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Battening down the hatches

14 Jun 2012

Who would be a senior unsecured bank bondholder? A bewildering cocktail of higher funding costs, reduced access to liquidity, balance sheet constraints and regulatory uncertainty is combining to make the outlook for European banks more opaque than it has been for decades. And that is leaving aside the storm clouds gathering more menacingly by the day over the euro.

Participants in the Rabobank FIG roundtable gathered in London at the end of May to discuss how they are positioning themselves in this hostile and uncertain environment.

Taking part in the discussion were:

Philippe Bodereau, managing director, Pimco

Michael Gower, head of long term funding, Rabobank

Robert Kendrick, senior credit analyst, Legal & General Investment Management

EUROWEEK: How can FIG issuers and investors best position themselves in this uniquely challenging climate?

Michael Gower, Rabobank: Anybody who is only starting to think about how to position themselves now is doing so too late. If you’re in a treasury or risk management position you need to have been thinking about contingency planning for some time.

Ultimately the simple answer is that as a bank you need to be well capitalised and very liquid. And you need to ensure that you have capital and liquidity in your balance sheet from as wide a range of sources as possible. That is the only way you can be prepared, but from a practical perspective this takes time. You have to live a paranoid existence where you are a taker of liquidity and capital whenever it’s offered to you, and you have to have some very strong contingency plans for some significant tail risk events. Those events are becoming more and more possible — if not yet probable — every day.

Two years ago, any discussion about whether the euro would or wouldn’t exist was frankly a fantastical conversation. It then became a tail risk conversation; and now here we are with the genuine possibility, which we all hope doesn’t become a probability, that the experiment with the single European currency may be just that — an experiment lasting a finite amount of time.

From a risk management point of view you have to put various plans into your locked cupboard that you can implement in terms of what happens to your asset, liability and capital base if the unthinkable happens and all of a sudden you’re presented again with 17 legacy currencies.

EUROWEEK: Do you have a concrete plan for responding to a currency break-up?

Gower, Rabobank: I think there’s a difference between having plans for a Greek exit and for a complete euro break-up. A euro break-up would be gradual by definition. In the event of an individual country leaving the euro and returning to a legacy currency — the new drachma or whatever else you want to call it — more plans are possible in terms of how you manage your assets. There are fairly well documented examples of corporates that have already renegotiated their contracts in Greece. So I think people have a fairly good idea of what to do with their Greek exposure.

To make concrete plans for what to do if the euro breaks up entirely is probably impossible because you’re getting into a situation which will call for an almost military response. We’re talking about closing borders, preventing immigration, imposing currency controls and so on. It would be very messy, and in that type of situation how can you make plans? It is effectively a military discussion. As a bank, we’re secondary to issues of civil unrest.

But with existing assets and existing portfolios you can make some contingency plans.

EUROWEEK: What’s your gut feeling about what is likely to happen?

Gower, Rabobank: Things will take a little longer to unravel than people expected. But I don’t see any reason why the behaviour of political decision-makers will have changed from what it has been over the last six to 12 months. This means that there is a need for people to look into the abyss before doing whatever is necessary to stop them falling into it.

Frankly at the moment I’m not sure they’ve seen the abyss. Perhaps they had a glimpse of it at the back end of last November, which was the impetus for the LTRO. But I don’t think politicians have seen or felt what the abyss would look like, were Greece to leave.

My concern is that Greece will do something itself, before politicians have had the chance to prevent it from doing so. So my expectations are that things may take a bit longer than expected, but that the process will be messy.

There doesn’t seem to be a mechanism for the EU to push Greece out of the currency union. It will have to be voluntary. How they do that is unclear. A straight default is a possibility. A refusal to abide by fundamental euro law is another. If the outcome to the next election is pro-austerity, we may see civil unrest leading to the eventual fall of the government.

I don’t personally believe that the majority of Greeks want to stay in the euro.

EUROWEEK: The polls say that 75% do — but presumably they don’t understand what staying in the euro means from a fiscal perspective?

Gower, Rabobank: Correct. So my expectations are that unless things improve dramatically or Germany changes its stance completely, the government will decide to pull out itself by giving back the key.

EUROWEEK: How can investors position themselves in this environment?

Philippe Bodereau, Pimco: The key quite simply is to have as little exposure as you can to the eurozone. In general the zone has turned out to be very risk-prone with some major failures of corporate governance, and I think what countries realise now is that the system is functioning more like a currency board than a true monetary union.

In that respect, all countries are de facto borrowing in a foreign currency. And countries that don’t have their own currency and their own central bank are subject to a higher level of default risk.

