EUROPE - ECB survey says private equity poses limited systemic risk to banking sector

Wietske Blees
19 April 2007

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European leveraged buyout activity poses a limited systemic risk to the European banking sector, says a report by the Banking Supervision Committee of the European Central Bank.

The survey was carried out in order to assess the risk exposures of banks involved in leveraged buyouts and gain a better understanding of the possible financial stability implications that could result from leveraged buyout activities. A total of 41 banks from Belgium, Germany, Spain, France, Italy, the Netherlands, Austria, Portugal, Sweden, the United Kingdom and Denmark, with total assets of at least EUR 80bn, participated in the survey.

Distinguishing between 'capital turnover banks' (arranging banks) and 'portfolio banks' (those that keep a significant share of exposures to receive interest income from holding the debt), the survey concludes that the risk to banks is limited, as the debt exposures of banks to the LBO market are not large relative to their capital buffers. Furthermore, the bulk of surveyed banks' exposure consisted of senior or secured debt, making them less vulnerable to the failings of private equity-owned firms.

However, the survey does warn that lead arrangers are highly dependent on the success of the intended syndication to reduce their risk concentration. The greatest risk for banks occurs between the date of commitment to to provide the leveraged finance and the date the transaction takes place, as typically distribution can only start after the formal transaction completion date. Any disturbances to the market at this time could result in difficulties in passing on the credit risk. Survey results showed rather substantial variations in the execution timeframes for banks’ top five deals, with the range varying between less than a week and two months from commitment in principle to the legal agreement, and between a week and four months from the legal agreement to the completion of the full documentation. However, after successful distribution of LBO exposures, any direct impact of a market downturn on banks' credit risk is expected to prove manageable.

The survey also included a set of qualitative questions on banks’ risk management and monitoring of their exposures to LBO deals. The responses showed that banks’due diligence and credit analysis of LBO deals is generally extensive. The main focus lies on determining the target companies’ ability to generate cash flows, to service debt and on assessing the banks’ ability to syndicate and distribute LBO exposures down to comfortable levels. A striking feature is that information from the secondary markets where LBO instruments are traded appears rarely used by European banks. As such, the ECB finds that EU banks’ credit analysis could be improved by taking into account more market-based risk criteria.

And although banks’ direct investment exposures to LBO funds were not found to be substantial, the survey established that many banks earn significant income from the investment, fees and commissions derived from LBO related activities. This could suggest that any slowdown in the market could have a negative, albeit most likely limited, impact on these institutions’ income streams.

Overall, however, the ECB believes that the likelihood of LBO activity posing systemic risks for the banking sector is remote at EU level. The effect of the study remains to be seen. Although the results may cause a blow to those politicians that are eager to curb the power of private equity firms, the ECB stresses that any proposals for supervisory action remains the responsibility of national banking supervisors within their respective jurisdictions.