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Some banks are unable to quantify their exposure to private equity, the Bank of England has found, in the latest warning that the $8tn industry could threaten the wider financial system.
BoE regulator Rebecca Jackson said on Tuesday that lenders should routinely stress test their exposure but “hardly any banks do it well”.
“Many banks are unable to uniquely identify and systematically aggregate or measure their combined credit and counterparty risk exposures to the private equity sector,” she said in a letter sent to lenders’ chief risk officers.
Jackson, the BoE’s executive director for authorisations, regulatory technology and international supervision, added in a speech that “very few firms carry out routine, bespoke and comprehensive stress testing for aggregate [private equity firm] related exposures”.
She likened the banking industry’s lack of knowledge of their exposure to private equity sponsors to their problems dealing with Archegos Capital, whose collapse in March 2021 cost six banks more than $10bn and contributed to the downfall of Credit Suisse.
Jackson’s remarks follow earlier warnings the BoE has issued about the effect on the broader economy of a private equity bubble.
Over the past decade, banks have become a kind of one-stop-shop for buyout firms, which play an increasingly influential role in the global economy.
Banks provide financing for deals as well as arrange loan and bond offerings for portfolio companies owned by private equity groups to refinance debt, which generate lucrative fee streams. At the same time, an explosion in private credit has forced banks to invest in and compete with funds in the sector.
While exposure to private equity has so far largely been a boon to bank balance sheets, higher interest rates and a worsening macroeconomic environment could pose new risks.
“The prospective correlations are everywhere, and it’s not difficult to imagine a scenario, such as malpractice at a financial sponsor or the bankruptcy of multiple portfolio companies, where risk correlations increase significantly, and liquidity evaporates, leaving banks open to severe, unexpected losses,” said Jackson.
The private equity industry has boomed during a decade-long low interest rate environment, which has seen its assets quadruple since 2012.
However, rising rates have increased borrowing costs at companies they own, putting them under more financial pressure.
It has also led to a weak market for initial public offerings and dealmaking which has forced some buyout groups to turn to novel forms of debt including so-called net asset value financing, where a portfolio of companies they own are used as collateral to borrow more cash.
This can help private equity managers return money to their investors and provide additional funding to the companies they own, although it has also increased the amount of leverage they use.
“The trends that this review has identified; of creeping leverage, large exposures, complicated structures, and poor risk aggregation, all suggest that banks may not be prepared for such a test, if or when it emerges,” said Jackson.