I think the market is pushing harder and harder for a choice to be made one way or the other. It is pushing for politicians to make a choice between fiscal union or the break-up of the euro. I don’t know how it is going to end. I think that given the tail risk of a break-up it is more likely that the endgame is fiscal union, but the journey to take us to that point will be a very painful one.

If we reached the point of social unrest and political implosion in Greece, what does that mean for capital controls in Greece and for deposits in other peripheral countries?

On the back of that we would probably see that for the first time ever the eurozone would genuinely be staring into the abyss. That would prompt eurozone governments into a more aggressive policy response. But their pain threshold is quite high and I think they will be able to endure quite a bit more.

So my view is that things are going to get worse before they get better. In the meantime nobody is forcing you to invest in the eurozone. So I aim to minimise my exposure and be underweight in this region, favouring either places where balance sheets are strong, like emerging markets, or some of the big multinational corporates. Within the Western world, we call it picking the cleanest of the dirty shirts, which means favouring those countries with control over their central banks, such as the US and the UK.

EUROWEEK: Robert, are you on the sidelines?

Robert Kendrick, LGIM: You can’t be completely uninvested when you’ve been given money to invest in euro denominated corporates. So then you have to think about which elements of banks’ credit profiles would make them less likely to explode in the event of a euro break-up than others.

If you’re trying to identify the survivors there are a few things you can look at. What sort of cross-border exposures does the bank have, and has it been lending heavily to its subsidiaries in riskier countries? But as Michael said, it’s important to stay liquid because although you can be as bearish as you like, there will be extended periods where spreads rally, as we have seen a few times over the last year or two.

One of the key problems I have when I think about investing in banks is the nature of the contingency plans they have in their locked cupboards. I’m sure every bank has a contingency plan, and I’m sure those plans are a lot more extensive now than they were two or three years ago. But I don’t know what they are, and even if I did, there is no way of knowing if they will work. Every single currency union has failed in the past and there is no reason to expect the euro to be any different. The difference is that the eurozone is so much bigger than any previous currency union, accounting for about a quarter of the world’s GDP. That’s massive.

I believe that much more likely than a break-up is some form of fiscal union where the Germans get dragged reluctantly into assuming more of the debt of the peripheral countries. The scale of what could go wrong if that didn’t happen is just enormous.

EUROWEEK: Can you build up a portfolio based on the expectation of fiscal union?

Kendrick, LGIM: Given the risks that some of the smaller Spanish banks have, in terms of sovereign risks on their balance sheets, and the amount of capital these banks need, it is arguable whether they fit within the realms of what investment grade credit should look like.

Given the likely losses at these banks, it would be hard to create an argument that they shouldn’t be junk-rated.

EUROWEEK: Michael, are investors prepared to differentiate between the better credits and the weaker ones? Or is it simply a case of risk-on or risk-off on any given day?

Gower, Rabobank: You do have to be very careful in terms of taking overall sentiment into account when you come to the market. One of the views that we have held very strongly over the last five years is that above all else, execution risk needs to be minimised. I think the dangers around execution risk have not been respected enough by the generic bank issuer.

There has been a lot of cash generically speaking in investors’ pockets. To an extent, as Robert hinted, there has been an element of forced investment because investors can’t do nothing with their cash. So ultimately if you sit within a given part of the credit spectrum you will have a certain amount of investment in your bond issue. But if you put that issue into the market at a bad time, the impact on pricing will be adverse and your spread performance will be negative. That doesn’t help with your image or with your ability to fund in the future — because people will eventually hold back either by not investing at all or with a smaller size of investment.

A lot of that has to do with whether it’s a risk-on or a risk-off day. Markets have become very volatile. We’ve been seeing intra-day spread swings which have hitherto been unheard of. They’re back to the sort of magnitude we saw post-Lehman and in November last year. When we put ourselves in investors’ shoes we ask why they would want to run that type of volatility risk on day one? Investors often buy for the new issue premium, certainly in the weaker banks, but if that’s wiped out by a factor of three on day one, why go into it?

Even in corporate land, there have been a number of occasions when a borrower has jammed something into the market during a volatile couple of days, and you can give that spread back pretty quickly. So there is nervousness out there, and when things go wrong, and if the abyss that we’ve spoken about comes a little closer, even in high-grade credit, those intra-day spread movements are going to be lethal.

Bodereau, Pimco: You can reach a stage of contagion where it no longer matters how well-capitalised you are. Italy is the world’s eighth largest economy and has the third largest government bond market, so it’s hugely systemic, and if there are concerns in the market about an economy of that size, it is hard to have a framework for investment in European banks because funding contagion becomes so serious.

