In May last year, the European Central Bank (ECB) published a Guidance on Leveraged Transactions with the aim of consistent risk management practice and harmonization of the definition of leveraged transactions. Since 16th November 2017 this has been binding for all the banks supervised by the ECB. Leveraged transactions are primarily credit transactions with a high default risk. To avoid negative effects on the financial system, comprehensive governance rules have been laid down for these loans, which require complex action by the banks concerned. How can banks ensure compliance with such regulations?
Leveraged transactions have become very popular as a financing instrument in the past. This can be well illustrated by the example of leveraged loans, which according to a general definition in the private banking magazine are special syndicated loans to sub-investment grade issuers (company rating ≤ BB+). Therefore, the ECB considered it necessary to establish a guideline: more regulation for a particularly high-risk business area.
Current circumstances are the renewed rise in leveraged transactions, as was already observed before the financial crisis in 2008. The market for leveraged loans, for example, is booming in both Germany and Europe. According to Bloomberg, this type of lending grew by 52 percent in 2017 compared to the previous year. This represents a record after the crisis. The ECB guideline thus takes up the present trend towards financing with a higher debt ratio and tries to avoid further negative developments through higher and standardized regulatory requirements regarding monitoring and management.
Comprehensive ECB governance requirements for leveraged transactions
Each relevant financial bank is instructed by the guideline to establish an institution-specific definition of leveraged transactions that is subject to recurrent self-monitoring. In this definition, the bank should take into account the following basic considerations of the ECB: A leveraged transaction occurs when the borrower's debt-equity ratio after financing exceeds four times the ratio of total debt to EBITDA (earnings before interest, taxes, depreciation and amortization) or when the borrower has a majority participation of financial investors. Exceptions to this are also specified in concrete terms. Such a loan does not qualify as a leveraged transaction, for example, if it is granted to a natural person or another financial institution.
Strategic specifications, such as the bank's risk appetite, must be defined regarding this type of loan. Syndicated leveraged transactions, as the above-mentioned leveraged loans, are subject to even more specific rules, such as debt limits.
In addition, 18 months after its publication, the Guidance requires a report to the Joint Supervisory Team (JST) by internal audit. In this way, the appropriate implementation of the institute's own processes is to be reviewed and guaranteed based on the guidelines.
The Guidance on Leveraged Transactions also defines certain standards for regular and comprehensive reporting that covers all trends and characteristics related to a bank's leveraged transactions. A Reporting and Management Information System (MIS) should contain information on financing in the portfolio and the planned financing that is still to be syndicated, in particular: current market developments and structural information.
Further framework and processes
In a blog post regarding the Guidance PWC describes among other things the following framework and processes for new business, monitoring and controlling of long-term leveraged transactions:
- A suitable and specific loan approval process should be implemented for leveraged transactions when granting loans.
- Detailed reviews and evaluations in the sense of due diligence must be carried out by the initiating division both within the framework of granting loans and when resubmitting, prolonging, modifying or refinancing existing transactions.
- Early warning risk indicators and triggers for impairment tests should be implemented.
- A stress test framework for the portfolio in the existing business should be implemented. The effects of the stress scenarios should be analyzed – in particular regarding the ability to service loans.
- Internal audit should include the implementation of and compliance with this guideline in its regular inspections, at least every three years.
How does digital credit management help to meet these requirements?
The requirements for leveraged transactions are not limited to just one area – banks are challenged on several levels: in new business as well as in existing business, but also in management and documentation. Digital credit management enables cross-divisional support and traceability of processes.
Support of specific processes for leveraged transactions
One main point of the Guidance on Leveraged Transactions is the creation of special processes for leveraged transactions that consider the high risk involved in this type of lending.
All types of basic process flows can be flexibly adapted to the special features of leveraged transactions – from variations in the application process to differentiated processing and specific approval processes. Defined processes with fixed specifications (for support during the workflow) can be combined with processing freedom for experts. Institute-specific processes are thus clearly and comprehensibly defined.
Changes to the process flow are possible quickly and reliably. Due to the digital design of the processes, these are immediately visible and practicable for every user - whether in the front or back office.
With digital credit management, financial service providers can cover a wide variety of processes. The integration of the existing systems in combination with a tool for follow-up and task management enables the complete management of existing business as well as the implementation of new business initiations.
Early risk identification and targeted data analysis
Within the processes, particular attention is paid to monitoring and early warning so that possible risks can be identified and managed quickly.
Due to the digitalization of the formerly frequently MS Office based processes, all process data is available for the implementation of early warning indicators. With certain triggers from the system or from external events, activities are automatically triggered, about which the responsible employee is notified in a process gateway. This significantly improves the overview and control of potential risks.
In addition to the risk-related evaluations, the data is also available for performance evaluations – this covers the various information requirements for controlling and supporting business processes.
Audit reliability and compliance with high data protection standards
The regular review required by the internal audit department focuses on traceability and transparency. Functions such as automated data logging offer valuable support: all data during the credit initiation process is completely logged and is available to the auditors at the push of a button.
In addition, digital credit management supports sensitive areas such as data protection. The latest standards can be realized and maintained through clear role and authorization management down to the field level to safeguard the need-to-know principle, i.e. the hiding of not needed information.
Conclusion and perspectives
The scope of the governance rules imposed by the ECB on leveraged transactions is extensive and implies significant changes in risk management, particularly in terms of the auditing, monitoring, and reporting responsibilities of the financial institutions concerned. Even if the implementation of the guidelines will initially only be pursued within the context of a banking supervisory dialogue, it can be expected that compliance with the guidelines will also be the subject of supervision audits in the future.
The finance industry must generally expect that risk scenarios will be responded to with far-reaching regulatory or government intervention, which in turn will lead to comprehensive governance regulations. Digital credit management enables banks to implement the often cross-divisional requirements of these regulations fast and transparently. From the documentation of specific processes to the highest data protection requirements: financial service providers must be prepared for the responsible management of their risks and the associated data.
Image Source: Teaser: William Potter- 868950364 - iStock