Copying and distributing are prohibited without permission of the publisher.

Watermark

Brexit casts long shadow over nervous UK banking sector

By Tom Porter
23 Mar 2016

The UK’s largest lenders may be operating in one of the developed world’s only growing economies, but an exit from the European Union could be about to turn their world upside down. Tom Porter reports.

“There is no Basel IV,” Bank of England governor Mark Carney told a packed briefing room on an unseasonably warm December 1 last year, while just down Cheapside at the London Stock Exchange, the shares of UK banks ticked steadily upwards.

The country’s seven biggest lenders had just passed the Prudential Regulation Authority’s second annual stress tests, and in many corners of the City there were glasses raised to the “end of banker-bashing”, as Carney laid out his plan to use regulation to strengthen banks in good times rather than restrain the credit cycle.

UK regulators cannot be accused of being too lenient on banks in the aftermath of the financial crisis. The Bank of England, and its watchdog the PRA, have imposed billions in fines for conduct both before and after 2008, with the payment protection insurance (PPI) scandal alone costing the sector more than £25bn to date — the latest stress test scenario imagined £40bn of conduct fines over five years.

4.1

They have also been at the forefront of the global attempt to do away with ‘too big to fail’, which has seen UK banks alter their debt issuance structures as they prepare to meet the Financial
Stability Board’s total loss-absorbing capacity (TLAC) requirements by 2019.

And having pro-active authorities has helped issuers as they face up to a challenge that will force HSBC, for example, to print some $60bn-$80bn of holding company level senior unsecured debt in the next three years, while just $51bn of its existing senior debt will roll off.

“Banks across Europe continue to face residual uncertainty about the details of the final TLAC and MREL [minimum requirement for own funds and eligible liabilities] implementation by regulators in their local jurisdiction,” says Tobias Kessler, who is responsible for capital solutions within HSBC’s financing solutions group in debt capital markets in London. “While it is hard to generalise on this point, there does seem to be a view in the market that UK banks are six to 12 months ahead of many of their continental European peers in terms of clarity TLAC/MREL implementation. 

“In some European jurisdictions there is a perception that it is still not clear what instruments are available for building up banks’ TLAC and MREL buckets, while the UK banks are viewed as being able to get on with the job.” 

As Alex Brazier, executive director of financial stability at the Bank of England, noted in a recent speech, UK banks are now “within a hair’s breadth” of reaching their required capital levels. 

The major banks now have core tier one equity ratios averaging nearly 13% compared with just 4.5% before the financial crisis, based on Basel III definitions. The question now is how each issuer plans to deal with swapping rafts of opco debt for the bail-inable holdco version. 

Start your engines

Most have wasted no time in getting to grips with TLAC, which requires global systemically important banks (G-SIBs) to have the equivalent of 16% of their risk-weighted assets in loss absorbing debt by 2019 and 18% by 2022.

“Most UK bank issuers are minded to ensure they have a decent chunk of their 2016 funding done ahead of the Brexit vote, which could lead to market dislocation and potentially challenges around market access,” says Anthony Tobin, European head of DCM syndicate at Royal Bank of Canada in London.

“They also don’t want to risk
overloading investors, which could put you on the back foot for 2017 and 2018 when you potentially want to issue more of these holdco instruments. But the appetite for UK
banks should remain strong. These are globally significant and well-run institutions.”

Barclays made its own intentions clear on January 6 this year when it printed a $4bn dual tranche holdco senior trade, the largest senior offering from a European bank in months.

It was joined in the US market on that day by a $1bn five year holdco deal from Santander UK, which then printed a strong 10 year holdco debut in sterling two days later.

The TLAC burden has also led these issuers to seek a broader investor base, heading to foreign markets where the UK brand is still pulling in demand.

Barclays printed the first ever holdco level Samurai in September, a multi-tranche ¥60bn ($539m) deal, after finding an order book of ¥100bn from more than 150 accounts.

Santander UK has even opened up a new funding channel in Tokyo’s Pro-Bond market, which is reserved for professional investors and allows for less stringent documentation, making it more cost-effective for new entrants to yen.

