United States: European Central Bank (ECB) Publishes Final Guidance On Leveraged Lending Transactions


Following publication of its draft guidance on leveraged lending transactions on 23 November 2016 and conclusion of a public consultation process, the ECB has published the final form of its guidance on leveraged lending transactions (the "ECB Guidance") on 16 May 2017. From its entry into force on 16 November 2017, the ECB Guidance will apply to all 'significant' credit institutions supervised by the ECB and introduce general criteria to identify leveraged transactions. The ECB Guidance aims to reduce systemic risk in the financial system and strengthen the underwriting and syndication practices of lending banks by providing guidelines for the sound management and supervision of leveraged transactions.

The ECB Guidance is similar to the corresponding guidance (the "U.S. Guidance") on leveraged lending issued for the U.S. financial services industry by the Board of Governors of the Federal Reserve System, the Office of the Controller of the Cur-rency and the Federal Deposit Insurance Corporation (the "U.S. Agencies") already in 2013. It is fair to assume that the effects of the ECB Guidance on the financial services industry in Europe may be broadly similar to the effects the U.S. Guidance had in the last few years in the U.S.


Significant credit institutions in the Eurozone

Under the Single Supervisory Mechanism (SSM), the ECB supervises credit institu-tions, financial holding companies and mixed financial holding companies which are established in the Eurozone (i.e. EU member states which have adopted the euro as their currency) and are treated as 'significant'. 'Significance' is generally de-termined on any one of the following criteria: size (total value of assets exceeding €30 billion), economic importance (for the specific country of the Eurozone or the EU economy as a whole), relevant cross-border activities (total value of assets ex-ceeding €5 billion and the ratio of cross-border assets/liabilities in more than one other Eurozone member state to total assets/liabilities being above 20%) or bene-fiting from public financial assistance (funding from the European Stability Mecha-nism or the European Financial Stability Facility having been requested or re-ceived). As of 1 January 2017, 125 entities were under supervision of the ECB, ac-counting for more than 80% of the banking assets in the Eurozone.

As the United Kingdom does not participate in the SSM, English credit institutions are not subject to the supervision of the ECB. This has been an area of concern dur-ing the consultation process of the draft ECB Guidance as it was considered to re-sult in an unlevel playing field among European credit institutions active in the lev-eraged lending markets. In practice, however, this issue should at least to some ex-tent be mitigated by the fact that Eurozone branches of credit institutions located outside the Eurozone are subject to the supervision of the ECB. Such ECB supervi-sion is likely to result in the ECB Guidance also affecting the leveraged lending businesses of such credit institutions located outside the Eurozone. This e.g. brings European branches of U.S. financial institutions within the scope of the ECB Guid-ance in the same manner as U.S branches of European credit institutions are al-ready currently covered by the U.S. Guidance. As regards credit institutions domi-ciled in the United Kingdom, it remains to be seen how the United Kingdom's with-drawal from the European Union (Brexit) will impact such effect of the ECB Guid-ance on leveraged lending businesses of UK credit institutions.

Leveraged transactions

At the core of the ECB Guidance is the definition of "leveraged transaction". The ECB Guidance does not seek to regulate the lending business generally, but focuses on leveraged transactions. While, similar to the U.S. Guidance, each credit institu-tion is expected to develop its own suitable definition of leveraged transactions, the ECB Guidance, in sharp contrast to the U.S. Guidance which does not provide for a uniform rule for the definition of leveraged transactions, requires that any lending transaction that satisfies one of the following two criteria must be considered a "leveraged transaction":

  • all types of loan or credit exposure where the borrower's post-financing lever-age level exceeds a Total Debt to EBITDA ratio of 4.0 times; or
  • all types of loan or credit exposures where the borrower is owned by one or more financial sponsors.

Both limbs of the definition have been subject of extensive comments and criticism during the consultation process,1 but have been adopted in the final form of the ECB Guidance largely unchanged.

Ratio-based determination of "leveraged transactions": Total Debt to EBITDA

With respect to the ratio-based determination of leveraged transactions, Total Debt pursuant to the ECB Guidance refers to total committed debt (including drawn and undrawn debt) and any "additional debt that loan agreements may permit". The ECB Guidance explicitly only carves out undrawn liquidity facilities and liquidity risk monitoring tools from such calculation. It should be noted that for the determi-nation of Total Debt, available cash may not be netted against debt positions.

