All material subject to strictly enforced copyright laws. © 2022 Euromoney Institutional Investor PLC group

Bank investing: too many variables, not enough time

Bank investors haven’t had an easy ride over the past few years. Primary supply is down but cash is building up and it has to be put to work somewhere.

But the goalposts are forever moving as new regulation fundamentally alters the dynamics of investing in bank debt. EuroWeek assembled a crack team of investors and bankers at the Bank Finance Investors’ Roundtable in London to discuss the myriad challenges facing buyers of bank paper.

Participants in the roundtable were:

Georgina Aspden, executive director, global fixed income and currency, Goldman Sachs Asset Management

Stefan Deirmendijan, head of European fixed income flow sales, Natixis

Peter Doherty, partner, Tideway Investment Partners

Roger Doig, FIG research analyst, Schroders

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

Denis Rath, FIG debt syndicate manager, Commerzbank

Pieter Van Rosenburgh, head of bonds and solutions sales, Commerzbank

Will Caiger-Smith, moderator, EuroWeek

EUROWEEK: One of the biggest concerns for investors in an age of new regulation is bail-in, which effectively turns senior debt into a form of capital, at the behest of regulators, whether it’s national regulators or the European Central Bank, which it will be soon. So I’d like to start off by asking you all whether you think the reality of bail-in has truly sunk in for investors.

Pieter Van Rosenburgh, Commerzbank: I actually think it has, and very much so. But to first go back to your point, I think if you lend to somebody you always have to worry whether you have to get your money back. It doesn’t matter whether it’s capital, or senior lending. The principle is providing credit, and senior unsecured, or even putting a deposit somewhere, involves making a credit decision. That’s something we forgot sometime in the late 1990s, and we only woke up in 2008 with Lehman to realise that we have to make credit decisions all the time.

In the Netherlands we learned about bail-in very early on, because we had DSB Bank which went bankrupt, and everybody with deposits above €100,000 actually did lose their money. And, of course, we’ve just recently experienced SNS Reaal. The Dutch minister of finance, Jeroen Dijsselbloem, is probably one of the main proponents of making sure the taxpayer doesn’t always have to pick up the bill. He is very much pointing out that people have to make credit decisions.

So definitely in the Netherlands people do that, but also elsewhere. A lot of the senior unsecured investors do as well. We got incredibly lucky after the initial crisis in that all these sovereigns were willing to step up to the plate and really get us out of a tight spot. I think people do realise.

Denis Rath, Commerzbank: In primary markets I have to say that we don’t really price it in at the moment. We’re still pricing off secondary market levels. And whether you look at 2018 or 2016, the newly proposed date for bail-in implementation, you don’t really see any kind of bump in the curve. So at the moment I would say in the primary market investors aren’t demanding any extra premium. 

Core senior unsecured spreads are still pretty close to where covered bonds are trading. At some point they will probably trade away from that, closer to lower tier two, but we’re not yet at that point so there is still room for senior spreads to widen.

Roger Doig, Schroders: I can’t see that’s the right conclusion from an investor point of view. I think the fact that there is no obvious bump in the curve tells you that bail-in has been accepted and there won’t be any significant shift. In a distressed environment today, senior will get bailed in.

There’s no reason to think that 2015 or 2018 is a date that makes a material difference. It’s being priced in. The fact that there’s very little credit spread in senior in the safest banks is because they are the safest banks, and the strongest capitalised. Credit risk is clearly present in certain senior spreads, but that’s because those banks are in countries where there is a material credit risk coming from their economic exposure or their sovereign exposure.

Rath, Commerzbank: I agree but senior spreads are to some extent also driven by a simple technical factor. Supply has been lower than expected this year and will probably stay low, so that plays a role in working out where new issues should price and if supply does not increase there will always be this technical support for senior unsecured, which is probably keeping core spreads lower than they should be at the moment. But to determine whether spreads are likely to move we need to take a look at the spread between senior and lower tier two. There’s still a lot more room for the spread to decrease, especially when you compare it to some other markets where depositor preference is already well established.  

The differential between senior and lower tier two spreads is around 100bp in core Europe. In the US, it is about half that. Just looking at the difference between these two markets leads me to think that there is still room for senior spreads to widen.

Peter Doherty, Tideway Investment Partners: The risk of getting bailed in is very much priced as an eventuality that is a long way out of the money. I’d be interested to see it in specific situations. Who knows what will happen with the Co-op? Who knows when the next bank that is going to fall over? If someone gets bailed in that might raise people’s awareness about it actually happening. What’s interesting about SNS Reaal, for example, with sub debt being wiped out, is that there are some legal challenges to bail-in.

But what is happening to senior there? Is there a mark-down? Is there a write-down? What is the recovery rate? We haven’t really had a situation where the recovery rate on a lower tier two bond is X and the recovery rate on a senior bond is Y.


EUROWEEK: They decided they weren’t going to hit the senior at all. That was a conscious decision from Dijsselbloem. He said he was afraid about the effect on the primary funding markets for other Dutch banks.

Doherty, Tideway: But isn’t that a complete contradiction of bail-in?

Van Rosenburgh, Commerzbank: Yes and no, because if you have a deposit above €100,000 you will be hit, because you’re not covered by the deposit guarantee. I think what the government in the Netherlands is suggesting is that your recovery rate on your capital’s going to be zero because they valued it at that, and that’s what all the court cases are about. And actually it’s been recommended that it goes to court, so we’re going to see how that works out.  