Kendrick, LGIM: Even the best banks are leveraged 15 or more times, and under normal circumstances a 10% tier one capital ratio is fine. But as Philippe says, Italy is the world’s third largest government bond market so if that goes down there will barely be a bank in Europe that won’t be left with much lower capital.

Bodereau, Pimco: This is why sometimes the debate about whether or not European banks are severely under-capitalised is irrelevant. If your core tier one capital is 9.5% but you haven’t addressed the Spanish and Italian problems, it doesn’t make much difference. So to some extent that’s a false debate.

There are some cases where more capital would of course help. But it’s not going to work in isolation. We need something more comprehensive that deals with sovereign exposure, bank funding and bank capital. We haven’t seen that. We’ve seen that at times of an escalation of the crisis the ECB has been willing to step in and provide unlimited liquidity, which was the driver of the entire rally we saw in the first quarter. But that hasn’t been followed through with any meaningful reform of the functioning of the eurozone area, which clearly needs to happen.

Ultimately debt needs to be mutualised. Otherwise we will continue to see capital flee from the periphery to the core. That is a very destructive process, which creates a huge amount of collateral damage for the functioning of many government and bank funding markets.

Gower, Rabobank: Coming back to the point Robert made earlier about needing to be invested, yes, you can have some cash on your books but there has to be an element of putting your cash to work — just by mandate. But one of the common mistakes that policymakers in Europe make has been to assume that there is a large enough amount of captive cash in the region to put into European banks to deal with the restructuring which they are envisaging.

One of my major concerns around this whole political direction is that there is a failure to recognise that the flight of capital away from Europe is going to be very dramatic, and already is, to some extent.

Kendrick, LGIM: And this is a banking system with a loan to deposit ratio of about 130%.

Gower, Rabobank: Absolutely. In that context, travelling on the west coast of the US or in Asia or Australia and talking to investors about Rabobank, while they feel comfortable about our high capital and liquidity levels, they tell us that at the moment Europe is not where they want to put their cash and capital to work. It has not been recognised by European politicians that there is not enough money in Europe.

Bodereau, Pimco: Europe needs international investors. But it has been doing everything in its power to deter them.

EUROWEEK: Presumably everything has a price, and we will eventually reach pricing levels that are appealing even to investors nervous about Europe?

Gower, Rabobank: I think this is the key discussion. What is the trade-off between price, availability and volume? If you’re a highly capitalised, very liquid and deposit-funded European bank, of which there aren’t many, you’ll probably be able to absorb enough of the cost to continue functioning. But for 90% of the European banking system, the requisite price is simply uneconomical from a business perspective. Even if there was enough availability, a major flaw is the assumption that there is a fixed pool of assets that has to be invested at a price that is manageable.

EUROWEEK: Would LTRO III do anything to turn sentiment around, or would this simply be kicking the can another few hundred yards down the road?

Bodereau, Pimco: LTRO was a signal from the ECB that it was standing ready to avoid a disorderly refinancing crisis such as the one that was faced by European banks last November. It therefore materially reduced the default risk.

But on the back of that we still have the fundamental issue that stronger decisions need to be made on the fiscal front to create a firewall and to control yields on Spanish and Italian government bonds at levels that make these countries’ debt trajectories sustainable.

Europe also needs some sort of plan to backstop banks’ capital, especially in the weaker areas of the European banking industry.

On all three fronts, Europe has not delivered. The credibility and the size of the firewalls are still debatable. On the banking front we’ve seen a process of incremental steps in Spain where they are now on the third round of announcements in three months which does not do much to restore confidence that they’re on top of things.

With regard to bringing Spanish and Italian bond yields under control, the LTRO has helped in that it has given the banks ammunition with which to buy more sovereign bonds in Italy and Spain. But that is not sustainable as we have seen recently with spreads coming under pressure again. LTRO III would be better than nothing, but it would be the same as LTRO I in the sense that it would be necessary but insufficient.

In Italy, there is an issue with the sovereign, not with the banks. Trying to cure the banks without curing the sovereign is not going to work. And the way to cure the sovereign problem is to do exactly what Monti is doing by introducing structural reform. But these things take years to play out. Look at the Schroder reforms that were introduced seven or eight years ago. There is no way labour reforms are going to have an impact straightaway. In fact, with unemployment already at high levels, labour reform only makes things worse in the short term.