While such definition of Total Debt pursuant to the ECB Guidance is in line with the U.S. Guidance, it contrasts to the typical determination of total debt in lever-aged loan agreements for purposes of calculating the leverage ratio where available cash is netted against the outstanding debt.

Furthermore, it is unclear which debt items will have to be included in the Total Debt definition by virtue of the phrase "additional debt that loan agreements may permit". In light of the apparent intention of the ECB to align its guidance on lever-aged transaction to the corresponding U.S. Guidance, it would only be consistent to assume that additional debt permitted under the loan agreement, in particular, 'in-cremental facilities', but also financial debt permitted to be incurred outside the relevant loan agreement, should be included in the calculation of Total Debt.

Whether this also applies to non-financial debt items permitted under loan agree-ments, usually set out in the financial indebtedness undertaking, is doubtful. The intended alignment of the ECB Guidance with the U.S. Guidance speaks against the inclusion of such items. Furthermore, it would cause substantial practical difficul-ties to include permitted non-financial debt items in the definition of Total Debt: A number of such items usually permitted in the financial indebtedness undertaking are uncapped or subject to flexible baskets, e.g. grower baskets the size of which de-pends on varying reference figures (e.g. total assets). It is unclear how such posi-tions should be reflected in the calculation of Total Debt.

In light of such broad definition of Total Debt, the 4.0 times multiple appears to be rather low and prone to capture transactions the risk-profile of which is not compa-rable to the usual leveraged lending transactions.

Contrary to the draft guidance, the ECB Guidance now acknowledges adjustments to EBITDA to the extent such adjustments are duly justified and reviewed within the credit institution by a function independent of the front office. This is also in line with the implementation of the U.S. Guidance by the U.S. Agencies.

Ownership of the borrower by a financial sponsor

Under the second limb of the definition, any financing extended to a borrower owned (i.e. ownership or control of more than 50% of the borrower's equity) by one or more financial sponsors shall automatically qualify as a leveraged transaction, irrespective of the debt quantum and/or Total Debt to EBITDA ratio. Again, this has been criticised during the consultation process as the mere ownership by a fi-nancial sponsor does not by itself result in an increase of the credit risk for the re-spective lender. Still, this limb of the definition for leveraged transaction has re-mained unchanged since the draft form of the ECB Guidance.

Besides stipulating criteria for the assumption of a leveraged transaction, the ECB Guidance also explicitly exempts certain financings from the scope of the ECB Guidance. Such exempted transactions include loans extended to natural persons, other credit institutions, investment firms, public or financial sector entities or small or medium-sized enterprises, loans resulting in an overall exposure of the credit institution of less than €5 million, specialised lending and trade finance transactions and lending to investment-grade borrowers (i.e. borrowers with a rat-ing equivalent to BBB- (S&P)/BBB- (Fitch)/Baa3 (Moody's) or above). Not only ex-ternal credit ratings assigned by rating agencies, but also internal ratings assigned by the respective credit institution should suffice.

The following table provides an overview of the key similarities and differences be-tween the ECB Guidance and the U.S. Guidance.


The ECB Guidance

The U.S. Guidance

Nature and goal of guidance

Non-binding and not intended to stipulate non-pass thresholds re-garding the origination of transactions, but supervised entities re-quired to set up sound risk-management and monitoring struc-tures for leveraged transactions

Non-compliance with guid-ance

No provisions dealing with formal enforcement or disciplinary ac-tion that may be taken against credit institutions that are not in compliance with the respective guidelines

Type of transactions covered

Loan origination, syndication, material modification or refinancing

Definition of leveraged trans-actions

Criteria: Leverage ratio or fi-nancial sponsor ownership as independent and mandatory triggers for assuming a lever-aged transaction Total debt: Same as per the U.S. Guidance, but doubtful whether permitted non-finan-cial debt items should be in-cluded EBITDA: Adjustments are in-cluded

Criteria: No uniform rule when a loan should be considered a leveraged transaction; in partic-ular, leverage ratio2 considered an (important) indicator (amongst other factors) Total debt: Including permitted additional debt (in particular, in-cremental facilities) under the loan agreement and deter-mined without netting of cash EBITDA: Same