But with SNS, Dijsselbloem was the first one to say this is where we need to go. That he didn’t totally live up to his words was perhaps not entirely his call, but a result of other factors.

EUROWEEK: So there are cases where depositors have actually been subordinated to senior bondholders, then?

Van Rosenburgh, Commerzbank: If you’ve got a deposit larger than €100,000 you’re effectively a subordinated debt holder. And that’s exactly what happened in DSB — they lost their money, while all the other ones covered by the deposit guarantee did not.

EUROWEEK: Isn’t that a perverting of the capital structure, though? Because if depositor preference is in play then you should not really be any worse off than senior.

Van Rosenburgh, Commerzbank: I go back to my first point. It’s like if you lend money to somebody, be that senior or subordinated. You have to ask yourself, am I going to get my money back?  Just because it’s called senior and you’re senior to somebody who’s below you doesn’t mean you still have to get all your money back. Does that make it capital or not?

EUROWEEK: Understood. But you would at least expect to be treated the same as everyone else.  If you’re a depositor above €100,000 and you’re losing money, but the senior bondholders aren’t, that’s quite a perverse situation to find yourself in.

Van Rosenburgh, Commerzbank: That’s a very interesting topic in itself. Should you have deposit guarantees? Why are they there? They were a reaction to the big depression in the US. When we started this whole process in 2007 I think the deposit guarantee was at €35,000, around that level.

And now we’re at €100,000. Why did that happen? And why did we provide all these sovereign guarantees and create the sovereign crisis? These are very good questions to ask because basically what we decided is to absolve senior investors from taking responsibility for their investments.

Georgina Aspden, Goldman Sachs Asset Management: What you’re pointing to is the power of contagion and I think it’s very strong, so the point of depositor preference is to prevent contagion and prevent deposit runs on banks. Since SNS we haven’t seen a significant underperformance of senior unsecured, in that there hasn’t been a significant step change to say that it can be bailed in. What SNS showed is that ultimately senior unsecured seems to be, for whatever reason, protected by this fear of contagion.  

Now, I don’t think that’s necessarily rational, or whether it’s the interpretation you should have according to the legislation that is now in place — but it seems to be the way things are. I recognise bail-in risk, but the probability of getting to the point of actually incurring losses or bail-in is very low, which goes back to your point about credit. But I don’t even think it’s necessarily a reflection on credit. It’s a reflection on the jurisdiction that the banks are operating in because there are still different country preferences as to whether you have a situation like Cyprus, where they don’t have control over bail-in, versus, say, France or Germany, where they do.

Robert Kendrick, Legal & General Asset Management: That point on contagion is a good one insofar as everybody’s been talking about bail-in for several years now and everyone round this table is clear that, yes, we’ll potentially get bailed in if something goes wrong, but no one’s really certain about it. And there’s a pretty good chance that if BNP Paribas or Deutsche Bank or a really big core bank found itself in big trouble, the French or German authorities wouldn’t have the bottle to say, right, ‘here is several hundred billion euros of senior debt that we’re going to write down’. What happens to the rest of the banking sector and the economy then when that happens?

Doig, Schroders: So you think there’s still an implicit sovereign guarantee?

Kendrick, L&G: Yes. Of course there is.

Van Rosenburgh, Commerzbank: If you look at the one country where they let a big one go, it was the US, with Lehman Brothers. If you look at the spread between subordinated and senior there and actually spreads in general, it’s tighter than what we have here in Europe and we’ve been muddling along with all kinds of government support.

Doig, Schroders: But there is a major structural difference, in that the senior at Lehman was issued out of a holding company, whereas the problem you have in Europe is a lot of your senior debt is still pari passu with deposits. A lot of the work on the recovery and resolution directive over the course of this year has been attempting to break that link between deposits, whether guaranteed or unguaranteed, and senior unsecured. But as far as I understand it, currently it’s still the case that corporate deposits, which are likely to be the flightiest and most destabilising, remain pari passu with senior unsecured, which for me leaves an unprecedented level of support because the last thing authorities want to do in the event of a crisis is to destabilise the banks’ funding by saying corporate deposits will be bailed in.

Doherty, Tideway: When you think about it, €100,000 is a trivially small amount of money, isn’t it, really? If you’re a corporation or even an individual you’re not going to have 15 or 20 accounts at a bank, are you, just because you want to have €100,000 each? I agree. I think there’s an implicit level of support.

Doig, Schroders: They’re also introducing this concept of SME money being super-senior as well. They’re trying to reshape the capital structure. Probably retroactively after SNS and after Cyprus they’re trying to work out how to actually legally subordinate senior unsecured versus flightier types of senior credit. But for the moment they are at a stage where it’s still the case that senior unsecured is pari passu with corporate deposits and while that remains the case I would say that the implicit support is absolutely there.

Rath, Commerzbank: But isn’t this why we’re discussing whether it has been priced in or not? Because it’s still so vague and regulation has become one of the most important risk factors because it’s due to change at any point, and we don’t really have a say. In the end it’s up to politicians and their current interests, so when it comes down to unsecured deposits versus secured deposits I think the individual bank account holder, whether they have €100,000 in their account or €150,000 in their account, will be bailed out by the government. When you want to get re-elected you are not going to impose some kind of threshold. And on top of that I think deposits above €100,000 don’t really make a big difference. The most meaningful number of individual deposits are below €100,000 anyway.