So at some point you need to have debt mutualisation. QE via the ECB would be the best way to do that, because the ECB is the only institution that has the ability to step decisively into the market. It has already done some QE, but without much conviction, because there is no pre-commitment or transparency. I think we’ll see this soon, but it amazes me that it has let the situation get as bad as it has. So the best thing is not to try to predict how the ECB will behave.

Kendrick, LGIM: Liquidity problems are often what kill a bank. But that is always driven by underlying solvency concerns. The ECB has quite rightly stepped in and ensured that banks are provided with plenty of liquidity, but all that does is buy them time, or buy the system time. However, as we were saying earlier on, it’s not really the capital position of many of the banks that is in question. It’s the solvency of the governments.

QE would certainly help in terms of providing monetary stimulus, in the same way that it has helped in the US and the UK. But investors are questioning the underlying solvency of countries like Spain. Until those questions are answered, the LTRO won’t have achieved anything.

EUROWEEK: Michael, do the investors outside Europe that you mentioned earlier take any comfort from LTRO? Indeed, does LTRO lead to moral hazard?

Gower, Rabobank: Yes to all of the above. Even today, we all feel much better than we did at the end of November and the beginning of December. In December, we were convinced that in the first week or two of January we were going to see a large bankruptcy in the European banking sector, and we were also pretty sure which bank it would be.

That was a danger that was being monitored on an hourly basis. We’re in a very different position today to where we were then. For that reason alone, I think LTRO was a game changer. It’s good for all of us. Had we seen a large European bank go under, the implications for everyone around the table would frankly have been horrific. It may still happen, if things go wrong in Greece and if Spain doesn’t sort itself out. But we have been bought a bit more time.

Is LTRO kicking the can? Yes. But I think in that scenario it was better to kick the can than to die. We were far closer than anyone realised at the time to having a large nuclear event happening in Europe. But as Rob said, these issues tend to be capital and solvency-related in their genesis.

I think we also have to accept that on a relative basis the deleveraging among European banks has been pretty poor.

Kendrick, LGIM: It hasn’t happened yet.

Gower, Rabobank: Yes — you could go so far as to argue that it hasn’t happened yet, particularly compared with other jurisdictions. Part of the underlying rationale of the ECB’s decision-makers is to force through bank deleveraging, which so far they haven’t been able to achieve. It’s going to be very expensive because 25% of the world’s GDP is generated in Europe.

There’s going to be a huge drop in lending, and in the short term it’s going to be very painful, but if the result is a reduction in leverage, then frankly over the longer term that will be no bad thing. The question is whether many European banks in the very near term will be able to survive such an aggressive approach to this deleveraging.

Kendrick, LGIM: The question is also whether they deleverage the right assets. The danger is that they keep the bad assets on the balance sheet and try to hide their losses, and any deleveraging we see will be the selling of their good assets. That will then hit their profitability because they’re running down the assets that are earning them a decent margin.

EUROWEEK: Historically, do banks have a good track record of differentiating between the good assets and the poor? Or do they just have very poor business models?

Bodereau, Pimco: It was a long era of very cheap credit that drove over-leverage. I don’t think it’s necessarily the responsibility of any specific business model. Nor was it solely the responsibility of the banks themselves.

Gower, Rabobank: The biggest single driver of banks’ business models since 2007 has been potential or actual change to regulatory restrictions, which at times has led to the cost of capital increasing.

Before the crisis I think the biggest single driver of banks’ business models was effectively relative regulatory freedom compared to today. So we have to look pretty closely again at regulation. Historically, apart from Basel II or III, it tended to be very local in its reach. There was very little pan-European legislation.

Kendrick, LGIM: Banks like any other organisations respond to the incentives they’re given. For the 20 year period leading up to 2007, banks came to expect that rates would be cut in response to any crisis which would nip any recession in the bud and they’d be back to the races again. That happened time and time again and it also encouraged bank investors to assume that spreads would move ever tighter. This assumption also encouraged them to try to squeeze as much added return as they could from all sorts of horribly leveraged structures. It has taken five years so far but it will take a lot longer for this to fully unwind.

EUROWEEK: Isn’t it the case that the pendulum always has a habit of swinging from under-regulation to stifling over-regulation? And if we are now in a period of stifling over-regulation, what can we do about it? Is there a danger that regulation makes it impossible for this industry to function?

Gower, Rabobank: As a regulated bank, one of the things I would say is that the industry has benefited over the last 20 years from apparently loose regulation that led to high profitability. One of the prices that is now being paid for that is tougher regulation. Unfortunately we have all had to pay for that, not only with losses and asset devaluations and so on, but also with a loss of our relevance as a voice.

