Leveraged finance – new guidance from the ECB | KPMG | BE

Leveraged finance – new guidance from the ECB

Leveraged finance – new guidance from the ECB

Leveraged finance has been an ECB priority and its new Guidance is a response to a combination of factors.

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On 23 November 2016 the ECB published a draft guidance on leveraged transactions(the Guidance) that will apply to all significant credit institutions supervised by the ECB. Leveraged finance has been an ECB priority and the Guidance is a response to a combination of the current economic environment (e.g. prolonged period of low interest rates) and the ECB’s identification of several areas for improvement in banks’ monitoring practices and significant discrepancies to define, measure and monitor leveraged transactions. The final deadline for submitting comments is 27 January 2017. The ECB will hold a public hearing on 20 January 2017.

In our view, the Guidance may have significant implications for ECB supervised banks since the ECB’s definition of leveraged transactions clearly includes loans that banks currently, typically define as corporate loans. Banks may struggle to implement, inter alia, the reporting and governance requirements for a set of transactions that they internally define as leveraged finance or corporate finance.

The Guidance consists of nine chapters and includes (i) a short introduction, (ii) scope of the guideline, (iii) a detailed definition of leveraged finance transactions, (iv) requirements concerning general strategic, organizational and governance related topics such as a definition of leveraged finance appetite and strategy (as part of a bank’s risk appetite framework), (v) the definition of appetite for underwriting and syndicating transactions, (vi) procedures for new deals and details regarding the ECB’s expectations for due diligence as well as (vii) requirements for secondary market activities (e.g. Chinese walls). Chapter eight deals with reporting requirements for both the underwriting book and the hold book as well as management information systems, which should be aligned to the key information which is outlined in the draft guideline annex. Finally, the ECB requires that banks provide an internal audit report to the joint supervisory team eighteen months after the publication of the final guidance which outlines the status of its implementation.

Shortly before the ECB released the Guidance, KPMG’s ECB Office hosted a Leveraged Finance Roundtable to allow for an open dialogue among European leveraged finance practitioners. One of the main focus topics was the definition of leveraged finance used by the ECB. The attendees were particularly concerned that the ECB may apply a broad definition of leveraged finance and this is exactly what happened. According to the Guidance, any loan with total debt exceeding 4.0 times EBITDA has to be considered as a leveraged transaction2. During the roundtable, the attendees referred to the US Federal Reserve’s (FED) Interagency Guidance on Leveraged Lending from March 21, 2013 which uses a similar approach: “Transactions where the borrower’s Total Debt divided by EBITDA exceed 4.0 times EBITDA or 3.0 times EBITDA, respectively, or other defined levels appropriate to the industry or sector.”3

Apart from the definition, both the ECB and the FED state that transactions with total debt to EBITDA exceeding 6.0 times at deal inception raise concern for most industries. The ECB defines this threshold as the “high level of leverage”. Banks will have to be able to explain why they deem such a transaction as appropriate.

KPMG professionals' recommendation is that banks with a leveraged loan business or corporate loan portfolio gets familiar with the Guidance, assesses to which degree they are impacted and closely watches or participates in the public hearing and finalization of the Guidance. Banks should consider performing a gap analysis in a timely manner. Only eighteen months after the final guidance, internal audit will have to report back to the JST on its implementation.

Footnotes:

1ECB “Draft guidance on leveraged transactions“, 23 November 2016.
2ECB “Draft guidance on leveraged transactions“, 23 November 2016.
3FED “Interagency Guidance on Leveraged Lending” March 21, 2013.

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