Stefan Deirmendijan, Natixis: Anyway, we’re talking about something that should be implemented in five years’ time, and when we talk about bail-in pricing I would say that I agree with you, it’s priced. If you compare it to non-financial credits of an equivalent rating, you have on average, in Europe, about a 60bp pick-up in senior CDS. There are technical factors that also put some discrepancy into the spread, but of course there is also an uplift from the ratings agency, systemic support. But above that there is the consideration of your equity and sub debt versus balance sheet ratio. If that reaches 8% the regulator will have the choice to bail-in or not bail-in the senior bondholders.  

The risk of bail-in is priced in. But there are still a lot of uncertainties until 2018, even if politically we can assume that everything could be done before then. But in the end, I’m pretty sure that most of the banks will stick to this 8% target.

Kendrick, L&G: This 8% number is a complete red herring, though. Some banks are trying to hide behind it and say ‘we’ll have more than 8% sub debt, so our senior is safe’. That’s wrong. If that bank gets in trouble and losses end up being bigger, all the 8% says is that they definitely have to take that amount of loss before the government is able to get involved. But it doesn’t mean the government is obliged to put more capital in at the 8% point. The creditors may just have to take the hit irrespective. Just because you’re senior, doesn’t mean you’re protected.

Deirmendijan, Natixis: Yes, but there’s one point in the regulation that says something very strong. For the avoidance of contagion, the regulator will have the option of this 8%. If a bank reaches this 8%, if the regulator considers that there’s a contagion risk, it can protect individuals or corporates that have deposits above €100,000, and can protect senior bondholders. And this is very strong support. And ratings agencies today do not plan to change their state support assumptions in the near future.

EUROWEEK: What we’re clearly establishing as we go round the table here is that senior debt is an incredibly complicated asset to assess at the moment. Maybe some of the investors around the table can illuminate what methods they use to price up senior debt and assess the risks. How do you even do that? How do you build a metric for regulation that is constantly changing? The number of different interpretations we’ve just seen around this table alone suggests that it could be an incredibly difficult job.

Doig, Schroders: We always have an ensemble approach of looking at capital metrics, and banks’ asset quality metrics. If there are potential problem assets, like real estate or whatever, then that will score worse than, say, residential mortgages in a strong market. We have an assessment of their funding and an assessment of what we think the regulator would do in the event of a distress. But those are the major fundamental factors. We also, as Denis mentioned, have some significant technical factors underpinning senior, in that there’s very little senior unsecured being issued at longer tenors. 

Doherty, Tideway: I wouldn’t say it goes as directly to the valuation of senior debt, but actually reading equity research these days has become more relevant, because those guys have a much better handle on interest margins, sustainability, and viability of the business. They ask a lot more difficult questions about the viability of the business. And I think that they’re extremely useful metrics about senior. But I’m also thinking that when you go down the capital structure, it seems to me you can get paid quite well to do that, especially given the uncertainty around the recovery rate on senior. Those numbers are looking quite attractive for investors. I just wonder how much you need to get paid to take that sub risk versus senior at the moment, and if that’s enough.

EUROWEEK: I was going to ask this question. I’ve heard this discussed quite a few times in the past couple of weeks, mostly by syndicates and research analysts — the idea of investors following a ‘barbell’ investment strategy where if you feel that you’re not being compensated enough for the increased risk of bail-in with senior unsecured, you buy subordinated debt for the higher yield it offers, and then you counter that by buying covered bonds at the upper end. So you discount senior entirely and you just go for subordinated and covered, because covered bonds give you safety. Historically that has been a completely bullet-proof asset class. 

Has anyone round the table followed the same kind of strategy or do you know of any of your peers in the market that follow the same investment strategy?

Aspden, GSAM: It is certainly something you take into account when you’re looking at relative value for senior secured. You look across the capital structure. You also look at how well you would get paid in senior versus covered and the relative value there. Are you better off putting your money into covered or senior unsecured given the potential bail-in risk, given asset encumbrance, given the capital stack beneath you? It’s something we certainly take into account. 

EUROWEEK: And what is that differential? Obviously it’s going to differ from credit to credit, but is it wide enough?

Aspden, GSAM: I think the differential has changed quite a lot over the last year — covered bonds have significantly outperformed senior unsecured — and I think it’s going to continue to do so. The differential will become wider because senior unsecured will continue to underperform. Is it enough? I think there’s not enough disclosure from banks at the moment to determine that. And that’s another topic, the levels of disclosure that you need to calculate your risks in bail-in, because part of that is what assets you get in a recovery scenario.  

And there’s not enough disclosure from banks to properly assess what assets you actually have in those eventualities. You may have very little because of all of the encumbrance that goes on that is not actually on balance sheets — not just through ECB funding or LTRO, but also bilateral trades, covered bond funding, securitisation, etc. A lot of that is not necessarily disclosed. Disclosure is improving, but it’s not there yet.

EUROWEEK: That was something that I wanted to touch on later, disclosure. But can I just open up the barbell question to the rest of the table to see if anyone has an opinion?