In a European context, if you talk to individual banks, regional regulators or investors, those entities no longer really carry weight in terms of being able to express an opinion at the European decision-making level. The concept of the taxpayer is now very powerful and is much more influential than the voice of the industry.

What will lead this cycle to move on to the next one will be a lot of time. People say the crisis is already five years old, but I think if you look at major economic crises over the last hundred years, they’ve all taken at least a decade to resolve themselves. So we’re probably half way through this one, if that.

There is still plenty of regulation that has targeted 2020, 2022 or 2023 for full implementation. So until then, it is unlikely that the pendulum will swing back. That makes the outlook challenging, although the main difficulty at the moment is lack of clarity.

Bodereau, Pimco: There are a lot of good things associated with regulation for credit investors in general. I’m not going to be the one complaining about the fact that banks are 15 or 20 times levered instead of 40 times. I’m not complaining about the fact that the wings of investment banks are being clipped; nor that prop trading desks with poor quality of earnings that only made money for traders are being closed.

So there are a lot of positives about regulation. The danger is that if you set the bar too high you end up creating capital shortfalls, and if you have no plans to address those shortfalls, then you create instability in banks’ stocks and across the capital structure.

If you say that Italian bank X has to raise €8bn and there is no back-up plan at a time when everybody is already concerned about the indebtedness of the sovereign, you clearly need to have a pan-European backstop. So although regulation is a good thing, you need to have contingency plans otherwise you create a huge amount of instability and uncertainty.

EUROWEEK: If we have control on leverage, restrictions on investment banking and so on, will we see banks effectively acting as utilities? If so, at some stage they will presumably come under pressure to deliver enhanced shareholder value?

Bodereau, Pimco: I have no doubt that the short-sightedness of banks’ management teams means that we will go through the same cycle of crisis and complacency again. We’ve already seen this to some extent in the US where there has been a lot of deleveraging, but the recent stress tests there allowed JP Morgan to start on an enormous share buyback. Thanks to its recently announced losses this is now unlikely to be executed in its entirety, but this could have amounted to 92% of 2012’s expected earnings. So this focus on shareholder value can come back pretty quickly.

Now that we have Basel III and G-SIFI and national rules on top of them there will be more pressure for banks to hoard retained earnings and capital and liquidity, especially in Europe.

But it’s not just capital that is important. Funding is as important. We’ve seen the average loan to deposit ratio come down from about 130% to 115% or 120% across Europe. But if you look at a country that went through a major banking crisis such as Japan, there the loan to deposit ratio fell to 80%. I don’t think we’ll go to 80% but there is clearly a long way to go before this process is over in Europe.

EUROWEEK: How can a decline in the loan to deposit ratio of that magnitude be reconciled with the clamour among politicians and the general public for increased bank lending to stimulate growth?

Bodereau, Pimco: It can’t be reconciled. One of the problems is that there is not a holistic view of the regulations in different sectors, and how they interact with each other. A good example is the net stable funding ratio, which is encouraging banks to term out their debt. But at the same time the biggest buyers of longer dated bank debt, which are insurance companies, are being encouraged by Solvency II to buy shorter dated debt. So in that instance there is clearly a lack of dialogue between the different regulatory authorities.

EUROWEEK: It’s not joined-up thinking, is it?

Kendrick, LGIM: You suggested that the aim of regulation may be to make the banks behave like public utilities. But as we went into the crisis it seemed that the banks already were acting as public utilities insofar as the taxpayer was on the hook for their ultimate losses. But they weren’t insofar as the private sector captured all the upside when times were good.

A large part of the regulatory thrust we have seen has fixed that, and in some cases banks have been wholly or partially nationalised, essentially making them public utilities.

But more generically, regulators are trying to get to a situation where capital levels are sufficiently strong to ensure that there won’t be massive holes in the future; and where there are holes in the future, to ensure there is a mechanism to find a resolution without having to write a cheque for hundreds of billions of euros, pounds or dollars.

The problem is that the resolution mechanisms so far have been quite unclear in defining the difference between capital and funding. When you read the commentary in the papers it is obvious that people often forget that there is a difference between the two. Whether it’s deposits, secured bonds, unsecured wholesale, commercial paper or whatever, bank funding is not risk capital. It’s supposed to be highly liquid and low risk. But it only works that way if there is plenty of capital to absorb any losses ahead of you.

Gower, Rabobank: This leads naturally on to the question of where we are with regulation. The failure to understand that capital and funding are two very different things is one of the two central mistakes that the regulatory powers have made, especially in coming up with crisis management directives. The danger is that they create a response that may have resolved the previous crisis and may well resolve the next one, but unfortunately we’re not at a point in the cycle where the system is able to stomach it right now.

