On Apr. 23, UK PRA said banks should review, assess their practices.
UK PRA published a speech by Executive Director, Authorisations, Regulatory Technology and International Supervision, Rebecca Jackson, given at UK Finance.
Discussed private equity sector developments, implications for bank safety, soundness.
UK PRA also published Jackson's letter to chief risk officers (CROs) of banks operating in the UK following PRA's thematic review of private equity financing businesses.
Follows UK PRA Apr. 2024 spoke the evolution of private equity markets, see #209483.
Market Developments
Jackson said the private equity market has grown considerably over the past decade, and with it, banks’ exposures to the sector have also grown considerably.
Global assets under management have grown from around $2trn in 2012 to around $8trn in 2023 - an annual growth rate of just over 13%; in 2006, global fund-raising record was $15.6bn, now it is almost twice that, $29bn fund raised by CVC, Jul. 2023.
Also been huge development in the variety and complexity of financing products banks now provide to private equity industry; banks used to provide financing by facilitating loans and bonds through the capital markets, on behalf of the companies that funds own - portfolio companies - in order to finance acquisitions and refinance debt.
Now this lending to portfolio firms downstream of the fund level is joined by a material increase in upstream lending, which has recourse to investors, fund managers and novel forms of leverage through midstream lending, to funds that own portfolio firms.
Seen emergence of complex structures and leverage on leverage, including net asset value (NAV) loans secured by fund assets, which provide leverage to funds against already leveraged portfolio companies; also growth in secured financing facilities.
Increased complexity has been driven by range of factors, including investors seeking exits from illiquid long-term private assets as initial public offer markets remain weak.
Noted emergence of private credit funds, who raise financing from banks in mutually beneficial relationship, compete to provide traditional and non-traditional leverage.
Said competition has a role to play in ensuring borrowers can access needed funding.
But also competition in any market can affect the price and quality of whatever is offered in that market, and sometimes that might not for the better.
Overall result of these developments is exposures, revenues in banks have grown considerably, as banks charge fees for arranging transactions and earn interest them.
PRA Scrutiny
In Aug. 2023, UK PRA decided scale, breadth, complexity and the interconnectedness of banks’ private equity related exposures, warranted closer attention.
Conducted thematic review to assess adequacy of bank risk management frameworks.
Review covered exposures and risk management practices of a large cross section of major UK and international banks with material aggregate exposures to the sector.
The thematic review also involved other regulators from across the globe.
Main finding was that only a very small number of banks can consistently aggregate data in a manner that is appropriate to their exposures to the private equity sector.
There were gaps, often significant, in most of the assessed frameworks.
But there is a great deal of variation across firms, with some demonstrating significantly more developed practices and having clear remediation plans for gaps.
Conversely, some firms had almost no ability to aggregate data/appreciate its crucial importance - unsurprising given the sector's development, but is disappointing.
Data Aggregation, Holistic Risk Management
Fund managers, investors, portfolio companies have sophisticated, varied needs for hedging and financing, meaning they now have more complex engagement with banks.
Many different parts of a bank’s business can now touch the sector, not only across different business lines within a division, but also across different divisions in a group.
Jackson said this fragmentation in business activity is mirrored by a fragmentation in the view that risk management and control functions have of the associated risks.
Counterparty and credit risk functions are usually organised by industry sector, counterparty type, underlying collateral class, or product, which makes sense, as it enables the development of business and risk management expertise.
But doesn’t readily support the holistic risk management of private equity linked exposures that are generated across separate business units and legal entities.
Review found many banks cannot uniquely identify, systematically aggregate/measure their combined credit and counterparty risk exposures to the private equity sector.
Of those that have made progress in identifying and measuring their overall exposures across business lines, most of those banks still did not calculate consolidated exposure amounts for individual financial sponsors or have a risk appetite framework that constrained the size of exposures linked to individual financial sponsors.
Lack of Holistic Risk Management Implications
Therefore, banks cannot holistically identify, measure, manage, monitor risks from their private equity financing businesses, despite emphasis PRA repeatedly placed on holistic risk management, particularly since default of Archegos Capital Management.
And despite existence of Basel Committee on Banking Supervision (BCBS) principles on effective risk data aggregation and risk reporting, that were issued over 10 years ago.
The reason this business needs to be managed holistically is that the exposures it generates may become highly correlated with one another under certain conditions.
Fund performance is correlated with the performance of its portfolio companies.
In turn, performance of a sponsor is correlated with the performance of its funds.
And the performance of legally separate portfolio companies and separate funds is correlated not only with the markets in which they operate and invest, but with broader macro factors such as interest rates and general economic conditions.
Prospective correlations are everywhere; can imagine a scenario - e.g. malpractice at a financial sponsor or bankruptcy of multiple portfolio companies - where risk correlations increase significantly, liquidity evaporates, leaving banks open to losses.