Doig, Schroders: We specifically deal with credit funds rather than more aggregate things for most of our investments, so the barbell doesn’t make a lot of sense for us, in that covered bonds as of today have certainly no credit risk and they offer very little return. So you’d probably just go with subordinated debt, one side of the barbell.

But that’s to do with where spreads in covered bonds are at the moment. Senior, for the most part, has very little credit risk left in it. In the strongest jurisdictions I don’t think the credit risk for senior is going to increase. If anything, the continued build-up of capital will be reducing that credit risk over time. So yes, I understand that senior has underperformed a bit over the last year or so, but if you did do a barbell you’d probably barbell senior with subordinated debt.

Van Rosenburgh, Commerzbank: Let me make two observations there. The covered bond market is the mainstay of the German insurance business and always has been. You just said the covered bond market is a bullet-proof asset, but FMS Wertmanagement and Erste Abwicklungsanstalt are the living testimony that we didn’t want that bulletproof nature to be tested. The German government put several hundred billion euros out there to make sure that the covered bond concept was not tested, because if we had brought those issuers to a liquidation then we would have found out whether the covered bond really worked in practice. We decided to put it on the government’s balance sheet to prove that it was bulletproof.

Doig, Schroders: I don’t think the market always thinks that covered bonds are bulletproof. You look at the pricing you’ve had of Cédulas over the last few years and you can see that there was a substantial credit risk being implied because of the underlying collateral, and because of the sovereign risks around certain banks. I think covered bonds are interesting tools at certain times and for certain funds because they are explicitly outside the bankruptcy estate of the bank, which means that as they move towards maturity their implicit rating is increasing all the time. 

I think covered bonds at certain occasions have credit risk pressed into them, which becomes an interesting opportunity versus senior and other asset classes. But as of today, for most jurisdictions in Germany or in France, you’re getting very little credit spread. I think the differential in spreads has been driven by the fact that there’s a dedicated investor base for the triple-A credits and because of technical factors driving spreads tighter.

Kendrick, L&G: Maybe we have to take a step back and think why is anyone asking this question or suggesting that strategy? I think it comes down to the difficulty in valuing senior debt. If you go back to fundamentals, and what should drive credit spreads, it’s probability of default and loss-given default. 

The probability of default can be split into the probability of reaching the point of non-viability and the probability of the bank getting bailed out if it does reach that point of non-viability. People have already talked about the many different ways that you can work out the viability of the bank and the likelihood of it reaching some sort of point of non-viability. But it’s almost impossible to second guess whether the government will blink and bail the bank out or not. 

For sub debt and covered bonds it doesn’t really matter whether or not the bank is bailed out. So much effort has been thrown behind making sure that covered definitely won’t get bailed in and even if the bank is bailed out it is safe to assume that this will only be after sub debt has been wiped out. We know from examples of where senior has effectively defaulted that recoveries have been anywhere between zero and 99. That doesn’t really help. 

So that difficulty of working out your recovery and your likelihood of being bailed in are unique to senior debt. You’re taking out a lot of uncertainty by going down the barbell route, so I suppose that’s why it’s attractive. But it doesn’t solve the problem that the senior funding market is big, banks are very reliant on senior funding, and investors fundamentally don’t understand how to value that.

EUROWEEK: Pieter, you alluded briefly to asset encumbrance. Is asset encumbrance something that investors worry about quite significantly when looking at senior?

Van Rosenburgh, Commerzbank: Yes, absolutely. Any investor is going to try to figure out what’s left for them in a liquidation, and then I think another very important factor, which Georgina already alluded to, is that it’s not only transparency in terms of capital ratios, it’s also transparency of asset quality, because that’s obviously your loss-given default calculation. Both those aspects are important.

Rath, Commerzbank: You mentioned that we are looking at covered bonds as a pure rates product again, which I think to some extent is true. I guess it does depend on the jurisdiction and, yes, the underlying assets. Asset encumbrance is a very important topic for senior unsecured investors because the more assets are encumbered, the worse off you are, but on the other hand a higher level of encumbered assets is always seen as positive for covered bond investors. But no one really talks about the quality of these assets because most pools are dynamic.

Doig, Schroders: There’s very little agreement on exactly how to measure it, and the big problem with asset encumbrance, particularly where you’ve got a lot of covered bonds, is that it is dynamic. As the underlying asset quality deteriorates, the more collateral you are potentially taking away from the senior. I don’t think there is any consistency of approach in reporting it. 

It is an area of significant uncertainty, partly because the reporting is not particularly transparent, and also partly because there aren’t any real set standards about what we should be concerned about. Regulators are very clear that they are looking at this. I think we will see a lot from the regulatory side about how they’re looking at asset encumbrance and that will also guide the debate among investors in terms of how to approach it. It will drive consistency of reporting and the like. 

Doherty, Tideway: Think of a struggling bank, typically in southern Europe, I suppose. NPLs are possibly under-reported, or unreported in some jurisdictions.  There was a covered issue recently from an Italian bank and I thought the spread on that was probably as much as they’re earning in the entire business, and that’s on an encumbered, low leverage product. 

So they’ve got a negative business model — they’re losing money on assets, they’re funding themselves at higher cost than they’re earning — what’s left in the middle? That’s going to be a slow bleed for years until someone says they’re bust.  