Their other mistake as I said earlier was to assume that there is a capped amount of liquidity for funding and capital for the European banking system. That simply isn’t the case. The analysis which has been done on this has been fundamentally flawed because there has been a lot of debate and publicity about rules and legislation being drafted on the basis of the average European bank. There is no such thing.

The system still needs to go through a lot of pain, which is ideologically a good thing. The regulation that has been drawn up so far has been fairly admirable in its aims and ideologies, but I think the execution, process and implementation is going to provoke volatility and will be very dangerous to some smaller banks. By definition it will therefore be very difficult for investors to feel comfortable and to manage their exposure to the region. Because of the absence of a voice for the industry, even among national regulators, politicians will do what they have to in order to uphold the holiness of the taxpayer.

I agree that every good crisis needs a casualty, and this is where the casualties are going to stem from — because people have only tended to look at new legislation once it has come in, and when the proposed crisis management directive comes in, I think people are going to wake up to that with quite a sweat.

EUROWEEK: What do investors think about the bail-in discussion?

Bodereau, Pimco: First of all we need to recognise that the appetite and willingness of taxpayers to bail out banks is a thing of the past. How many countries in Europe can credibly say today that they can bail out one of their national champions? Not many. Perhaps Germany could, if Deutsche Bank were to need bailing out. But if you look beyond that, I don’t think anyone else could afford it, because the difference between now and 2008 is that concerns about public deficits have become much more acute, and the ability of governments to take the hit has gone.

So the first point is that we need to be realistic and to accept that the era of bail-out is over. Once you’ve recognised that, you need to find something that works better, and I think that bail-in is a reasonable framework conceptually, but it comes with a long list of complications that regulators need to be aware of. That’s not being alarmist. It’s just being realistic.

Why do I say bail-in is a fair concept? It’s fair because if you’re against bail-in you’re arguing that if you make a bad call and the company you invest in is failing, you should still get par back. I don’t think that’s reasonable. We’re credit investors and we’re paid to take credit risk, which we do in every other sector. In high yield it happens all the time that companies fail and creditors become shareholders.

The issue with banks is that they operate on higher leverage so your recovery expectations are much lower. The other point is that this new regulation will be coming in at a time when the system in Europe is still very over-levered. The deleveraging process has barely started, and the banks therefore still need a lot of refinancing in the capital market. In many respects I’d say that legislation is being pushed through at a time of extreme volatility with all these uncertainties on the sovereign front. So the timing is very brave.

In addition, regulators need to accept that there isn’t a fixed pool of assets that needs to be invested in European banks. Money can easily go elsewhere. This legislation is basically driving an acceleration in the deleveraging process among European banks. With that goes a drop in asset values, so it is not a silver bullet. It comes with a lot of unintended consequences, given how dysfunctional markets are today.

Kendrick, LGIM: It’s worth considering what the cost to an economy of a banking crisis is. Clearly it is significant — several percentage points of GDP. Then it’s a case of how do you allocate that cost? Should that cost be borne by the public sector or not? The consensus seems to be that the public sector shouldn’t have to absorb that cost.

I would agree that if you buy the bond of a bank that isn’t explicitly guaranteed by the government, and if that bank fails, you should be prepared to live with the consequences. To the extent that bail-in makes the failure of a bank as analogous as it can be to the failure of a non-financial then it’s not a bad thing. Nor would it prevent us from buying bank paper. We do the credit work on banks to the same level of diligence as we do for other sectors. So we’re comfortable taking the credit risk.

One of the big problems with the banking sector compared with other industries is that if Tesco, say, defaults, the company either stops trading or is sold. The creditors end up taking possession of the company and doing whatever they choose with the assets. The senior management probably gets changed and the chances are that a competitor ends up buying it because that’s the best way for the creditors to realise the most value out of it.

If you have a similar situation where a bank has failed, and the unsecured creditors take ownership of that bank and generate their recovery value based on whatever happens to the bank, that’s fine. But it appears that bail-in is being held up as a tool that will allow a struggling bank to get itself back on its feet, and carry on going as though nothing was wrong, while shareholders continue to own the company and management remains in place with no major change made to the running of the bank. That’s very dangerous, and puts senior debt into the category of risk capital.

Bodereau, Pimco: I don’t think that’s the plan, though. There is supposed to be change of management and conversion of debt to equity which would essentially wipe out shareholders.

Kendrick, LGIM: Yes. But even the use of bail-in as a tool to facilitate an open bank model with continuation of operations doesn’t seem right. A closed bank model where you can capitalise the closing down of the bank is fine.

