Leveraged Finance – Final ECB guidance | KPMG | GLOBAL

Leveraged Finance - Final ECB guidance

Leveraged Finance – Final ECB guidance

On 16 May 2017, the ECB has published its guidance to banks on leveraged transactions.

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On 16 May 2017, the ECB has published its guidance to banks on leveraged transactions. In comparison to the draft guidance (click here to view) (PDF 168 KB), the guidance makes some amendments to definitions. SME, sovereign and investment grade lending are now excluded from leveraged transactions. Even so, it makes few other concessions to banks’ concerns. For example, the €5mn threshold remained unchanged. Significant Institutions now have a limited window to implement the guidance and report back to supervisors. Banks need to address these new requirements sooner rather than later.

Prior to the publication of the guidance, the ECB arranged a consultation on the draft guidance, which ended in January, and a public hearing for industry representatives. The new guidance applies to all significant institutions within the Single Supervisory Mechanism, and enters force in November 2017. Implementation will be reviewed as part of the Supervisory Review and Evaluation Process (SREP) and enforced through ongoing supervision. Thus, we expect that the ECB will include the requirements in the SREP 2018.

The ECB views enhanced scrutiny of leveraged finance as a priority, given the environment of prolonged low interest rates. An ECB survey conducted in 2015 revealed that banks have grown more willing to underwrite and retain leveraged finance, and more likely to weaken credit criteria. It also detected room for improvement in firms’ approaches to risk monitoring, and significant discrepancies between banks’ approaches to defining, measuring and monitoring leveraged transactions.

The new guidance has major potential implications for ECB supervised banks. KPMG’s ECB Office wrote about the draft guidance at the start of 2017 (click here to view), and in April we hosted a lively Leveraged Finance Roundtable to discuss different banks’ approaches. We now want to draw banks’ attention to some of the changes the ECB has made in its final guidance.

The ECB received a lot of feedback – 24 submissions with 445 comments – on its draft guidance. More than half of these related to the definition of leveraged transactions. Despite this, the final guidance only makes minor changes to the definition or to the exclusion criteria.

  • One major concern for banks was the treatment of undrawn commitments - and cash - in the definition of total debt. Where the draft guidance defined ‘total debt’ as “IFRS current and non-current financial liabilities (or similar GAAP requirements applicable to the institution)”, the final guidance defines it as “total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit”. This addresses some banks’ concerns, but does not change the treatment of undrawn commitments.
  • With regards to the debate over whether total debt is defined gross or net, the final guidance states that “cash should not be netted against debt”.
  • In response to banks’ comments on the draft guidance, the final version makes some additional exclusions although the ECB chose not to raise the materiality threshold of €5m. The additional transactions now excluded from the definition of leveraged finance are:
    • SME loans, unless the borrower is owned by one or more financial sponsors;
    • Sovereign and sovereign-related exposures; and
    • Loans to investment grade borrowers (those with ratings above or equal to BBB- at Fitch/S&P or Baa3 at Moody’s).

The above points merely highlight some of the most notable changes made in the final guidance. The full guidance addresses governance, initial lending, ongoing monitoring and syndication, and is available here (PDF 228 KB) on the ECB website.

We believe that every ECB supervised bank with a leveraged lending business or corporate loan portfolio should familiarise itself with the final guidance and its potential impact. Significant institutions should consider performing a gap analysis as a matter of urgency. After all, banks need to submit an internal audit report on implementing the new guidance to their Joint Supervisory Team by November 2018.

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