Van Rosenburgh, Commerzbank: Going back to equity research, discounts to book speak volumes as well. 

If you can see very deep discounts to book, basically the equity market is telling you we’re not really sure how big that skeleton in your closet is.

Doig, Schroders: It’s quite ironic you’re saying that. A few years ago the equity market was looking at CDS spreads as a measure.

EUROWEEK: I guess what this boils down to is something that also came up in the issuer roundtable. Are people really looking at loss-given default in a serious way at the moment, or are they investing more on probability of default?

Doig, Schroders: My personal view is that loss-given default for any capital instrument is zero now. Most senior investors buy senior because they’re getting a spread for providing tenor, and they’re getting a spread for providing liquidity. They’re not really betting on the probability of default, and they’re certainly not looking at what the recovery value afterwards is going to be. So it’s not surprising, from the point of view of a senior investor, that you’re going to be looking first and foremost at the probability of default.  

Doherty, Tideway: It’s just the lack of uniform information. Two big opportunities have been missed in recent times. One is to standardise capital structures and reporting. Maybe that will come with the single regulator, but at the moment it is just very hard to compare a bank in France or Italy to the UK or to Germany. And the second thing, which is related, is that new instruments, particularly Cocos, are so diverse. There are already so many different examples, and it’s very hard to price in this trigger, that trigger, risk-weighted asset triggers, non-viability points, all those things. What’s the value of getting equity versus getting written off? You’ve immediately got a very idiosyncratic market and that shouldn’t happen. It’s hard work just to value those new instruments. One of the new things that could have come out of the whole process was a uniform framework which we just haven’t got.

EUROWEEK: This comes back to the question I wanted to ask about disclosure. Conventional wisdom would say that issuers should be building up buffers of tier two debt to protect senior bondholders from bail-in. We’ve already seen some banks being very vocal about doing that, like Rabobank. But some issuers have said there is no cost benefit to doing that.

At the issuer roundtable for this report, one issuer was saying that is because investors don’t do enough work with the figures that banks put out. It’s not difficult to find investors that will say that banks don’t give enough disclosure. But he was saying that there is a lot more disclosure and it’s the way that the numbers are digested, or the lack of digestion, that’s the problem. So do the investors round the table think banks disclose enough information, and do you think investors digest those numbers properly?

Doig, Schroders: For most banks, any incremental capital is going to make no difference to senior spreads. That point will vary by bank, for sure, but the assessment will ultimately come down to whether there are assets on that bank’s balance sheet which you think are materially working against price, either because they are under-reporting losses which are there today or losses which you think may be there in the future. So first of all, do you think there are any asset quality problems? Secondly, do you think there are any material funding problems facing the bank? If you’re happy with the capital, happy with the overall leverage, and happy with the asset quality, then having a 15% capital ratio versus 18% makes no difference.

Aspden, GSAM: I agree with you, but I think total capital is an important issue at the moment and it’s no longer enough just to have an adequate core tier one capital ratio. The reason it’s important is because of recovery and resolution and whether or not you say it’s priced into senior unsecured at the moment. There’s a reason regulators are talking about bail-inable debt and having a certain amount of it.

Now, to what that issuer was saying, I think the reality is we’re expecting some form of bail-inable debt and at the moment, outstanding senior unsecured is not necessarily considered bail-inable, because it is not contractually bail-inable.  

If regulators are going to require issuers to issue contractually bail-inable debt, be it subordinated, senior or whatever, to make sure that they have enough of a buffer to total capital, then that’s when investors will get concerned about how much that buffer is, and issuers will need to pay up for that. But at the moment we’re still in a place where senior unsecured is considered to be sacrosanct because of SNS and contagion fears. It’s not really bail-inable. Subordinated debt is bail-inable but there’s not much of it yet. Look at the UK regime. There’s a reason all these banks are having to build up PLAC (primary loss absorbing capital) buffers — it’s because core tier one isn’t enough. Banks are going to have to start doing that, whether it is with subordinated debt or Cocos or whatever. 

Banks that are doing that want to defend their senior unsecured levels. There are other banks that have such a low probability of bail-in that they don’t need to because if they’re in a regime where senior unsecured is always going to bailed out, it doesn’t make a difference if you’re at a 15% or an 18% capital ratio.  

Rath, Commerzbank: That’s a very valid point that you mentioned, the fact that they have to defend their levels. It’s obvious that issuing more lower tier two will not have a positive effect on senior spreads. The market is far away from buying more senior just because there’s more lower tier two debt outstanding at a certain bank. But as I said earlier spreads will move towards lower tier two at some point. So, at the moment the more subordinated debt you have out there will definitely help defend your levels, but it’s not going to make senior any cheaper for you — in fact it’s probably a rather cheap source of funding now.

Doig, Schroders: As we said before, it’s dynamic. At the moment I think most people would say that Scandinavian banks’ senior is very well supported with extra capital. But if you did have a situation where residential mortgage losses in Scandinavia were expected to change, then that perception would change. 

EUROWEEK: Do you think that some banks, particularly in the periphery, are divorced from a rational assessment of where they should be trading in senior because of where the sovereign trades? Take Italian banks, Spanish banks, for example — is it fair that they trade more in line with the sovereign?

Doig, Schroders: Yes, of course, because the largest single credit disclosure on the balance sheet is going to be Italian government bonds. Naturally there’s a correlation and there will be until you have Eurobonds or something like that. There’s no argument on that.  