Bodereau, Pimco: I think the Tesco analogy is a good one. But the other issue with banks is that they are systemic and interconnected. If Tesco fails, that does not mean everybody will assume that Sainsbury is going to fail the following day.

Gower, Rabobank: And you could still buy your bread somewhere else.

Bodereau, Pimco: Exactly. Whereas in the case of the banks, if you replay the movie from the financial crisis and look at what happened in the UK, in October 2008 HBOS would probably have been bailed in. But I’m pretty sure a number of the other UK banks would also have had to have been bailed in.

Gower, Rabobank: Yes. And that’s exactly why we need so much time to make certain that this legislation is worded, constructed and implemented correctly. The knock-on effects if it’s not done well would be dramatic. By definition, throwing these sorts of questions to the investor base and the issuer base creates volatility and the concern that this is not just another tool as part of a resolution regime, but that there is some different underlying rationale.

We as an industry tend to be quite poor at marketing ourselves, but I’m not sure that this bail-in discussion has done many favours to the regulators.

There does seem to be an insistence on employing this new legislation, and the plea from the industry has been pretty clear. This is that in terms of when and how this tool can be used, there needs to be a reassurance as Rob said that it is there to help the winding down of an existing business model, not to get it up and running again as though nothing had ever happened. Because in that instance those lines between liquidity and risk capital can be blurred very suddenly. Were they not blurred I think availability of liquidity and capital would be reduced under this regime; but were they to become blurred, there might not be any at all for most of the European banking system.

It’s hard enough to see how this would fit into a capital structure from a treasury perspective, let alone from an investor’s perspective.

Kendrick, LGIM: Looking at it from the perspective of the regulators, maybe they think that if they can have this in their toolkit for crisis resolution, it will be one more thing that makes it less likely for a bank to over-leverage itself. Less likely to get itself into a position where it takes a bet that means management may be fired, the shareholders wiped out and the bank run down. It won’t have the excuse that it is OK because everyone else is doing it.

So it may be a self-correcting tool that helps to prevent excessive risk building up in the future.

Bodereau, Pimco: From what’s been leaked to the press, while people were expecting implementation of bail-in in 2016, now it’s expected to be pushed back a couple of years. I think that makes very little difference. It’s a bit like Basel III in the sense that when they ended up going for higher capital requirements it pushed the implementation date back. But the market will front-run the implementation of any new legislation anyway, and behave as though it is already in existence.

Kendrick, LGIM: Two years ago, when Barnier started looking at crisis resolution, a lot of policymakers thought the crisis was over, and that a resolution mechanism should be put in place before people started to forget how traumatic 2008 was. But three years down the line things weren’t much better.

EUROWEEK: How do you see the outlook for bank issuance over the next six to nine months? Or is it impossible to say as long as so many uncertainties remain over Europe?

Kendrick, LGIM: As you said earlier, deals may work on some days but not on others. That’s not going to change over the next six months. The fact that a lot of banks had already completed the lion’s share of their funding needs by the end of the first quarter relieves the pressure somewhat. But as soon as we get to September and people start assessing their funding needs for next year we’ll be part of the way towards the end of the LTRO. So it won’t be pretty.

Gower, Rabobank: There is an immediate pressure release because of LTRO. But it’s public knowledge that various regional regulators have encouraged their banks to try to maximise that LTRO benefit as soon as they possibly can.

You asked earlier about crisis planning. I think if you start crisis planning now you’re too late, and the same is true from a liquidity and funding perspective. You needed to have been planning for this a number of years ago. For a wholesale funder, as we are, you couldn’t suddenly have decided six months ago to extend the duration of the liabilities on your balance sheet. You had to start doing that three or four years ago in order to reduce your funding reliance on markets such as these.

Going back to the casualty analogy, this crisis hasn’t created any real casualties yet in Europe. How can we have a crisis of this magnitude without a proper casualty? Arguably the crisis in the US was more acute, but did not last as long, because there was a big casualty and big deleveraging. Have we had that in Europe? No.

Bodereau, Pimco: You could say that Greece is the big casualty.

Gower, Rabobank: But we’re not there yet. There was a bit of a technical default, but Greece is still functioning and is still part of the euro. We haven’t yet had the Monday morning after the Friday before. But that is coming. Maybe a sovereign will default before a bank collapses. But as long as this threat is around, bank funding markets for the rest of this year are going to be perilous.

