The ECB’s speech focuses on the leveraged finance market

Introduction

On 1 March 2016, Sabine Lautenschläger, Vice-Chair of the ECB’s Supervisory Board, delivered a speech to the Global Association of Risk Professionals about the critical function of risk management in today’s economic environment, in particular where banks are exposed to the leveraged loan market.

Black swans vs business model risks

Risk can be viewed on a spectrum. Black swans – those risks that cannot be foreseen – are on one end. At the other end of the spectrum are those known risks that can be foreseen, measured and managed – these are the risks that are driven by the bank’s business model.

The only way of increasing resilience against black swans is by holding more capital. The ECB feel that the banking system has become much more resilient than it was back in 2008 when the Great Recession broke out. Tier 1 ratios have increased from 8.4% to 13.7% while the quality of capital has also been enhanced with a higher level of CET1 capital being held.

Despite becoming more resilient to withstand economic shocks, risk management for those risks driven by the bank’s business model remains critical. The key is to take a forward-looking, risk-based approach. This is, in fact, the focus of SSM’s supervisory review and evaluation process (SREP). In this process, the supervisor conducts an assessment of the viability and sustainability of the bank’s business model and strategy in the light of the current and future business environment, and any risks that may materialise given the particular business model.

Focus on leveraged finance

In her speech, Sabine Lautenschläger focused on the increased exposure of European banks to the growing market of leveraged finance. European banks represent a small part of the global market for leveraged loans, accounting for around 15% in 2014. Nevertheless, interest in this asset class is growing fast in the search for higher yields, with European bank exposures to leveraged loans growing by 16% between 2012 and 2014.

Increased exposure to leveraged finance exemplifies the need for good risk governance, a well-defined and closely monitored risk appetite framework and highly assertive risk management. Robust contractual documentation and credit approval procedures are key to managing risk associated with leveraged finance.

Adequate pricing is essential to ensure banks are compensated for the risk of exposure to leveraged finance. In fact one of the focus areas of SREP is on using the ICAAP and ILAAP as management tools, which includes using the risks built into these frameworks for pricing. The ECB also stressed for improvement in three main areas, being the credit approval process, exposure limits and stress testing on leveraged finance portfolios.

How can we help?

Certain asset classes, such as leveraged finance, require reinforced governance and risk management. Our team of risk and regulatory experts has extensive experience in stress testing and recovery planning, and can provide assistance in relation to SREP readiness.

Our holistic SREP approach ensures that your business model and strategy are viable and sustainable, and closely interlinked to the ICAAP and ILAAP. Our gap analysis approach will bring your governance policies and procedures in line with EBA guidelines, while our tailored training solutions ensure that board members are up to date with the latest risk and regulatory developments.