If the credit risk in Italian government bonds disappeared, it would disappear for the banks as well. But I think most people still perceive there to be a remote credit risk in the Italian government.

EUROWEEK: But what about BBVA which has a large portion of its balance sheet outside Spain? Or UniCredit, which has large German and eastern European operations? 

Rath, Commerzbank: The national champions in the southern European countries obviously have some kind of advantage over their smaller peers, just because their business model’s a bit more global. If they run into problems at one end, hopefully they can make up for it at the other end. That’s why you see a differential between the top one or two names out of Italy, Spain and other non-core countries, and lower tier banks in those same countries but credit spreads in those countries are still very much driven by the sovereign.

Doherty, Tideway: And that differential is getting wider. I would point out that it’s often down to the way they’ve solved the problem. So UniCredit had to do a massive rights issue and that’s helped their bond spreads. Who would buy equity in smaller regional banks? Not many people. BBVA were able to issue an additional tier one Coco — that shows that people have the confidence to actually buy a high-risk instrument, that they could do something and didn’t need to do equity.  

So it’s almost like you see this tiering borne out in terms of what you can do. In the worst cases, you’ve got banks which can only issue covered bonds or go to the ECB.  There’s a whole bunch of banks out there where you wouldn’t touch a lower tier two in the next 10 years unless they gave significant clarity on their balance sheet, write-downs, and everything else. You mentioned the correlation between Italian banks and the Italian government — there’s implicit support there. But what could the first big negative credit event be in Italy?

Van Rosenburgh, Commerzbank: Probably the single largest one out there is Banca Monte de Paschi, and I think we’re halfway through containing that problem. At the higher level we need to break the circle between that implicit sovereign support, which created a sovereign crisis. That is the whole correlation you’re talking about and that that’s what a lot of people are focused on.

To get back to the Italian thing, we’re coming to a point in the market where Spain is almost flat with Italy. I think we’re starting to normalise.

Even the Berlusconi thing might be affecting BTPs a little bit at the moment, but people are starting to realise that we’re going to go through with this euro experiment. We will have these resolution measures. And over time countries will recover and we will divorce the sovereign credit risk more and more from the banks. With that, Monte de Paschi is going to be OK. I’m more concerned about whether there is something in Spain that may come and haunt us. 

Doherty, Tideway: The thing is, you only break the circle if your private investors, including equity, sub debt and potentially senior, are going to take losses. Lehman is always talked about, but don’t forget that Lehman wasn’t the only bank in the US to go bust — you also had Washington Mutual, which was a huge write-off. Some big numbers have been written off, and the US bounced back. I just don’t think we’ve quite got there in Europe yet. SNS is a good example, but I think in southern Europe we’re still limping along without actually taking the hit.  

EUROWEEK: Peter, you mentioned the BBVA AT1 deal. Obviously this is a burgeoning asset class that’s going to become a lot more important in the years and months to come, but for investors it must be incredibly complex to assess the risks involved. Forget valuing senior unsecured — how do you go about valuing a Coco? There are so many different factors in terms of when it could be written down, where it should price, where its equity conversion should price versus temporary write-down or permanent write-down.  

Doig, Schroders: There are instruments with two valuation bases. There’s the good valuation basis in which you have a coupon of X and a call. And it will be called because it’s trading above par. Then you have the second valuation which is the stressed one, where you have no coupon, you have a perpetual instrument in which the starting point is zero and then there’s an option value on top of that. So the problem with the instrument is the gap between those two valuation bases. There’s no valuation support in between — it’s neutral. That makes it very difficult to put. 

Doherty, Tideway: I don’t want to pick on any one particular issuer, but I went to the Crédit Agricole Coco presentation and what was very strange was that they have a smaller percentage gap between their current tier one equity ratio and the trigger than Société Générale. And they made the point three or four times that their buffer was bigger because it was a bigger number in absolute terms. It was just insane. 

That was just not very smart in public at a lunch. And to me, the write-off deals are bordering on madness for the investor. You really are subordinated to equity. I don’t know why you would ever buy that unless you’re getting paid enormous amounts in the meantime, and that’s a very remote possibility. It comes back to the binary argument — someone’s got to give you something that’s extremely unlikely to happen, and you’re getting paid for that.

But you want equity. You want to own something and stay in the game. Write-off doesn’t make sense. I just don’t think you’re getting paid enough, not with high single digit coupons.

Kendrick, L&G: We’ve been quite vocal in the past about this. The permanent write-off deals are insane. I agree with what you said, Peter. Unless you get paid a significant coupon, above the realistic cost of equity, then they’re useless. And I’m very wary of the temporary write-down structure at SocGen. Essentially it’s permanent write-down with a bit of window-dressing.  

Nevertheless, they managed to get a very good book for that and they probably got it 50bp cheaper than if it had been permanent write-down, so good luck to them. But really it’s just as bad. The equity conversion deals are a little bit more investor friendly, but even if the bank has 2% or 3% of risk-weighted assets in these instruments, if the bank gets into trouble these things are wiped out already. It’s just a way that banks are desperately hoping to leverage their ROE. Regulators should just insist on proper levels of core equity, and sub debt should be there to support the bank through resolution, not on a going concern basis.  