Underwriting standards, credit approval, general monitoring and transaction-management policies

Credit institutions shall set up comprehensive framework es-tablishing binding underwriting limits, quantum, types and ar-eas of financings that credit in-stitutions are permitted to par-ticipate in and related internal standards and monitoring func-tions, including by independent risk functions

Banks shall have "clear, written and measurable" underwriting standards

Aspects to be taken into ac-count in setting up such standards

Independent pricing verifica-tion; leverage test and amorti-sation test (cf. next row); spe-cial monitoring regime and standards for dealing with transactions not syndicated within 90 days ("hung transac-tions"); tracking of weak cove-nant features, e.g. absence of any (financial) covenant or presence of significant head-room in financial covenants

Leverage test and amortisation test (cf. next row); undertaking of independent enterprise valu-ation using capitalised cash flow and/or DCF models

In particular: Leverage test / Amortisation test

Leverage test: may be industry-specific; high leverage levels ex-ceeding 6.0 times (at deal inception) should remain exceptional and form part of the credit delegation and risk management esca-lation framework of the credit institution3

Amortisation test: Cash-flow projections should show the ability of the borrower, over a 5-7 year period, to fully amortise senior se-cured debt or to repay at least 50% of total debt

On-going monitoring

On-going internal review of outstanding leveraged transactions and updates to be sent to the senior management of the relevant credit institution. Update reports shall, inter alia, include key mar-ket trends, information on leveraged transactions across business units and (non-) compliance with internal limits, potential concen-tration of transactions in type, industry sector or location as well as exposure to weak covenant features.

The ECB Guidance will come into force six months after its publication, i.e. on 16 November 2017. Eighteen months after its publication, i.e. on 16 November 2018, the credit institutions subject to the supervision of the ECB shall draw up an internal audit report and submit such report to the supervisory bodies. The report shall provide details of the implementation of the governance requirements under the ECB Guidance. Until such date, it is to be expected that the ECB Guidance will also become part of the day-to-day supervisory dialogue between the ECB and the individual banks supervised by the ECB. Given the non-binding nature of the ECB Guidance, it is currently not yet clear what the consequences of a failure to comply will be.

The practical results of the ECB Guidance on the issuance and syndication of lever-aged loans by credit institutions which are under ECB's supervision remain to be seen. Looking at the effects the U.S. Guidance had on the U.S. leveraged loan mar-ket, market diligence shows rapid growth of leveraged lending in the U.S. in the years 2011 and 2012 with lending activity peaking around the first quarter of 2013 and a decline in leveraged lending since then, suggesting that the U.S. Guidance may have slowed the origination of leveraged lending transactions. At the same time, subordinated / hybrid financing instruments, e.g. preferred equity instru-ments, seem to have absorbed a significant part of the decline in senior leveraged lending and led to an additional layer within the capital structure.

In addition, and despite the non-binding nature of the U.S. Guidance, regular re-views undertaken by the U.S. Agencies have shown a constant decline of loan origi-nations from U.S. financial institutions that do not satisfy the requirements under the U.S. Guidance ("non-pass loans") and a continued progress toward full compli-ance with the underwriting and risk management expectations set forth in the U.S. Guidance. Presumably, the ECB will expect a similar development in the European leveraged lending market, in particular given that its ECB Guidance closely resem-bles the U.S. Guidance. Apart from avoiding regulatory arbitrage by credit institu-tions active in the leveraged loan markets in the EU and the U.S., this has presuma-bly been one of the key drivers for the ECB to publish the ECB Guidance.

At the same time, however, the aforementioned reviews noted a migration of lever-aged loan origination to non-bank entities as a potential response to the U.S. Guid-ance. The trend toward non-bank lending in the leveraged lending market may therefore also become stronger in Europe as a result of the new ECB Guidance.


1 23 out of the 24 submissions made in the consultation process raised this term and/or one or more of its elements as an issue. 

2 Total Debt to EBITDA ratio of 4.0 times (or above) or senior debt to EBITDA of 3.0 times (or above). 

3Whereas the draft form of the Guidance provided that leverage levels in excess of 6.0 times always had to be referred to the highest level of credit committee, the final form now permits referral to the compe-tent body within the usual credit delegation and risk management escalation framework of the credit institution. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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