The European Central Bank is planning new "supervisory expectations" — what the ECB wants to see from entities — in relation to banks’ significant exposure to private equity and private credit funds.
In a supervision newsletter published Nov. 13, the ECB outlined findings from a recent “exploratory review of bank exposures to private equity and private credit funds in order to better understand these channels and to assess banks’ risk management approaches.”
Its overarching message was that “complex exposures to private equity and credit funds require sophisticated risk management,” highlighting the strong growth of these private markets over recent years.
Banks’ exposure to private equity and private credit funds arises in a number of ways, the ECB said. “Fund managers and investors use bank financing to introduce leverage, finance investments and provide bridge financing,” with banks also having exposure to funds through derivatives they offer to clients for interest-rate or currency hedging.
Risks include increased competition from private credit funds, which “introduces the risk of a potential deterioration in lending standards.” A decrease in the number of initial public offerings in private equity markets means “funds have resorted to other ways to give payouts to investors, most notably the use of leverage at the fund level. This additional layer of leverage can be a source of risk and creates a more opaque environment for market participants and supervisors,” the ECB newsletter added.
The review of banks showed that credit risk is the main risk for banks in relation to private equity and private credit funds, but that European banks generally have less involvement in the private markets than larger U.S. peers. However, a number of European banks with high exposures make considerable profits from this segment of the market, the ECB said. The bulk of exposure is also to private equity funds.
A key finding from the survey is that “banks are not able to systematically identify transactions where they are co-lenders to portfolio companies alongside private credit funds,” but are better able to do so where the borrower is owned by a private equity fund. “The failure to properly identify — on an aggregate level — exposures to companies that also borrow from private credit funds means that this exposure is almost certainly understated and the concentration risk cannot be properly identified and managed,” the ECB warned.
Overall, the ECB said banks’ “risk management approaches appear not to have caught up with the developments in this market segment. Given that the exposures involve complex, multilayered risks, with leverage entering at several levels, sophisticated approaches are key to effectively managing these risks.” As such, the ECB will continue to monitor bank exposures closely, and is also set to outline supervisory expectations for the risk management of exposures to private equity and private credit funds, it said. The central bank will ask banks to submit information on their risk management approach, and also complete a gap assessment against the ECB’s expectations.
The ECB is not alone in identifying risks in areas of private markets. “The ECB’s focus on private equity and private credit risk follows the similar concerns from (the) Bank of England and focusing on demonstrating integrated risk management of these growing exposures of banks’ balance sheets is positive,” said Ana Arsov, managing director of global financial institutions and private credit at Moody’s, in an emailed comment.
A recent Moody’s survey showed that banks' funded loans to private credit increased by about 18% annually between 2021 and 2023, vs. 6% annualized growth in total loans. That increase kept pace with the 19% annualized growth in capital raising in the private credit sector over that period, Moody’s added.
