The intervention of the main European banking regulator was triggered by a routine audit of what has long been considered one of Deutsche’s best performing business lines. The lender is one of the major European players in leveraged finance – the practice of lending to private equity firms and other buyers of corporate assets.
In a letter to Deutsche this summer, the ECB warned that the lender’s internal risk management framework for highly leveraged transactions was “incomplete”, and gave the bank until the end of September to correct the shortcomings . The Frankfurt-based regulator also “encouraged” Deutsche to suspend high-risk transactions until the ECB approves its new risk framework.
Deutsche, however, told the ECB it was “unrealistic” to follow through on its request, according to people familiar with the matter. It was able to avoid having to suspend part of its leveraged finance activities, as the regulator’s suggestion to do so was not binding. Instead, Deutsche has tightened its internal approval process and is currently reporting every high-risk leveraged financial transaction to the ECB.
Deutsche said in a statement: “Leveraged lending is an important business for the economy and for many banks, including Deutsche Bank. We have a solid background in the business and we follow a prudent approach to risk management in accordance with regulatory requirements. In principle, we do not comment on the dialogue with our regulators. ”
The ECB declined to comment.
The regulator’s intervention increases the pressure on Deutsche Christian Sewing’s chief executive, who has repeatedly pledged to tighten internal controls and end his long history of compliance and governance gaps.
A temporary suspension of leveraged finance operations would have been painful for Deutsche. In the first nine months of this year, the Frankfurt-based lender controlled 8.6% of the leveraged finance market in Europe and 3.7% of the much larger US market, according to data from Dealogic.
Leverage financing is part of the investment bank’s debt origination business, which generated € 1.2 billion in revenue in the first nine months of 2020 and increased 43% year over year.
In recent years, the ECB has become increasingly concerned about the risks associated with leveraged finance transactions, with stiff competition between banks leading to relaxed underwriting standards and increased leverage.
At the heart of the confrontation between Deutsche and the ECB is the question of how to define “high levels” of debt. The ECB defines it as the set of transactions in which total debt, including unused lines of credit, exceeds six times earnings before interest, taxes, depreciation and amortization.
These transactions “should remain exceptional and [ . . .] should be duly justified ”, as such high leverage for most sectors“ raises concerns, ”the ECB said in its 2017 guidance.
Deutsche’s very definition of highly leveraged transactions was less strict because it excluded unused lines of credit – an approach that Deutsche’s senior executives described as consistent with industry practice.
As a result, many of Deutsche’s leveraged finance transactions over the past three years have not been subject to the stricter internal approval and control procedures that the ECB expects for high leverage transactions. .
Since receiving the letter from the ECB, Deutsche has adjusted its internal risk framework to bring it in line with ECB guidance and the regulator is currently reviewing the bank’s revised risk framework, according to people with knowledge of first hand.
Last year, two botched leveraged finance deals at Deutsche highlighted the risks associated with these lucrative deals. The German lender suffered multi-million dollar losses after struggling to offload two risky business loans it had agreed to underwrite for private equity clients. One was to finance the takeover of the Smart & Final grocery chain by Apollo Global Management and the other to divest part of Evonik, a German manufacturer of specialty chemicals.
The coronavirus pandemic has further heightened regulatory concerns, as the growing risk of corporate default increases the risks for banks heavily exposed to credit in this area. In May, the ECB warned that global leveraged loan markets “are currently facing headwinds not seen since the 2008-09 financial crisis”.