On 23 November 2016, the European Central Bank (“ECB”) published draft guidance on leveraged transactions (the “Guidance”) for public consultation. The consultation period will end at midnight on 27 January 2017, during which time banks, trade bodies and other interested parties may submit comments to the ECB. The Guidance follows similar guidelines which have been applicable to banks in the US since March 2013.
The backdrop to the Guidance is the strong recovery of the European leveraged finance markets since the financial crisis, resulting in increased competition between credit institutions for leveraged lending business and more borrower-friendly lending conditions in Europe, as shown by increased levels of indebtedness and the introduction of “covenant-lite” deal structures. The ECB is keen, therefore, to develop a clear and consistent definition of what constitutes a leveraged transaction and to rein in credit institutions’ exposures in this market.
The Guidance, once finalised, will be applicable to all “significant credit institutions” supervised by the ECB. Whether an institution is significant is determined by reference to a number of criteria, but in particular its size, its importance for the economy of the EU or any Eurozone state and the significance of its cross-border activities. For example, any institution with assets exceeding €30bn will be considered significant unless justified by particular circumstances.
Although the Guidance will not have the force of law, it is difficult to see how an affected institution can escape the key supervisory aspects expected to be incorporated into credit institutions’ internal policies. The ECB expects the Guidance to be implemented consistently with “the size and risk profile of institutions’ leveraged transactions relative to their assets, earnings and capital”.
Credit institutions should create an internal definition but transactions meeting at least one of the following criteria are to be considered “leveraged transactions”:
The following types of transactions are not expected to be considered “leveraged transactions”:
It should be noted that although the Guidance focuses on leveraged transactions, the ECB considers that similar guidelines – in particular those that relate to underwriting and syndication – could be applied to other types of transactions where relevant.
The Guidance contains several key provisions with which credit institutions will be expected to comply. In summary, institutions will be expected to:
Deal statistics in the US show that tighter leverage constraints have led to sponsors increasing the size of their equity contributions in leveraged buyouts, which is seen as positive. However, there has been little improvement in lending terms.
Many Eurozone credit institutions are already likely to be following some, if not most, of the Guidance as a matter of good business practice. We note that in 2015 the ECB had asked banks to submit details of leveraged loans arranged and underwritten in May 2015, and it gave lenders feedback on how their portfolios compared with other banks. This move followed a similar exercise by the Bank of England in late 2014, which concluded that no action was required. We will wait to see whether or not the Bank of England will now follow in the ECB’s footsteps but if such guidance becomes regarded as the international norm then the Bank of England may follow.
Institutions that will be subject to the Guidance should now, therefore, begin assessing their internal processes from the perspective of ensuring compliance.
We will be actively following this development and will provide analysis and insight on implications arising from the Guidance once it has been issued in final form following the consultation period.
In the meantime, please contact your usual Shearman & Sterling contact or one of the authors named below for further information.
 Joint guidance was issued on 21 March 2013 by the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation in respect of leveraged lending by financial institutions (together, the “Agencies”) and is applicable to financial institutions (whether domestic or foreign) which are supervised by the Agencies. The announcement of this guidance is available from the website of the Federal Reserve at https://www.federalreserve.gov/bankinforeg/srletters/sr1303a1.pdf, with a follow-up set of responses to “frequently asked questions” at https://www.federalreserve.gov/newsevents/press/bcreg/bcreg20141107a3.pdf (released by the Agencies in November 2014). Please also see our client publication reviewing the answers to the FAQs, available at http://www.shearman.com/en/newsinsights/publications/2014/11/bank-regulators-review-leveraged-lending.
 For more information on banking supervision within the Eurozone, please see our client publication available at http://www.shearman.com/en/newsinsights/publications/2014/11/banking-supervision-within-the-eurozone.