Deirmendijan, Natixis: But you can’t deny issuers the right to find a way to raise capital at a cheaper level. 

Aspden, GSAM: I agree with you in the long-term, but over the short-term we’re in an environment where as European risk recedes, banks are strengthening, capital’s growing, liquidity is strengthening — so really we’re going to be in a more credit-positive, friendly environment over the next two to three years. 

And if you look at these instruments with just that timeframe and do a relative valuation across the capital structure, looking at equity, what you’re expecting to get for return on equity in these banks is dire. So, from an equity perspective, I can see why if you had a fund that could do both, you might look at the relative value  and think I’d prefer to have a fixed coupon of 8% or for the next three years because it’s looks a better reward for the risk.

EUROWEEK: You were saying that we’re in a more credit-positive environment and things are starting to improve. But surely we have to admit that most of that recovery has been driven by central bank liquidity, things like the LTRO, QE, to a lesser extent the FLS in the UK and other such measures. Liquidity is no longer based on fundamentals — it’s based on an assumption of central bank support that one day is going to have to disappear.

Aspden, GSAM: You’re talking about liquidity in the system, and I agree with you that that has been supported by extraordinary measures that need to come out eventually. What we’ve seen with the Fed and possible tapering is that the regulators and the Central Bank are not causing an undue amount of volatility in trying to remove that. In Europe I wouldn’t argue that we’re in a strong enough economic position to be able to withdraw any of that support in the near term. But in terms of liquidity in banks, the question of funding, and risk to the banks, they are managing their liquidity buffers and their funding ratios, their asset liability mismatches, much better than they were before the crisis.

That’s something that has been a real about-turn, not just driven by regulators but by the banks themselves. I don’t think that the amount of liquidity injected into the system over the last three years or so has actually caused that strengthening of liquidity and banks’ balance sheets. So I don’t think, as you reverse that support, banks’ balance sheets are going to become riskier in terms of liquidity. They’re not going to erode their own liquidity buffers or increase the asset liability mismatch to the extent that they’re going to cause undue liquidity risks more than they had pre-crisis. I think they’re two separate issues — the amount of liquidity in the system, and the amount of liquidity you can run on your balance sheet. Because that’s actually just how you structure your asset liability in terms of your business model, and I think banks are much more focused on that now, not having models where they are very heavily reliant on very short term wholesale funding.  

EUROWEEK: I guess the point I’m making is more in terms of the way the market functions, and price. Are we not looking towards a fairly fundamental correction?

Doherty, Tideway: Well, there are two factors. I think the biggest macro factor in European banks is they’re shrinking. We’re about halfway to the €5tr of deleveraging that needs to be done. Some €2.5tr-€3tr of stuff still has to roll off over the next five years. So there’s a big deleveraging to come. I can’t help thinking that senior spreads are extremely supported by the LTRO and that has to run off eventually. But they may just keep on doing the LTRO for a long time. You can’t say it’s going to happen overnight, but it is an extraordinary measure. Banks have shrinking needs for liquidity, and there is ample liquidity provided by the central bank — those things have got to be supporting senior spreads. And in terms of banks building up capital, that is all fantastic but they’re just getting to a minimum requirement really, a new minimum requirement that’s higher than before. I’d pick on the insurers as a much better run, much more solid industry, with the exception of AIG, which was a complete one-off.

Doig, Schroders: But if your question is: ‘Does liquidity cause a problem for European banks?’, I think it’s absolutely to do with how they handle the LTRO roll-off. Clearly, a lot of that is the Italian and Spanish banks. That money, in theory, has to be replaced by private sector funding. If they take a very hard line and say you have to replace it then, clearly, that’s going to widen credits in those countries. If they actually do what I think most of us would expect, which is allow some form of open-ended central bank liquidity for the banks which need it, then it would be a much smoother process.

Van Rosenburgh, Commerzbank: I think that’s exactly what’s going on. There was a treasury conference yesterday in Canary Wharf, and I had the pleasure of having quite a few of the German treasurers for dinner. What Georgina said about asset liability matching is interesting. There’s a whole industry developed around your liquidity modelling, and now they’re sharing their models. It’s not even proprietary. There are seven banks who are saying ‘this is how we model it’ and they have a discussion about their models. So the industry is almost sharing knowledge. Over dinner, I said to them, ‘your job has become a lot more interesting because of the crisis, because seven years ago money was money and everybody said treasury is not that interesting’. Now, suddenly, it’s a whole industry, with specialists going from one bank to the other. The other thing is I asked them was about the LTRO and the Germans said, ‘there will be another one but it’s not for us anymore. Right now, we cannot pledge any of that stuff. We can pledge Bunds, then we can get other stuff, but it’s not going to work’. I think the ECB will come in, perhaps with another LTRO very much focused on southern Europe, and other banks will be able to use it but they will be penalised. I think the ECB is much more on top of things than we think in terms of taking that extra liquidity out of the system. It is in much better shape than the Fed, which has almost been abusing the reserve currency status and just been flooding it, and has now become the prisoner of its own situation, where they’ve got the whole of the emerging markets depending on their monetary policy.

