FRANKFURT, (Reuters) – The European Central Bank has instructed banks to reduce lending to most indebted borrowers. This could lead to a gap in their balance sheets if interest rates rise or the economy goes south, according to an ECB Letter on Wednesday.

Due to record-low interest rates, banks sought returns in more risky parts of the market in order to grow their leveraged transactions (LT) portfolio from 300 billion euros in 2018. This has resulted in a 500-billion-euro-pile in the hands of 28 of the largest euro zone lenders.

Andrea Enria, chief supervisor of the ECB, wrote to chief executives of the 115 banks under his supervision, urging them to tighten controls and reduce the risks associated with this business type.

He also criticized banks for their lenient attitudes to these loans.

It was a concern for the sector during a slowing economy due to the conflict in Ukraine. In order to counter the high inflation, interest rates were likely to increase.

“High levels of LT exposure on banks’ balance sheets leave them vulnerable to renewed shocks, which could arise from unexpected and sharp economic slowdowns or higher than expected interest payments,” Enria said in the letter https://www.bankingsupervision.europa.eu/press/letterstobanks/shared/pdf/2022/ssm.2022_letter_on_leveraged_transactions.en.pdf?1dd5c0299bf7b93080e4b383bccb023c.