A cursory glance at any UK newspapers front page over the past 12 months will have revealed a plethora of banker bashing stories. A quick look at the bond markets, however, reveals a different story. UK bank debt is the flavour of the year for investors looking to gain access to financial institutions that are protected from the euro and the European sovereign debt crises.
Banks are deleveraging quickly and balance sheets are far cleaner than they were before the crisis and even two years ago. But the speed of the transformation is not without its side-effects. Alastair Ryan, co-head of European bank research at UBS, says that while regulators have whipped the banks into shape, the result is that the FIG bond issuance pipeline is dry.
"In 2007 and 2008 banks in the UK generally had poor funding structures," he says. "They had large balance sheets, they were wholesale funded, the funding was generally short dated and they held relatively little liquidity against risks of market deterioration. Its understandable that when the risks embedded in that range of aggressive structures crystallised, the authorities would respond aggressively.
"Now, the situation is reversed. Banks are overly liquid and they have conservative funding structures. Because of constant pressure from the regulator, the banks have over-issued for the past few years. Now they have £300bn of excess liquidity sat on their balance sheet."
It seems almost perverse that a group of financial institutions so beset by controversy in the popular press should be so popular with investors. Barclays was battered by the Libor scandal and will remain bruised until its new management team can regain the initiative. HSBC admitted to accidentally laundering money for terrorists and drug dealers. Royal Bank of Scotland suffered a catastrophic IT meltdown, and Standard Chartered broke trading sanctions with Iran. In August, a well known investors almanac rated three of these firms as "sell" StanChart was the only "hold".
But a regulatory regime well in advance of most eurozone jurisdictions has given UK banks something of a gold plating in the eyes of debt investors. While the big four UK banks share prices have tumbled over the course of 2012, their senior CDS is at worst stable and at best around 125bp tighter.
The same is happening in the securitisation market, especially among US investors. One securitisation banker says prime UK RMBS paper has tightened more than 60bp on the secondary market during the last two months.
David Hague, head of UK & Ireland FIG DCM at Royal Bank of Scotland, says the market was caught out by how quickly UK banks went from spewing out deals left, right and centre, to taking their debt back off the market.
"A lot of issuers are keen to get the message out that they are well funded, liquid and will be pretty rare in coming to market, and the UK has followed through to the letter in terms of not issuing," he says. "That has caused a huge tightening in secondary spreads for UK banks.
"If you mirror that against continental Europe the potential for Greece to exit the euro, the risk that other countries could exit, the destabilising effect that would have the UK and sterling balance sheets are a natural hedge to that. Not only is that getting a lot of attention from domestic investors but its a story that carries well over to continental Europe we get a lot of continental investors looking for UK bank assets."
Letting the air out
Lloyds and RBS are two of the best examples of balance sheet deflation in the UK market, both having more or less publicly withdrawn from the senior unsecured market this year.
RBS has not printed a single benchmark sized public deal in that format since May 2011. It has issued covered bonds, as well as senior in the private market, but the scale of its deleveraging means it simply no longer requires funding in the sizes offered by the public market.
Lloyds, meanwhile, issued two public senior deals this year a 1.5bn five year in January, priced at 305bp over mid-swaps, and a £1.4bn five year in April, priced at 55bp over Gilts. However, having completed its funding programme, it announced in its first quarter results presentation that it would only be accessing markets on an opportunistic basis.
All the while, both banks have been offloading assets. Lloyds has sold several loan portfolios, building up a large buffer of excess cash which it put to work with a mammoth liability management operation in July.
Lloyds bought back £4.9bn of its own senior debt, equivalent to 24% of the outstanding amount of the securities it was targeting. RBS announced a copycat deal in early September, targeting just over £16bn of sterling, euro and US dollar bonds.
Having seen banks like Lloyds able to pull off such trades, which would have been impossible just a couple of years ago, it is not too much of a stretch of the imagination to think the UK may have been well served by hitting crisis point before Europe.
"In terms of deleveraging, given the historic size of their balance sheets, UK banks were forced to be ahead of the curve," says Harman Dhami, head of FIG syndicate at RBS. "We are now much further ahead of our continental peers, and that is being reflected in the credit perception of UK banks."
Deleveraging is not the only factor influencing the new issue market, however. In his annual Mansion House speech in June, Bank of England governor Mervyn King spoke of a "large black cloud of uncertainty" hanging over Europe and the UK, "dampened animal spirits" and households and businesses "battening down the hatches to prepare for the storms ahead". How to get the banks lending again?
The answer, or at least one of them, was the Funding for Lending Scheme (FLS). The scheme offers cheap funding to banks, not on the condition that they increase their lending to UK households and businesses but simply that they reduce it by less than they had planned. The fee starts at 25bp for banks whose sterling lending to UK households and non-financial companies is flat to positive between the end of June 2012 and the end of December 2013.
An extra 25bp charge will be incurred for every 1% fall in net lending, up to a limit of 150bp. This means participating institutions can expect a funding cost of between roughly 0.75% and 2%, taking into account the Banks 0.5% base rate.
Many market participants are sceptical about the schemes ability to boost lending. But banks are certainly taking an interest after all, the levels on offer are generous. But while it may stave off a contraction in the UK economy and is undeniably a boon for the banks, some worry that it might not be such a good thing for the credit markets.
The sort of collateral banks would normally use for securitisation mortgages, credit card loans, auto loans is perfect fodder for the FLS, and they can get more bang for their buck putting it in repo with the Bank of England than they would packaging it up into asset backed securities and selling it to private investors. In August, Leeds Building Society issued an £897m RMBS deal named Albion but chose to retain it to get this benefit. Bankers say other building societies are considering doing the same.
