European Central Bank highlights buyout risk to financial stability

Central bank has called for more and improved data to better understand the potential impact on financial stability posed by hedge funds and their involvement in credit derivatives used by banks to offset risk in lending to buyouts.

European Central Bank has called for more and improved quality data to monitor increased credit risk thanks in part to “a surge in leveraged buyout activity facilitated by private equity funds”.

The authors of the bank’s December Financial Stability Review have joined a chorus of regulators concerned at the industry’s impact on financial stability.

Rapid re-leveraging driven by buyout activity coupled with growing household debt required close monitroing it said.

It said: “Faced with the prospect that pension and retirement obligations could be underfunded, some investors may have been pushed into assuming too much risk, leading to an over-compression of risk premia, especially in emerging markets and high-yielding corporate bond markets.”

Banks hedged their lending with credit derivatives to transfer risk, which has spread risk, but not eliminated it, the report said. The rise of hedge funds as counter parties to the banks in the transfer has increased concern that a collapse of a key fund or of a cluster of funds might undermine the market.

Valuations could prove vulnerable to several potential unexpected adverse disturbances, including renewed spikes in oil prices, which the report said “would imply significant market portfolio losses for banks and non-bank financial firms.”

“Moreover in such a scenario market liquidity could dry up and undermine the hedging of financial risks, while primary issuers, especially corporates with ratings at the lower end of the credit quality spectrum, could struggle to find investors for their securities,” the report said.

The drying up of liquidity could trigger a deterioration in the credit cycle, by rendering banks more cautious about extending loans if they cannot lay the credit risk off in the market, it concluded.