No more free lunch for bank treasurers
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No more free lunch for bank treasurers

Banks have emerged from a gruelling few years increasingly hopeful that the worst is now in the past. But they have been left with higher funding costs, especially in Europe. This has forced a rethink about funding strategies and which kinds of business they want to be involved in. Solomon Teague reports.

European FIG issuance has been notably low this year across a range of asset classes, from senior unsecured to covered bonds. Wholesale funding is also down. But this is not evidence of a lack of access to the markets, says Chris Hittmair, head of European FIG DCM at HSBC. 

It is, to a great extent, a byproduct of bank deleveraging. Bank funding needs have been decreasing, with many scaling back their activities and running off their non-core portfolios. “It is not about want, it is about need,” says Hittmair. 

Deleveraging has occurred against a backdrop of considerable regulatory uncertainty. In particular, new European bail-in rules have shaken traditional assumptions about bank capital structures to the core, forcing investors to reassess where risk resides, and where they can find sanctuary. 

Although investors say they are up to speed with bail-in, many feel that the increased risks it implies are yet to be fully reflected in funding costs. There is still considerable uncertainty about how bank failures will be managed in practice, and exactly when and how different classes of bonds will be forced to accept losses. 

Bank of Cyprus effectively went through the bail-in process, but this may not have been representative, and other banks experiencing similar problems have avoided this path altogether. With the new approach not legally binding until 2018 the market has time to price in the impact. 

2014 spread test

Another bank failure may therefore be needed before the implications of bail-in can be accurately priced in. Ultimately bail-in will have implications for the spreads of all European banks. The forthcoming market stress tests in 2014 should also provide some clarity about funding costs for individual banks. 

Although the exact details of the impact are still hard to pin down, it seems clear that bail-in will have profound and long term implications. Perhaps the most significant of these is the undermined status of senior debt: once almost inviolable, it is now firmly in the firing line when banks go bust. 

“If senior debt and tier two bonds are both bailed in, which one is going to be more appealing to investors?” asks Hittmair. “Some investors may gravitate towards the higher spread in tier two. So I think we could see a stronger convergence of tier two and senior unsecured spreads.”

While convergence between senior and subordinated paper may occur in some cases, the reality is likely to be more nuanced. The value of any liability is dependent on many factors, including the composition of the issuer’s balance sheet structure, says Arno Kratky, head of liquidity risk at Commerzbank. Senior bonds will be considered safe when there is more equity or subordinated paper to buffer them.

“There is a shift in market perception with regard to the riskiness of debt,” says Kratky. “Once the taxpayer would pay the final bill in case of unsustainable losses of a bank, now partly it is creditors. That may fundamentally change the value of bank debt, though this is such a new dynamic that it is impossible to quantify at this time.”

The impact is likely to be experienced differently across Europe, as bail-in means different things in different countries. German banks derive most of their funding from the domestic market, where investors are more familiar with the credits and are therefore less concerned about the implications of bail-ins. But Nordic and Dutch banks, for example, are more active in the international markets with benchmark deals. The institutional buyers of such paper are far more concerned about the implications of bail-in.

While the outlook for senior unsecured may in some ways look bleak, given the implications of bail-in and the likelihood of such bonds incurring greater losses in the future, other forces may at least partially offset such negative pressure. The deleveraging of banks generally has sharply reduced supply, as has the persistent low rates environment. That should be positive for prices. 

Because regulation is much tougher than it was, risk is perceived to be lower, which should support prices for senior debt. “I think overall funding costs will probably remain stable,” says David Soanes, global head of FIG at UBS. “The impact of greater confidence from tougher regulation will cause spreads to tighten, while the shift towards term funding and banks chasing deposits will cause them to widen. I think broadly speaking the two sides balance each other out.”

Change at the molecular level

Even if this is correct, funding costs have changed significantly since the onset of the financial crisis, which has already changed the inner composition of banks in a fundamental way. Before 2007-08 it often seemed as though there was an infinite supply of capital, which made it possible to finance most types of business. Banks could subsidise less profitable businesses with more profitable ones. 

