Banks have found the sector offering higher yields at a time of low interest rates, which have been cut further since March as central banks seek to mitigate economic downturns following COVID-19 lockdowns.
The European Banking Authority (EBA) said exposures at a sample of 26 European Union banks to loans made to highly indebted companies that typically don't have an investment grade credit rating, totals 400 billion euros (361.4 billion pounds).
While this is just 2.5% of their total assets, the holdings are concentrated in a few large and highly interconnected lenders, EBA said.
"As the pandemic and the ensuing economic lockdown impair leveraged borrowers' capacities to repay their debts, some banks may suffer losses related to the increase in credit risk and from their mark-to-market positions," EBA said.
"Banks may also face drawdowns on the revolving credit facilities granted to leveraged borrowers and may be left holding leveraged loans that they intended to securitise or sell (hung deals) if investors' appetite vanishes."
So far, default ratios have remained very low due to low maturing volumes, but stresses from COVID could change this, EBA said.
The Bank of England has estimated that the global leverage loan market is worth up to $3.2 trillion (2.46 trillion pounds). The BoE and other central banks around the world including the European Central Bank have already begun asking banks about their exposures to leveraged loans.
"The relaxation of lending standards on leveraged finance has clearly increased the riskiness of these exposures," EBA said, adding it was important that banks' boards have a complete picture of exposures.
By Huw Jones