had dipped for temporary reasons. But the formal guidance remained unchanged, and the ECB set out on a mission to enforce it.
Supervisors at first took a closer look at what banks were doing in leveraged finance, imposing “capital add-ons” where the ECB believed risks were not fully captured by loan loss provisions. In 2023, three banks, including Deutsche Bank AG and BNP Paribas SA, had such surcharges.
Then, in September 2023, the crackdown intensified with work starting on a thematic review across 12 banks operating in the European Union that had large leveraged finance exposures, or where leveraged finance was a big part of the overall business. It was one of the bigger probes the ECB had ever undertaken, involving around 20 staffers and another 230 from outside consultants including Interpath, Deloitte and BDO.
Spokespeople for those firms declined to comment.
The banks under scrutiny included heavyweights Banco Santander SA, Deutsche Bank, BNP Paribas and Societe Generale SA, as well as EU offshoots of international megabanks HSBC Holdings Plc, JPMorgan Chase & Co. and Bank of America Corp. The set was completed by smaller European banks Nordea Bank Abp and Rabobank, as well as MeDirect Bank, a niche lender in Malta.
The probe was intense. The ECB and their consultants demanded granular data to populate as many as 100 data fields for a single debtor. Overseas leveraged finance came in for particular attention. In the US, the ECB got into a colorful dispute with Rabobank about prudent collateral valuations for cows that had been intensively milked. Rabobank declined to comment.The information the ECB gathered was then fed into a “challenger model” where the watchdog generated its own probabilities for defaults and future losses. The results alarmed banks. Some cite cases where the model ignored guarantees — even sovereign ones — that would reduce potential losses. Others complained about the quality of the consultants used by the ECB to carry out much of the work.
When the initial results were delivered to banks in June, they called for an extra €13 billion ($14.4 billion) of provisions across the dozen lenders, people familiar with the situation have said. Several banks received recommendations for extra provisions exceeding €1.5 billion, including one for a €2.7 billion provisions top-up.
The protests were fierce and prompted the ECB to delay the final results until September or October to address banks’ technical concerns about the work, people involved said. The ECB also conducted internal meetings between the staff involved in the leveraged finance review and those who supervise the banks day to day, in an attempt to broker agreement on what the next steps should be.
Banks - led by the French, Italians and Germans - have been lobbying hard, warning that draconian requirements will hurt lending to European businesses, including energy companies vital to the green transition whose debt is often high. Lenders have also revisited old arguments about international competitiveness, saying a hard line from Europe could further disadvantage them against rivals from the US.
“A lot of leveraged finance is very international — large-scale borrowers operating in multiple jurisdictions,” says Jackie Bowie, a managing partner at Chatham Financial who advises clients including private equity firms on leveraged loans as a source of financing.
The ECB is now having to dramatically pare back its earlier demands. In an indication just how far off the initial results of the probe were, it already cut its estimate for additional provisions to around €7 billion, Bloomberg previously reported. People involved in the discussions say the number will likely decline further.
Andreas Dombret, a member of the ECB’s first supervisory board, says the watchdog’s reputation wouldn’t necessarily take a hit if it changed its position. There is some support in the board for such a pragmatic approach.
“Supervisors and banks have to be in a dialogue and a strong supervisor may sometimes change his or her position,” he said.
The matter will ultimately be decided by Buch, who has a reputation as tough on banks and hard to sway. The former Bundesbank vice president is continuing her predecessor's push to give oversight officials more freedom to focus on the risks they deem to be most relevant for individual banks.
"Generally, banks that are subject to more intense supervisory scrutiny tend to be safer, without showing signs of lower profitability," Buch said in a speech on Thursday in Budapest. "More frequent supervisory examinations of banks are associated with reduced loan losses and delinquencies and thus higher profitability."
--With assistance from Giulia Morpurgo.
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