Bank of England highlights private equity vulnerabilities

By Huw Jones and David Milliken

LONDON (Reuters) -Risk management in the private equity sector needs improving, the Bank of England said on Thursday, particularly as the period of low interest rates ends and leads to higher financing costs for risky debt in a highly leveraged industry.

The BoE said in its twice-yearly Financial Stability Report that an investigation of the sector showed "vulnerabilities" and challenges from higher borrowing costs.

The BoE's report is the latest sign of how regulators globally are increasing scrutiny of the rapidly growing non-bank and market based finance, now accounting for about half of global financial assets, and their links to banks.

PE backed companies account for 5% of UK private sector revenues, 10% of private sector jobs or more than 2 million employees, the BoE said.

Vulnerabilities include "multiple layers of leverage" and strong links with riskier credit markets, with "opaque" valuation and risk management practices, it added.

"Improved transparency over valuation practices and overall levels of leverage would help reduce the vulnerabilities in the sector," the BoE said. "Risk management practices in some parts of the sector need to improve, including among lenders to the sector such as banks."

Private equity industry body the BVCA said many of the BoE concerns are already being addressed by the Financial Conduct Authority, and it was "highly engaged in these processes".

The BoE's Financial Policy Committee said it would consider the results of work being done internally and by the FCA to address some of these problems.

BANK VALUATIONS

The report also looked at stock market valuations of British banks after concern from Britain's Conservative government that they had been lagging those of U.S. rivals. But the BoE found that valuations were in line with euro zone peers and had begun closing the gap with the United States.

"The difference in banking sector equity valuation in the UK relative to the U.S. is similar to that of other economic sectors," the report said. Market-wide factors, such as differences in economic outlooks and "market depth" were significant drivers of bank valuations in Britain, it added.

"The FPC will continue to monitor developments in UK banks' market valuations, including in comparison with international peers," the BoE said.

The BoE said it would also undertake a "desk based" stress test of Britain's major banks this year, meaning it would use its own models rather than requesting data from them. Aggregate results would come in the fourth quarter. A standard stress test with individual results is anticipated in 2025.

The UK banking sector had the capacity to support households and businesses, even if economic and financial conditions were to be substantially worse than expected, the FSR said.

The so-called countercyclical capital buffer (CcyB), or 'rainy day' buffer on banks that can be drawn on in stressed times, remains at its neutral setting of 2%, the BoE said.

It also set out the initial findings of its first system-wide exploratory scenario or SWES, which tested the impact of theoretical shocks affecting different market participants on the UK government bond market.

So far the SWES test showed that liquidity needs rose significantly as 'margin' for backing positions increased, with selling in corporate bonds also rising.

After the near-meltdown in the UK government bond market in September 2022, liquidity buffers of market participants are now well above regulatory minimum levels.

A second leg of the test is now being rolled out with overall results published in the fourth quarter, helping to shape regulation going forward.

(Reporting by Huw Jones and David Milliken, editing by Alexander Smith)