In its most recent warning, the Bank of England found that some banks were unable to quantify the exposure they have to private equity. The industry, which is worth $8tn, could pose a threat to the financial system as a whole.
Rebecca Jackson, BoE regulator, said Tuesday that banks should stress-test their exposure regularly but “hardly any do it well”.
In a email to chief risk officers of lenders, she stated that “many banks are not able to identify and measure in a systematic way their credit and counterparty risks to the private equity industry.”
Jackson, an executive director of BoE, said in a speech, “very few firms conduct routine, bespoke, and comprehensive stress tests for aggregate exposures [of private equity firms]”.
She compared the lack of awareness of the banking industry about their exposure to private-equity sponsors with their problems in dealing with Archegos Capital. The collapse of Archegos Capital in March 2021 resulted to Credit Suisse’s downfall.
Jackson’s comments follow warnings that the BoE issued regarding the impact of a bubble in private equity on the economy.
In the last decade, banks became a one-stop shop for buyout companies, who play an increasing role in the global economic system.
Private equity groups own portfolio companies that are owned by banks. They can arrange loans and bonds for these companies to refinance their debt. This generates lucrative fees streams.
A boom in private credit forced the banks to compete and invest with the funds in this sector.
Although exposure to private equity was largely a boon for bank balance sheets up to now, a worsening macroeconomic climate and higher interest rates could pose new risk.
Jackson said that “the prospective correlations were everywhere. It’s not hard to imagine a situation, like malpractice at a financial sponsors or bankruptcy of several portfolio companies where the risk correlations would increase and liquidity would evaporate, leaving banks exposed to unexpected, severe losses.”
Private equity has grown during the decade of low interest rates, and its assets have quadrupled since 2012.
The rising interest rates have increased the borrowing costs for companies owned by PE equity groups, increasing their financial stress.
This has led to a lack of initial public offerings (IPOs) and dealmaking. Some buyout groups have been forced to use novel forms of borrowing, such as net asset value financing. A portfolio of their own companies is used as collateral for more cash.
Private equity managers can use this to return money to investors and to provide additional funding for the companies that they own. However, it has increased their leverage.
Jackson said that the trends identified in this report, such as creeping leverage and large exposures along with complex structures and poor risk aggregate, suggest that banks are not prepared to face a similar test, when or if it occurs.
UK Finance, a trade body for UK Finance, said that the BoE highlighted “number of important issues” banks should consider when it comes to exposure to private equity.
The Bank of England added that “banks will take this into account and look at how they currently assess exposure levels, and what improvements can be made to align with the Bank of England letter and findings.”