Warning issued on ‘excessive leverage’

In the global financial crisis, we learned the hard way that excessive leverage can bring down the economy — even if it doesn’t sit directly on the balance sheets of systemic banks. We also learned the importance of robust governance, risk management and controls. Unfortunately, we are seeing evidence that, in some parts of the banking and wider financial system, these lessons are being forgotten.
We should be clear: 2022 is not 2006. Since the global financial crisis, the regulatory framework has been overhauled, supervision has become stronger and more extensive, major banks’ capital levels have increased substantially, and their risk management practices have improved.
However, despite the Covid-19 pandemic, recent
times have seen renewed complacency within some financial markets, where risk-taking is high by historical standards. As we go through a period of significant economic and geopolitical uncertainty, with inflation challenges and the Russian invasion of Ukraine slowing economic growth and increasing volatility, more vigilance and caution is required.
The European Central Bank and the Bank of England have recently flagged two areas of specific concern: leveraged lending and prime brokerage. Both these segments of the banking business are global in nature, which is why the two authorities continue to exchange information on banks’ practices and act in as close alignment with each other as possible.
The global leveraged lending market came through the pandemic largely unscathed, but banks should be careful not to conclude from this episode that the current high levels of leverage and weak loan documentation are prudent.
They are not; and without the widespread pandemic-related support of economies from public authorities, losses would likely have been substantial. Risks in the leveraged lending market continued to increase last year.
Global primary issuance in 2021 set a new full year record, bringing the global stock of leveraged loans to more than $4 trillion for the first time. In parallel, underwriting standards and lender protection safeguards have continued to deteriorate.
It has been found that banks have increased their risk-taking in the sector, in line with market developments, even as their
overall risk appetite and risk-management frameworks lagged behind.
Furthermore, we are concerned that the leveraged lending market remains opaque: its size is subject to considerable uncertainty and the ultimate risk holders remain largely unknown. Risk trends may not be well-captured in the data and risk building may consequently not be well understood. For example, market data may underestimate leverage levels as they rely on borrower earnings inflated by what are known as “add-backs” for future cost-cutting and synergies that may not be achieved.

—Bloomberg