PRA finds gaps in banks’ private equity financing risk management

What does this mean?

Context and market development

The backdrop for the PRA’s letter includes the expansion of PE markets in recent years, and an associated increase in banks’ PE financing activities. The PRA also continues to have a strong focus on ensuring banks have robust governance, risk management and controls in place.

The PRA notes that private credit funds have begun competing strongly with banks in the leveraged lending primary markets. As the total assets under management (‘AuM’) of private credit funds has grown, from approximately $2 trillion to $8 trillion over the last decade, there has been an associated increase in the provision of leverage by banks to private credit funds, as well as an increase in the level of subscription financing lines.

The PRA also notes an increasing trend of banks providing collateralised and asset backed lending to the PE sector, where the collateral is largely privately held assets with limited secondary market liquidity, and the emergence of new ‘non-traditional’ forms of PE financing.

PRA findings and expectations

The PRA’s thematic review focussed on the adequacy of banks’ risk management frameworks governing their PE linked financing businesses and related derivatives exposures. The review particularly focused on banks’ independent credit and counterparty and credit risk management (CCRM) processes. The findings are grouped under a number of thematic issues:

Holistic approach to risk management

The PRA expects banks to be able to identify and consolidate relevant counterparty and credit risk data to enable them to monitor their overall PE sector exposure, as well as exposures linked to individual financial sponsors and funds.

• The PRA identified that it is typical for a bank to enter into PE exposures across a number of business lines and for multiple business units to maintain individual client relationships. This can lead to a siloed approach to business, independent credit and CCRM oversight that does not support the effective risk management of combined PE exposures. The PRA also found that banks did not have adequate systems for measuring and controlling their combined credit and counterparty risk linked to individual financial sponsors.

Credit and counterparty risk interlinkages

The PRA expects banks to be able to identify and measure overlapping credit exposures across all PE-related activities where there are interlinkages.

• Most banks were not able to identify their risks arising from exposures that have a direct or indirect link to the same underlying PE fund or portfolio company, and do not comprehensively record risk interlinkages. This may lead banks to underestimate their risk of loss should multiple PE portfolio companies experience financial stress.

Stress testing

The PRA expects banks to conduct routine stress testing of exposures to the PE sector as a whole, as well as those linked to individual financial sponsors. Stress tests should be modular and should consider the potential for higher levels of default and loss than have previously been observed. The results should be aggregated, and should systematically inform banks’ assessments of their overall PE-linked financing activities as well as the appropriateness of exposures linked to individual financial sponsors.

• The thematic review identified a range of stress testing practices among banks. While a small number had developed frameworks that enabled stress test results across different categories of PE-linked exposures to be aggregated, others were not able to combine their stress test results.

Board level reporting

The PRA expects Boards to be informed about banks’ aggregate PE-linked exposures. Boards should ensure the scale and composition of risk exposures is appropriate in the context of the banks’ overall risk profile.

• The PRA found that a number of banks’ boards were not sufficiently informed about the overall scale of their PE-linked exposures and therefore had not holistically assessed their level of risk. This can lead to a risk that credit and counterparty exposures become outsized and overly concentrated, making banks vulnerable to the risk of severe losses.

What do firms need to do?

The PRA continues to focus on ensuring banks have robust governance, controls and risk frameworks that are tailored to the evolving risks firms are facing. Banks should ensure they review the PRA’s findings and expectations and discuss the letter’s content at their Board Risk Committees. 

Banks should also be cognisant of the expectations set out in other PRA communications on risk management controls, such as the Archegos findings letter, PRA banking supervisory priorities letter, and recent PRA business plan.

Banks should undertake a benchmarking exercise to map their current risk management framework and practices against the PRA’s findings and expectations, and produce an assessment of areas for remediation in the short and medium term. Banks may wish to establish appropriate oversight and governance structures to oversee this exercise. 

Following the benchmarking exercise, banks should  develop detailed remediation plans that take into account the PRA’s expectations, particularly regarding the need for a holistic view of PE exposures and the uplift needed to stress testing scenarios.

More broadly the PRA’s focus on improving risk management capabilities and embedding the right risk culture across organisations is highly likely to continue. Banks should prepare for ongoing supervisory scrutiny in this area. Supervisors are likely to test the extent to which banks are applying best practice in risk management across their organisations. Investing in optimising risk management capabilities, including through the deployment of technology and data analytics will support the delivery of positive regulatory and business outcomes.

Next steps

The PRA expects CROs to discuss the output of their benchmarking exercise with their Board Risk Committee, and provide this analysis alongside any remediation plans to the PRA by the end of August 2024.