These findings have implications in relation to stress testing, and governance.
Stress Testing
Found hardly any banks do it well in this context, very few firms carry out routine, bespoke and comprehensive stress testing for aggregate sponsor related exposures.
Most other banks have not developed comprehensive frameworks/do not carry out disaggregated, uncoordinated stress tests in individual business unit or product silos.
Also found creeping sense of complacency, especially in relation to the large, growing business of subscription financing, due to a lack of loss history in this type of business.
Board Engagement
At many firms, there is a notable lack of board level engagement with this business.
Even firms with some ability to aggregate private equity exposures had not considered the scale and composition of the risks relative to the overall risk profile of their bank,.
Many boards have not specifically been informed of overall scale of their firm’s combined exposures linked to the sector, or to individual private equity firms/sponsors.
Overall risk is that when banks fail to properly measure, assess aggregate exposures, with no defined risk appetite framework and board engagement, it’s easy to develop an outsized and concentrated exposure that leaves one open to the risk of a large loss.
PRA little patience for risk of outsized, illiquid, unintentionally concentrated exposures.
Addressing Risk - Stress Testing
Trade capture and risk management systems should ensure transaction, exposure, and collateral information is assigned the right metadata, as this data is what risk managers need to be able to identify private equity exposures, wherever they may be.
And when done right, this is what would allow banks to calculate and monitor not only their exposures linked to individual fund managers, funds, and companies, but also their overall consolidated direct and indirect exposures to the sector as a whole.
Credit and counterparty risk due diligence procedures and management information processes should also recognize where there are overlapping credit exposures, collateral pledges, financial claims, across range of private equity related exposures.
Jackson said stress testing is crucial; should be a routine part of the toolkit.
Stress tests should reflect highly idiosyncratic risk profile that private equity linked financing structures and hedges can create, both individually and in aggregate.
Useful for managing individual sponsors/funds counterparty, credit risk exposures.
Addressing Risk - Boards
Also stressed that board engagement is key; for a business that is such a large contributor to bottom line of many banks, let alone their risk profile, it would be remiss of boards not to be informed of their firms’ aggregate exposures, and to actively consider group's overall business strategy regarding the sector, related risk appetite.
Boards need data to inform such decisions, even though data preparation is hard.
Downstream risk systems can’t aggregate data automatically, and banks need to go about manually identifying relevant exposures in order to aggregate them.
This lack of data impedes production of dynamic and timely risk reports, and instead, banks are more likely to aggregate exposures as part of one-off periodic exercises.
Even when risk exposures can be aggregated, there comes the tricky question of how to aggregate various different exposure measures in a way that is conceptually valid.
That too is a very tricky task, but most forward-thinking firms realize that aggregating data isn’t just a matter of good risk management, it’s good for first line too.
The same systems that are used to identify exposures, risks can also be used to identify client touchpoints, doing double duty for first line of defence and the second.
Challenge for second line will then be their ability to set exposure limits and constrain what is and will continue to be a materially capital generative revenue stream.
Letter to Chief Risk Officers
In her letter to chief risk officers (CRO), Jackson brought firms' attention to the review.
Explained banks need to better employ group-wide risk data aggregation tools, stress testing capabilities and consolidated management information reporting processes.
Boards must be fully involved in overseeing the firm-wide strategy and combined business initiatives relating to the private equity sector and be properly informed of aggregate exposure trends in associated credit and counterparty risks.
They should consider and satisfy themselves of the scale and composition of such exposures within the context of the overall risk profile of the bank, and take measures to ensure they can take a consolidated view of their exposures to other important business segments and any associated counterparty and credit risk concentrations.
Jackson said this expectation is in line with previous UK PRA communications.
Letter's annex set out UK PRA's main findings that the CRO should review and assess against current practices; the findings include UK PRA’s expectations of what effective risk management requires in light of the risks identified by the thematic review.
CROs must confirm they have shared the output of their benchmarking exercise with their Board Risk Committee, provide this analysis, along with detailed plans to remediate any gaps in processes to their supervision team by Aug. 30, 2024.
Conclusion
Strong growth, attractive return profile of private equity over last 10 years emerged during period of relatively benign market, economic and liquidity conditions.
Despite major economic bumps in the road, avoided extended downturns.
This means the sector remains untested; trends identified in the thematic review of creeping leverage, large exposures, complicated structures, poor risk aggregation, all suggest that banks may not be prepared for such a test, if or when it emerges.
Broader, longer-term question is whether developments in the industry constitute a displacement - a change in macro environment or technology of banking, that would be a necessary albeit not sufficient condition for more systemic issues to emerge.
In any event, immediate need for major improvements in risk management is clear.