But regulatory changes have already raised funding costs for banks and significantly changed their funding mix. Sovereign spreads have become an integral part of the equation, especially for peripheral banks, adding to the uncertainty of bail-in.

Although confidence is slowly re-inflating the market, treasurers cannot guess the future volatility of sovereign spreads. The spectre of a Fed exit from quantitative easing looms large, and European sovereigns themselves have already demonstrated their sensitivity to such concerns. 

“We can hope for a reduction in the correlation between sovereign and bank spreads, but the link will never be completely broken,” says Elie Darwish, senior fixed income analyst for banks at Natixis. 

Despite bail-in, sovereigns will always be seen by some as the lender of last resort for banks, especially in core countries, while bank balance sheets will always be in large part determined by the health of the economies in which they operate.

There is a greater emphasis than in the past on asset and liability management (ALM) to limit duration risk on the balance sheet, also in part down to new regulations such as Basel III’s Net Stable Funding Ratio (NSFR). In the past banks funded at the overnight rate, even if their positions were long dated, but now long term positions are funded at the long term rate. 

“Funding costs are driven by two factors — one is the price of funding, the other one is the tenor of funding,” says Kratky. The need to comply with regulatory requirements such as the NSFR and the Liquidity Coverage Ratio (LCR) may affect the bank’s overall need for long term debt on the balance sheet, with issuers having to pay up for duration, he says.

“Compared to 2007-08 funding is more centrally controlled,” says Darwish. “Resources are not as cheap as they were and so the decision about which businesses will subsidise others is very important financially — as well as highly strategic.”

Time for a rethink

A lot of banks have used this as an opportunity to rethink which businesses they want to compete in. One of the most notorious examples of the pre-crisis mentality is UBS, which used its ABS desk to borrow at Libor, channelling the proceeds into triple-A rated securities paying Libor plus a small spread. This arbitrage trade generated a small return many times over. But over time the bank amassed billions of dollars of positions, and because it hadn’t priced in the true cost of capital it was exposed when market conditions turned. 

UBS was not the only bank engaged in this kind of internal carry trade, and it has been open about its inner reorganisation that has seen it focus on its core businesses — even to the extent of cutting its well respected SSA business. Today banks are more sophisticated in ALM, measuring the true cost of capital and appropriately allocating resources to their various businesses and managing the risk of those positions. 

Banks have always had an ALM function within the treasury but it has traditionally been seen as a mundane business that was often neglected. The experiences of institutions like UBS and Northern Rock have changed this perception, reinventing ALM as a crucial, strategic function that can be key to profitability and even survival. 

By ensuring they use the most sophisticated models, banks can improve their performance, generating better returns relative to the risk they are taking. 

The result is that some businesses are no longer attractive for all but a small number of banks. The repo market is a very expensive business to be in from a balance sheet perspective, as repo transactions must be booked on the bank’s own balance sheet. Neither is it particularly profitable. It is therefore not a business all banks will want to be in, though some will take the view it is strategically important for them because they need to service the needs of clients that are important in other businesses. 

Banks have to think globally, as their clients increasingly do, but in an age of increasingly costly capital, if there is little reason for a bank to be active in a business, it makes more sense to get out. 

On one level this is healthy, but the global economy has had to adjust to a new reality, in which banks can no longer afford to offer credit so freely or cheaply. A healthier and safer banking sector means more moderate growth than politicians and electorates are accustomed to. 

“We have experienced an unsecured funding crisis and the solution has been to replace it with secured funding, but that has not solved the underlying problem,” says Soanes. “Secured funding is less attractive to issuers. It is a fundamentally different model from what we had. It means bank balance sheets are collateralisable and can be securitised, but it makes it harder to engage in the riskier end of the lending spectrum, for example SME loans and some forms of consumer finance.”

Banks have mitigated the impact by diversifying into new currencies and investor types, to avoid having to rely on any one market. This strategy, long pursued by the likes of Rabobank and KfW, is becoming more prevalent, and will continue to do so. But this does not fully compensate for the changes to bank funding costs. 

Whether politicians and regulators will have the stomach to see the process through remains to be seen. If the cost of regulation is too steep for the real economy, the future may see a gradual watering down of the new, tough regulatory regime.

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