Rath, Commerzbank: I hope that’s true. But at some point, if you take that kind of liquidity out of the market, it will have an effect on pricing and on the market as a whole. At some point, banks have to think about how they communicate that they are actually better banks and that the crisis has led to something positive, like shrinking of the balance sheets and the reduction of other significant risk factors. If they manage to communicate that in a certain, standardised way, over the next couple of years, then maybe they have a chance of remaining where they currently are in the market pricewise.

Doherty, Tideway: I think that’s quite a long way away. It’s three, four, five years away. Then the question is surely they can come to market but do they have a viable business given the levels at which they’re funding themselves. They’ve got issues to work through, but they’re literally on life support from the LTRO. Or is that too harsh?

Kendrick, L&G: Yes, they are. They’re unlikely to go back to normal until they’ve worked through their bad assets. Many of the Italian banks, even some of the big ones, have got massive hidden losses that they’re going to spend the next four or five years, or maybe longer in some cases, working through. 

Doig, Schroders: The Spanish have done a huge amount. The problem is that a lot of the process of resolving the banks is shifting a fiscal burden on to the state, which these states are increasingly unable to support in the long term. So, if anything, we’re going to have a problem a couple of years down the road. It’s going to be sovereign driven, and it’s going to go back into the banks because of the liquidity portfolios. I think the only way to break it is if we get real progress not just on banking union but also on the market behind it, with Eurobonds and a proper fiscal transfer mechanism. That’s the way to do it, and that’s ultimately what you need to harmonise the cost of capital across all these countries. 

Van Rosenburgh, Commerzbank: Yes, I think you make a good point. What these countries need to do is improve their terms of trade because they lived the life for a period of the euro boom and they were taking in far too much money as income than there really was. Spain is already becoming quite competitive and you’re now seeing foreign direct investment going back into Spain, where you’ve got 24% unemployment. That has to pick up and, as it picks up, the debt will become manageable. Italy is a little bit stuck and that’s why I think it’s a bit of a problem child.

Strangely enough, Italy should have a primary surplus. There’s a lot more money than there is but what they’re not doing is changing their terms of trade.  They’re staying expensive, and that’s why diffusion of their problem is going to take much longer. Spain took a lot of pain and then started to recover. Greece is taking enormous amounts of pain, but the Italians are not that good at taking the pain. That’s why I think it could be a 10 year process, while the Spanish bank might be quicker coming back. 

EUROWEEK: Roger, you mentioned banking union. Obviously it is an epic project and it has hit numerous obstacles along the road, but as plans stand, do you think it’s a realistic goal?

Doig, Schroders: Banking union today is a supervisory union, which is great. They’re making progress for all of us. Is it realistic? Yes, it probably is. In terms of breaking the link between sovereign and banks, a single supervisory mechanism is the best way to do that but on its own it doesn’t work. To break the link, you need to have things like common collateral. You need to have a much greater fungeability of capital across the union. That’s still a long way off.

Kendrick, L&G: That’s political. It’s not a technical thing about capital ratios or anything — it’s whether people in northern Europe, particularly Germany, want to be on the hook for other people elsewhere in Europe. It needs to be sold to the populus.

Van Rosenburgh, Commerzbank: I have a hard time seeing politicians sell that at home. But with growth a lot of things will become a lot easier.

Rath, Commerzbank: At some point, you just have to get there. It will just take a lot longer than we think. It’s been five or six years and we’re just stable now. So we’re just getting started again. I think the only mistake that people are making at the moment is that they think this will be one, two, three years down the line but it’s maybe 10, 15, 20 years down the line.

Kendrick, L&G: One thing we’ve seen over the last year or two is that unless policymakers in Brussels have the market’s boot to their throat, they don’t do anything.

EUROWEEK: So how would you think the banking union could affect you, as investors? One way that it could affect you, it occurs to me, is in terms of instruments affected by point of non-viability. At least with national regulators we have some degree of past performance that we can look at. But the ECB is unknown as a regulator. It’s a completely new role for it. Could there be a step change in the risk of these instruments, when the ECB becomes the one that is in charge of pulling the trigger?

Doig, Schroders: I think there certainly could be, as the transition is made. But once they’ve done it, I think it is a step towards making banks fundamentally stronger. So it’s only a step but, potentially, if you think that the banking union, as proposed at the moment, is a stepping stone on the way to the other things we discussed, then you can take the view that you can invest with more confidence in these institutions.

Aspden, GSAM: I agree with you, and it’s positive in that you’ll have a collaboration of all the regulators into one entity. And ultimately what that gives you is an amalgamation of the spectrum of regulators. But without the history there, that’s going to be difficult.

Doig, Schroders: I think what people will fear now is that there is uncertainty around what the asset quality review and the stress test could throw up. When the Bank of England took over regulation of the UK banks, they took quite a hard line, and we saw a lot of concern around RBS and Lloyds about capital shortfalls. It’s quite conceivable, or people have a right to be fearful that, as the ECB takes over, they could take quite a hard line on certain issues towards some of the banks under their jurisdiction. But once that’s done, it should be a positive.

Doherty, Tideway: Yes, that’s the conundrum. Look at Nationwide — overnight a large part of its capital structure became a concern because it was viewed differently by the regulator. No one thinks it was badly run or fundamentally unsound, but all of a sudden it has a gargantuan project on its hands. That could throw people into a tailspin.

We use cookies to provide a personalized site experience.
By continuing to use & browse the site you agree to our Privacy Policy.
I agree