(Bloomberg) — The Bank of England found a number of UK banks were unable to measure their exposure to private equity giants and their portfolio companies and ordered them to begin stress testing those relationships.
The central bank’s Prudential Regulatory Authority reminded lenders’ chief risk officers in a letter Tuesday that it expects them to “comprehensively identify, measure, combine, and record risks” tied to buyout funds and the companies they back.
The letter comes after the central bank discovered many banks haven’t been stress testing their loan portfolios to better understand how cracks in the private equity industry could spill over into their own business, Rebecca Jackson, the PRA’s executive director for authorizations, regulatory technology, and international supervision, said in a speech on Tuesday.
“On stress testing, unfortunately I do not have a huge amount to say,” Jackson said at an event hosted by UK Finance. “Not because we found that firms are excellent at it, or because we think it’s unimportant, but because we found that 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.”
The Bank of England has been increasingly voicing its concern about the ways that the growth of the private equity industry could threaten the stability of the UK’s financial system. The central bank’s Financial Policy Committee is planning to publish a bigger assessment of the risks tied to the PE industry in a June report.
Earlier this week, Nathanaël Benjamin, the central bank’s executive director for financial stability strategy and risk, said he was concerned about the ways that private equity giants value their holdings and how that could amplify any economic shocks in the UK. The Financial Conduct Authority is also carrying out a review of valuation practices for private assets, Benjamin said.
In one example offered by the regulator in the letter on Tuesday, a bank might have a derivative arranged for a buyout fund’s portfolio company as well as provide a form of credit to that private equity firm known as a net asset value loan. The lender could also be offering funding to the fund’s limited partners.
“Many banks do not comprehensively record these risk interlinkages in their credit analysis systems,” Jackson said in the letter, which was also signed by Charlotte Gerken, the PRA’s executive director of UK deposit takers supervision. “Without full credit analysis and internal transparency, banks may underestimate their risk of loss due to overlapping and linked credit exposures should multiple PE portfolio companies suffer distress.”
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