Why is the PRA concerned about the levels of leveraged finance that some lenders are exposed to, especially those involved with VC finance?

Key Findings and Expectations

1. Data Aggregation and Holistic Risk Management The PRA found that many banks were unable to systematically identify and measure their combined credit and counterparty exposures linked to the PE sector. Banks often engage in various PE-linked exposures across different business lines, leading to fragmented client relationships and risk management oversight. The PRA expects banks to implement group-wide risk data aggregation tools, stress testing capabilities and consolidated management information reporting processes to manage these risks effectively. Boards must be fully involved in overseeing firm-wide strategies related to the PE sector and be informed of aggregate exposure trends in associated credit and counterparty risks.
2. Exposures Linked to Individual Financial Sponsors The PRA noted that many banks did not calculate comprehensive consolidated exposure data to measure and control combined PE credit and counterparty risks linked to individual financial sponsors. The absence of a risk appetite framework constraining the size of combined PE exposures linked to individual sponsors was also highlighted. The PRA expects banks to systematically flag all transaction and exposure data, along with relevant collateral pledges, relating to the PE sector in their risk management systems. This data should enable the calculation and monitoring of exposures to the PE sector overall, as well as exposures linked to individual financial sponsors and PE funds.
3. Credit and Counterparty Risk Interlinkages The review found that most banks lacked procedures to comprehensively identify, measure, combine, and record risks arising from overlapping financial claims, liens, and security interests linked to the same PE fund or portfolio company. The PRA expects credit due diligence procedures and management information processes to recognize and measure the presence of overlapping credit exposures, collateral pledges, and financial claims across all PE-related activities where performance and recovery values are interlinked.
4. Stress Testing While some firms had developed stress testing frameworks for PE sector-linked exposures, others had not or had conducted stress tests only within individual business units or product silos. The PRA emphasises the importance of evaluating the potential for higher default and loss correlations in stress periods. Banks should conduct routine stress testing of exposures to the PE sector as a whole and PE exposures linked to individual financial sponsors. These stress tests should be modular, tailored to the specific risk profile of different products and structures, and consider theoretical scenarios beyond historical default rates and observed risk correlations.
5. Board Level Reporting The PRA found that several banks' boards were not adequately informed about the overall scale of combined exposures linked to the PE sector or individual financial sponsors. This lack of information hindered a holistic assessment of the risks associated with these aggregate exposures. The PRA expects boards to be informed of aggregate exposures linked to the PE sector and to consider the overall business strategy concerning consolidated PE-linked activities. Boards should ensure that the scale and composition of risk exposures linked to material financial sponsor clients and the PE sector are appropriate within the context of the bank's overall risk profile.