European Central Bank to strengthen supervision of bank private equity business, related loan growth may be suppressed

The European Central Bank is intensifying its review of the exposure of lending institutions to risks in the private market business, as concerns grow over the rapid rise of related asset classes bringing in a significant amount of new risks. According to sources familiar with the matter, regulatory authorities have signaled that they will be sending letters to top executives of certain banks, reminding them to be mindful of their practices in financing private funds. The sources mentioned above said that this further demonstrates the resolve of the European Central Bank. The central bank plans to conduct on-site investigations of this issue at several large European banks. Regulatory authorities recently conducted such an investigation at one bank, the Industrial Bank of France, marking one of the first attempts of this kind. Regulators worldwide are expressing concerns over the rapid expansion of private credit, as investors increasingly funnel funds into funds not subject to the same strict regulations as banks. Traditional lending institutions, sometimes conducting business with companies controlled by private equity firms or borrowing from private credit funds, have been trying to capitalize on this growth trend by providing various forms of leverage support to these funds and their managers. These actions by the European Central Bank are further advancing the review work that began last year. Reports indicate that regulatory authorities had requested major banks, including those in France and Germany, to provide details of their exposure to risks in private credit companies and the loans they provide to funds operating in that area. The review found that banks were unable to accurately identify the nature and extent of their comprehensive risk exposure to private credit funds. Following the 2008 financial crisis, facing stricter regulatory requirements, banks have been abandoning some corporate lending businesses, leading direct lending institutions to step in and provide financial support to these companies. However, this sector is increasingly challenging existing companies in other transactions, claiming they can offer faster due diligence and better services. In the past five years, loans granted by U.S. banks to private debt funds have increased by 145%. According to a report released last week by the Federal Reserve, by the end of 2024, banks' exposure to business development companies (which aggregate direct loans) and other types of private debt instruments had reached around $95 billion. The European Central Bank stated in November last year that European banks' involvement in private equity investments and debt business is generally lower than their American counterparts, but some European banks "indeed have a significant amount of such investments, and this business segment contributes substantially to their profits." According to bankers, private credit has been rapidly growing, but regulatory reviews in Europe may indirectly curb this growth trend. The letters sent to banks by the European Central Bank are an important means for the ECB to convey its views on how banks are handling certain issues. If the regulatory authorities believe that banks are ignoring the contents of the letters, they will have the authority to take further action. However, this review could also lead bankers to believe that regulatory concerns about systemic risks in the private market are inappropriately spreading to the supervision process of individual banks. Previously, there have been similar allegations of excessive regulation regarding leveraged lending (a more mature business area for European banks). Two senior bankers revealed that credit ratings have become a focus of concern for the European Central Bank. They stated that regulatory authorities have questioned some cases where certain lending institutions did not conduct such expensive evaluations for specific customers or the financing provided to private credit companies. At least one bank has started purchasing insurance for the credit limits it provides to direct lending institutions, in order to reduce the impact on its own capital levels. One banker stated that due to the lengthy communication process with the European Central Bank, the bank had to reject cooperation with private credit institutions. A banker mentioned that although the base fees and related service fees charged to private credit companies are still substantial, the additional safeguards have essentially erased most of the interest income from such loans. The European Central Bank stated in November last year that banks' risk management has not kept pace with market developments. At that time, it pointed out, "Given the complex, multi-layered nature of these risk exposures and the leverage effects manifested at multiple levels, complex approaches are essential for effectively managing these risks."