The ¥30bn dual tranche deal was the issuer’s first ever in yen, and could be a guide for smaller UK issuers as they look for alternative sources of loss-absorbing funding. 

The bulk of UK bank holdco funding so far, however, has been done in the dollar market, where investors are said to be more comfortable with the extra risk involved in holdco debt and charge a much smaller premium over equivalent opco paper.

But that could change.

HSBC sold a €3.25bn dual tranche holdco senior deal in March, just days after grabbing some $7bn of holdco funding in the much deeper US market.

The issue attracted a combined book of more than €10bn — the largest so far this year from a FIG borrower in Europe — and more than 540 accounts were involved, suggesting that UK banks will be able to print larger sizes in the currency in future.

“A lot of issuers have found dollars tend to win out on pricing, because US investors tend to charge less of a premium for that holdco-opco delta,” says Tobin. “The interesting thing about the HSBC euro transaction was it was much closer to dollars in terms of pricing, which has not been the case so far. Net interest margin is very important and even more so now banks are paying higher spreads for holdco instruments. 

“HSBC taking €3.25bn at good levels is an encouraging sign that there is more comfort with these holdco structures, and that will continue to improve as more is printed in euros and sterling.”

Shrinking or sinking?

FIG bankers are clearly not exactly daunted by the prospect of selling loss-absorbing UK bank debt to investors, wherever they are in the world.

4.2

The UK economy has its problems, and the country’s public finances are a constant source of fierce debate among its politicians and its voters. But its gross domestic product is rising, which is more than can be said for a number of the world’s developed economies, and it is more immune than many other jurisdictions to the global risques du jour — commodity prices and China.

However, UK banks are facing a number of challenges, as the publication of their 2015 full year results made all too clear.

Barclays shares shed 10% on March 1 after new chief executive Jes Staley unveiled another turnaround plan, which involved halving the dividend for two years and divesting its African business in favour of a transformed and ringfenced ‘transatlantic’ investment bank.

Royal Bank of Scotland, too, is still struggling to stride clear of the legacy of the financial crisis, despite sweeping cuts to its own investment bank as it retreats to focus on its European and UK clients.

The UK banking sector is now experiencing a big divergence in strategies between its major players. 

“The main issue for the group is no longer capital, as some remark, but earnings and returns,” said Barclays chairman John McFarlane, alongside his bank’s results.

You could copy and paste those comments and stick them at the top of most banks’ results presentations this year.

The five biggest UK banks made just less than £18bn in pre-tax profits between them in 2015, and £12.3bn of that was at HSBC.

Bank paper is normally a nice play for investors on a growing economy like the UK’s, but globally institutions are faced with an unprecedented low interest rate environment, unprecedented capital requirements and an unprecedented era of messy central bank policy.

A number of more UK-specific challenges remain on the horizon, such as ringfencing and the global effort to harmonise risk-weighted asset calculations, which could make life difficult for some of the bigger mortgage lenders in particular.

But it is currently pretty much impossible to see that horizon, because of the game-changing decision UK citizens are being asked to make on June 23.

On that day voters will be asked whether they want to remain part of the European Union or not, and a ‘Brexit’ would simply tear up any plans made for the next few years.

That goes both for the banks, and for the City they have played a big part in transforming beyond all recognition since the 1970s.

Banking on a Brexit

4.3

FIG DCM bankers are split on the impact of a Brexit on their ability to sell the UK banks’ credit stories.

Many believe a UK free from European law would in the longer term be beneficial, or at least not detrimental, for the banking sector, particularly given the Bank of England’s apparent willingness to “take its foot off the throats of the banks”, in the words of one London-based bank capital specialist.

They wonder, for example, whether UK regulators, left to their own devices, would impose anything like MREL on the country’s smaller lenders, which they are keen to support to foster greater competition in the domestic retail market.

Still more say they simply haven’t yet heard a convincing argument why financial services activity would start draining away from London after a Brexit.

“The Brexit impact has been described by some as a tick shaped curve, so you will see a downturn in the economy because of the initial uncertainty, but then a bounce that exceeds the drop thereafter,” says Tobin at RBC. 

