When the European Banking Authority took a poll of the capital markets in the summer, one question stood out as something of a no-brainer for the respondents. Nearly everyone involved in the questionnaire agreed that banks would have a very clear objective in terms of their funding plans going forwards: to build out their debt for the minimum requirement for own funds and eligible liabilities (MREL).
This focus on MREL is hardly surprising. Regulators and rule-makers are finally in a position to tell banks what types and what quantities of debt they require to comply with the standard, which aims to ensure that institutions have the proper resources to be able to deal with financial distress without needing any help from taxpayers.
But Europe’s banks have been given the green light on MREL at a very delicate time in the world. Investors are becoming increasingly nervous about what is happening around them, as a number of G8 nations enter into a late stage in the economic cycle.
And, simultaneously, the European Central Bank is dialling back its support for markets that it has been running for the best part of the last decade in one form or another.
“We know that central bank funding is going to be withdrawn next year and we also know that there will be a much clearer picture around the requirements for MREL,” says Wolfgang Strohbach, a policy expert at the European Banking Authority in London.
“These two things combined mean that banks are going to have to issue a lot more debt.”
Strohbach is concerned that it may be difficult for the market to manage the sheer volume of bond issuance forecast in 2019 and 2020.
Initial estimates from Crédit Agricole suggest that the supply of MREL-eligible senior instruments could hit about €165bn-€175bn next year, with redemptions rising and with member states having approved new laws permitting issuance in these formats.
Nordic institutions have so far been a big missing element from the equation on MREL, but they will join their peers in other member states issuing non-preferred senior debt in 2019.
“With many banks coming out and issuing new deals in the market, you have to ask whether demand is going to be able to keep up with supply,” says Strohbach.
Back to life, back to volatility
There were already clear signs in 2018 that investors were losing some of their appetite for riskier types of bonds. Banks were being asked to pay higher and higher premiums to get new trades away, having grown accustomed over the last few years to getting the very best terms on their transactions.
The problem for credit funds was that volatility in the financial markets had begun to weigh heavily on their returns. Fund managers could no longer trust that any upside they received from investing in a transaction in the primary market would not be completely obliterated within a matter of days in the secondary market.
Anyone who bought Lloyds Banking Group’s €1.25bn six year non-call five senior deal when it was issued at 47bp over mid-swaps in January, for example, would have found the bonds trading at 120bp over by mid-November.
Unfortunately for issuers in the capital markets, there is little reason to suggest that credit spreads will reverse direction in 2019 and begin grinding tighter. Pretty much all of the big political drivers of this year’s volatility have refused to go away.
Fears have continued to swell around the management of the Italian economy, following a series of clashes over spending plans between the country’s government and the European Commission. And trade tensions are still bubbling away as a result of frequent spats between US president Donald Trump and various other world leaders.
At the same time, the outlook for global investment is changing. Rises in US interest rates have opened up a number of new opportunities for funds, which in the years since the financial crisis have had to get used to dealing with low returns across many different asset classes.
“The move in underlying rates in the US has meant that the front end of the curve now presents an alternative investible opportunity with a reasonable yield for the first time in several years,” explains Mark Geller, deputy head of FIG DCM EMEA at Barclays in London.
The upshot of operating in a tougher market environment is that financial institutions may need to think more creatively if they want to get on with reshaping their liability structures for MREL without feeling too much pushback from investors.
“After strong periods for credit in 2016 and 2017, when monetary policy was particularly conducive, we are now seeing an adjustment to higher rates and of course QE tapering within Europe,” says Geller.
“As issuers look towards 2019, there is an elevated risk of more market volatility and so accessing good windows of execution will be key to successful funding.”
One of the more popular methods for beating the crowds has been for banks to look away from their home markets for both funding and capital.
European financial institutions leaned on the dollar market between July and October, for example, favouring the currency for about 60% of MREL-eligible issuances, according to CreditSights.
The yen market has also emerged as a popular option for those seeking a broader spread of investment for their loss-absorbing bonds.
International banks have increased their debt sales into Japan by 40% this year, taking advantage of a ruling from the Japanese Financial Services Agency in April that made investing in MREL-eligible senior debt a more attractive option for local bank treasuries.
“Diversification of investor base and currencies remains a key focus for large MREL issuers,” says Geller. “We have witnessed an increase in transactions across several currencies, including Japanese yen, Australian dollars, Swiss francs and Canadian dollars, as banks seek to build a complement to core markets.”
Haves and have-nots
But clearly the task of attracting investment will be more challenging for some issuers than it will be for others. Europe’s smaller banks, for example, will have their work cut out if they want to stand out in the market, as the numbers of issuance windows decrease and as conditions become more volatile.
“Investors have realised that any type of debt can absorb losses and, subsequently, they have showed sensitivity to different names depending on the profile of their balance sheets,” says Vincent Hoarau, head of FIG syndicate at Crédit Agricole in London. “This focus will increase in 2019, when portfolio managers will be scrutinising a longer list of capital metrics during the due diligence process.”
In particular, there could be trouble ahead for the middle tier of financial institutions in southern Europe, many of which will be looking at taking their first steps towards MREL next year. These banks took the lion’s share of a cheap liquidity programme run by the ECB since 2014, known as the targeted longer-term refinancing operations (TLTROs).
Having filled up on these four year loans, a good number of potential issuers have only accessed the capital markets on very rare occasions in recent years. But the ECB has now signalled the end of its TLTROs, and the deadlines for MREL are creeping closer, meaning that southern European banks will have to start thinking about re-establishing a dialogue with their credit investors soon.
Italy is undoubtedly the elephant in the room here. Volumes of new bank debt issuance out of the country sunk to a five year low in 2018, as issuers tried their best to deal with long periods of political instability.
The Bank of Italy estimates that the country’s largest banks could be left with an MREL shortfall of up to €60bn in three years’ time, with their cost of funding set to jump by 10bp-30bp following the standard’s introduction.
“The pattern we can see is that the institutions that relied most heavily on central bank support measures, particularly in the European periphery, are the ones that are most likely to face challenges from rising funding costs,” says Strohbach, drawing attention to the fact that net interest margins have been on a steady decline in the industry.
A storm is brewing
There is a feeling that the European banking sector has reached a bit of a turning point at the end of 2018.
Central banks have taken the stabilisers away from the capital markets at a time when the majority of financial institutions are only just learning how to move forward with the tough job of reshaping their liability structures for MREL.
In several member states, the ink is still wet on laws that were passed to enable banks to issue non-preferred senior bonds as a cost-effective way of meeting the new loss-absorbing debt requirements.
And in a speech in Naples earlier this year, Fernando Restoy, chair of the Financial Stability Institute, drew attention to the fact that 60% of significant institutions under the ECB’s supervision have never issued additional tier one instruments before, and that 25% of them have never sold any form of subordinated debt.
The start of their journey into these new markets will coincide with the start of a much trickier period for deal execution. At least six banks had to pull deals from the euro market after opening order books this year, and many more were forced to shelve their plans to raise debt.
Borrowers may find that they simply struggle to access the market when they want or need to next year.
“There is a new regime in primary,” says Hoarau. “The stop and go mode is here to stay.”