Of course there will be good days when there is some positive economic data and a good following wind allowing a stronger bank to get a five year issue done at a relatively good spread relative to where secondaries are. Fine. But everyone will get upset two weeks later when things blow up and it’s trading 50bp wider.

Things will continue to be very volatile until we reach the watershed moment. But I don’t know what that watershed moment will be.

Bodereau, Pimco: There will come a day when choices have to be made about what the eurozone is supposed to look like. The decision hasn’t yet been made. So far that has allowed policymakers to muddle through. But the gap between crises is becoming shorter. We saw that with LTRO, which led a lot of European leaders to say in February and March that the crisis was over. We only need to look at what’s happened since then to see that it is obviously not over.

I don’t think we need to see a Lehman moment. But experience tells me that whether you look at the ECB or at fiscal policymakers in Europe, they always seem to be reactive rather than proactive. That is dangerous because there comes a point at which you can lose control.

In European capital markets we have seen a process of re-nationalisation of government bond ownership. All the LTRO has done has provided an exit for foreign investors. It gave them the opportunity to sell Spanish and Italian bonds, and that is exactly what they have done. What we haven’t seen is a policy breakthrough which would allow people like us to shake hands with Europe and start buying Spanish and Italian government bonds again.

EUROWEEK: On the subject of the capital market, do you welcome recent developments in the Coco market?

Kendrick, LGIM: There have been a couple of deals in the last few months that had some features that we didn’t like. We find permanent writedowns very hard to stomach. That can’t be the model for broader Coco issuance. We still have issues with guidelines and client instructions that make it difficult for us to own something that converts to equity. So a temporary writedown with a write-back would be the preferred option for us.

Bodereau, Pimco: Compared with last year I think there is a little more clarity in terms of what the Coco structure should look like. The Swiss are the only ones who have created a template.

I agree that permanent writedowns are a non-starter as far as we are concerned.

When you look at the definition of what sort of instrument would qualify as Basel III tier one, at this juncture it is uninvestable and in some respects worse than equity. It is a shame that regulators have cut off a source of hybrid capital at a time when Europe’s banks need to be recapitalised. But they’ve come up with a structure which I think is unviable.

Gower, Rabobank: Let’s be under no illusion that the new crisis management directive is another way of ultimately ensuring that capital ratios get increased by the back door. The question is, what is capital going to look like? From our experience there will always be a market for an instrument from a very highly rated, high quality bank. We’ve had direct experience of that. But by no means do we see it as a template for future issuance by the industry, because as Philippe said, these instruments are generically

Ultimately what you’re getting to with crisis management is a model where the quality of capital between debt and equity is going to be much less important than the quantity of capital between the two. We won’t be talking about probability of default and loss given default, but about the probability of bail-in, and loss or haircut given bail-in. The discussion has moved away from the technical standards around these instruments to how much stuff do you have to have below senior debt.

Clearly, analysts are going to look at the quality of banks’ capital and at how much is equity and how much isn’t. But given the uncertainty of the regulatory regime, senior debtholders aren’t going to care what is below them in the capital structure as long as there’s a lot of it. From a structural and academic standpoint that is rather disappointing.

Given the SIFI requirements and the Swiss construct there will always be a market for layers of different instruments, but I think they are going to be much smaller than the EBA or the EU authorities had hoped when they put this together a couple of years ago.

Bodereau, Pimco: A fundamental mistake in Europe was that a couple of years ago there was a good opportunity to redefine the capital structure in a framework that was relatively simple, as the Swiss have done. They have a pretty neat capital structure with a clear layer of common equity, a layer of contingent capital that is almost the same size as the equity layer, and a layer of senior debt which in the new framework should be bail-inable in case the capital below that is insufficient.

Instead of that, Europe has gone for something that is pretty much unworkable. It’s a shame.

EUROWEEK: Are Cocos fundamentally more suitable for retail than institutional investors?

Bodereau, Pimco: No. There is an institutional market for Cocos — not right now, because at the moment there is no market for sovereign debt or senior debt. But theoretically I don’t think they are uninvestable for fixed income investors. Having said that, there are some instruments such as Basel III tier one that are just wrongly conceived, irrespective of whether you’re an institutional or retail investor.

Kendrick, LGIM: I suppose the guideline issue is more applicable for generic corporate bond mandates. But there will always be money available for specialist-type mandates that can take different types of risk.

Gower, Rabobank: If we have this discussion again next year, I think there will need to have been some form of watershed event. We will also have had a crisis management directive which we think will go ahead with very little adaptation that will have gone through national law. So we will be able to say with a lot more certainty what the market is or isn’t going to look like for bank funding.

14 Jun 2012