“I’m a little more nervous that actually that uptick is more challenging to deliver than those that argue the Brexit case maintain.”

Into the unknown

He isn’t the only one. A majority of bankers and other City professionals — and certainly the banks themselves — don’t even want to contemplate the event and there are several risks they can point to with ever increasing anxiety in the lead up to June 23.

The first is the potential impact on the still fragile UK economic recovery. The UK would have a two year grace period where its legal relationship with the EU would be unaffected, but the uncertainty would likely be catastrophic for business investment at home.

RBC reckons 2%-4% would be knocked off UK GDP in the two to three years following the move.

“The access to Europe is absolutely critical in financial services,” says Etay Katz, a partner at Allen & Overy in London.

“The UK will start incrementally losing its gravity as a financial centre. We would have a different regime, which would affect the ease with which we can provide cross-border services from the UK. And your ability to leverage a successful business in the UK, for example, by expanding with branches in Europe, would be very much thrown into doubt.”

If the race stays close, there will be a glimpse of this uncertainty in the second quarter of this year, as businesses put plans on hold until the outcome is known.

The buyside has already shown its hand. Sterling dropped 2% against the dollar on the morning of February 22, the day after London mayor Boris Johnson confirmed he would be campaigning for an exit.

Second, there is a risk that uncertainty will not just impact the banks’ clients, but the banks themselves. “The business environment for UK banks would be vague at best,” says Katz. “UK banks will become a more jittery investment. The uncertainty is not just a problem for small
businesses. If the UK is being
marginalised as a country, some of the large banks are very synonymous with the UK as a country. That’s even before drilling into issues like currency impact and exposures and how that plays into the profit margins of the institutions.

“I have no doubt that investors will look at UK banks as a different investment on day one following a Brexit.”

From a regulatory standpoint, the way ahead would be even murkier. Some proponents of Brexit
see this as a good thing — some corners of the City are hoping the move would usher in a new period of relaxed regulation in the UK, as a way for the country to keep business being done in
its capital.

The UK government fought the EU hard on bonus restrictions, they might be fighting even harder on capital requirements in the coming years if their banks are struggling against resurgent European rivals.

Brexit or Smexit?

Third, and perhaps most pertinent for UK banks, is the fate of London’s status as a financial centre, both for Europe and the world.

“In my mind there is no doubt that a Brexit would have a significant impact in boosting other major European cities as contenders to the crown of the centre of financial services in Europe,” says Katz.

4.4

“It will also lead to fragmentation. Business won’t naturally go to just Frankfurt, Paris or Milan, it will spread all over.”

This is one of the major points of contention, on which there is a wealth of opinion but absolutely no certainty. As RBC Capital Markets senior UK economist Sam Hill questioned, could there be a Brexit without a ‘Smexit’ (an exit from Europe’s Single Market)? The UK is unlikely to retain all of its single market privileges if it leaves, and it is even more unlikely that the political and legal wrangling to sort out any new relationship would only last two years. When was the last time an EU negotiation finished on time?

Senior French government officials have already warned that they could stop processing migrants in Calais and make them Britain’s problem, and that a UK-less EU would not want London to be the biggest trader of euros on the planet — it currently does $640bn per day just on the
euro-dollar pair.

Merely giving politicians the opportunity to play out a tit-for-tat power struggle seems a bad
idea already.

HSBC has suggested its large French subsidiary would allow it to continue trading unaffected, and Barclays also believes it has European entities that could provide protection from new cross-border services passport laws.

But it is equally valid to argue that the European Central Bank could claim it didn’t trust the PRA to supervise banks to European standards, and force those banks to hold more capital and liquidity at the local level, destroying any competitive advantage they had left.

And Katz is unequivocal about the wisdom of opening that can of worms. “A Brexit is negative in the short, medium and long term from a financial services business perspective,” says Katz.

“The role Europe plays in London being an attractive place to do business is very substantial. The argument that over time that effect recedes, for me, is a fantasy.”    

By Tom Porter
23 Mar 2016