"Given the size of these institutions, it is much easier to put that packaged-up collateral into the FLS and pass the cost saving benefit back to their members than sell those bonds to third party investors," says Hague at RBS.
"It shows that our banking system is healthy and the people at the top are making decisions based on economic considerations. In the current environment where every bank CFO is focused on net interest margin, overall profitability and what that means for share price performance, banks will look at all the options to reduce their funding costs and thus improve the outcome for all stakeholders, both customers and shareholders. But it does mean there is a lack of assets for people to put their money into."
Investors are sensitive souls, however, and banks will not want to neglect them. Robert Plehn, head of asset backed solutions at Lloyds, believes borrowers will do their best to keep their buyers sweet and not be completely seduced by the generous, windfall wiles of Mr King.
"To a certain extent the FLS is a temporary phenomenon and most institutions will want to keep their investor base active," he says. "This is relatively easy in respect of UK investors but new overseas investors particularly in the US and Asia have spent time educating themselves on the UK markets, the assets and structures that back the securitisations, asset performance, etc. Even existing overseas investors need to spend time keeping this knowledge fresh.
"If there is no supply of product for an extensive period of time then this knowledge base could disappear making it more difficult, and probably more expensive, for issuers to raise funding in these markets in the future. Most issuers are aware of this and so I expect to see some regular, albeit reduced, securitisation issuance out of most of the larger UK issuers, notwithstanding the FLS."
A marathon, not a sprint
For its part, the Bank of England is keen to emphasise that the scheme was introduced with the aim of boosting lending and therefore, in turn, borrowing. Five or six other building societies are understood to have a similar view to Leeds regarding their use of retained securitisation in the FLS, but the long term effect on the wholesale markets should be positive, says Andrew Hauser, head of the Banks sterling markets division.
"First, banks and building societies are keen to use the FLS but also recognise that they need to keep a foothold in funding markets, so will ensure they have a continuing issuance programme," he says. "That will be helped by the fact that getting new lending onstream takes time we expect take-up of the FLS to be smoothed over the 18 month window, rather than coming in a big cliff right at the start of the scheme.
"Second, the cost of issuance is coming down quite sharply. That reflects all sorts of factors, of course but the FLS is likely to have played a part. Indeed, reducing funding costs is one of the key objectives of the scheme. With yields coming down, the attraction of wholesale funding should increase over time."
The aim of the FLS is to boost lending to households and firms relative to what it otherwise would have been, he says. Some substitution of wholesale funding is likely in the short term, but the aim is that increased lending should help growth, in turn boosting banks need for wholesale funding to finance further lending.
"The FLS is there to kickstart that process," says Hauser. "Also, the wholesale market can actually be cheaper than retail funding for some lenders, given the very competitive conditions in retail deposit markets. So some banks and building societies may adjust their retail funding rather than their wholesale funding."
Stable doors slam...
It is clear that the FLS is a big thing for the Bank a macroeconomic tool in the same league as quantitative easing. Despite the positive rhetoric, however, some feel the scheme is the Banks way of remedying a disease it caused through regulation overload.
"The FLS is a belated but welcome response to elevated funding costs which were themselves driven by regulatory changes, bail-in, too-big-to-fail, and ringfencing," says UBSs Ryan. "The regulator made banks debt lower quality. The cost of issuing went up, and the regulator made them issue a lot. The banks response was to lend less, so the regulator responded by making their funding cheaper."
"When it expires we would expect the cost of issuing wholesale debt to have fallen again. I dont think you will see UK covered bonds at these levels again. The FLS has closed a chapter in which UK banks were required by the regulator to issue the wrong quantity at the wrong spread."
...before fences are erected
While stopgap measures like the FLS may affect issuance in the short term, in the longer term, the shape of the UK banking sector is changing, and banks funding strategies will have to adapt with it. The ringfencing proposals put forward earlier this year by Sir John Vickers Independent Commission on Banking (ICB) are still being worked through, but they will arrive sooner or later, and it will inevitably affect the mechanics of debt issuance.
There is a school of thought that says ringfenced entities the retail part of the bank should be funded entirely by deposits, meaning any operations outside the ringfence would have to be wholesale funded. However, the amount of surplus capital retail banks will have from mortgage lending and potentially corporate lending make it seem unlikely that they would prohibited from accessing at least the securitisation or covered bond markets.
UBSs Ryan believes the end aim of ringfencing is to force investment banks to shrink by making it more difficult for them to access markets.
"Ringfencing is not designed to make UK banks safer," he says. "It is designed to make UK banks have smaller wholesale operations. How that works is that the investment entity will have less reliable access to wholesale operations and will therefore want to be smaller. It seems likely that unless an outside-ringfence business was significantly better capitalised than a retail business, it would be lower rated and therefore harder to fund."
Indeed, the difference in rating between retail entities and investment banks may start to bite even before the regulations are enforced. At some point, investors will be forced to take a view on which which part of the bank will be charged with servicing their assets accounts buying debt maturing in 2020, for example, will have to start thinking not just about what they are buying right now, but where that security could be transferred to in the future.
"There will be a ratings gap between a standalone investment bank and a fully retail-funded retail bank," says Dhami at RBS. "However, spreads are currently attractive enough for bank debt to be a compelling investment offer. Additionally, the extended transition period [to ringfencing], coupled with the strong regulatory and banking infrastructure in the UK facilitates a positive outlook for UK bank funding platforms."The great British public has given its banking industry a rough ride this year, probably deservedly so. However, as hard as it may be to look past the IT failures, bonus rows and rate fixing scandals, the market for UK bank debt is something of a success story. Perhaps, in time, the sector can make its people proud again.