UK bank issuance figures make grim reading for syndicate desks. RMBS deals in 2013: four. Public senior unsecured benchmarks in euros and sterling in 2013: four. Covered bond deals since May 2012: zero. The only bright spot for investment bankers with transaction fees to consider has been the capital market, to which banks and insurers have been driven in the last 12 months by regulatory demands.
But the country’s nascent economic recovery gives those bankers renewed hope. As a very general rule, UK banks are long liquidity and short capital. Next year FIG bankers predict they will have less of the former and more of the latter, as credit demand improves and banks issue capital either to meet Basel III-compliant ratios or replace old instruments with new ones recognised by the European Union’s Capital Requirements Directive (CRD IV). There is even talk of a UK covered bond hitting the market in the next few weeks.
Taking into account that ‘normal’ issuance levels will be half or even a third what they were pre-crisis, 2014 could finally be a full year to which that word applies.
“If we continue to see the economic situation in the UK improve in the way it has been, and if we continue to see an improvement in the UK housing market, the demand for credit from UK banks will increase from both the retail and the corporate sector,” says David Hague, head of UK & Ireland FI debt capital markets at Royal Bank of Scotland.
“On the back of that we may see a return to a more normalised funding requirement from UK banks in 2014, and they can hopefully start to enjoy the benefits of the secondary spread compression we’ve seen in the last 12-18 months.”
Can’t lend, won’t lend?
In those last 12-18 months UK banks simply have not needed the money. Banks say there is precious little demand for loans from creditworthy companies and individuals, no matter what the government says.
The UK economy has been stagnant at best for the past three years. Individuals have held off on buying that new car and companies have held off on acquiring that new competitor. As a result, retail and corporate deposits have swelled, and they are a very cheap alternative funding source. Loan to deposit ratios at the major UK banks have decreased between 10% and 30% since 2011, while customer deposits are around 10% higher and wholesale funding some 40% lower.
Into that environment the government launched the Funding for Lending Scheme in July 2012, offering banks yet more cheap funding at 25bp over the Bank of England’s base rate, provided their sterling lending to UK households and non-financial companies was flat to positive between June 2012 and December 2013.
Despite the obvious appeal FLS withdrawals have been limited, at least from the larger UK banks. The extra cost incurred for failing the terms are high — an extra 25bp for every 1% fall in net lending — and banks don’t want a choice between lending to riskier credits and taking the penalties for not doing so.
“General bank deleveraging, a reduced demand for credit, and increased retail and corporate deposits have all affected the issuance profile of UK banks,” says Hague.
“But has the Funding for Lending Scheme had a material impact on UK bank issuance? No.”
But putting collateral such as mortgages and credit cards in repo with the BoE in exchange for FLS funds can make wrapping them up into securitized products look like an awfully expensive process.
“It is not the biggest factor behind the lack of issuance, but the FLS has clearly had an impact, in particular on the secured market,” says Cecile Houlot-Hillary, co-head of FICM FIG coverage in EMEA at Morgan Stanley.
“Once the FLS was in place it just wasn’t economic to do a securitization or a covered bond versus where the banks could get money from the Bank of England. But it has also had a positive impact in that UK banks have been able to show investors they don’t have a funding need, so they shouldn’t have to pay a premium when they do come to market.”
Little, and not often
As syndicate bankers are fond of saying, it is always best to visit the funding markets when you don’t need the money. But there are downsides to not issuing very often, particularly for smaller issuers.
“Lloyds Bank and RBS, for example, have a lot of paper outstanding,” says Houlot-Hillary. “Even though they are not out there in the primary market they still have a lot of secondary paper that is getting traded and is very liquid.
“The lack of supply is more of an issue for the mid-size banks, which don’t have many benchmarks out there. For them it is important to have investor engagement and to consider tapping a very strategic part of their curve even if they don’t need the money. It is important to have a reasonably liquid senior curve if you want to issue capital.”
Smaller lenders could do worse than Santander UK as a role model for keeping a credit visible for investors. The bank has issued five and seven year senior unsecured deals through Abbey National this year, as well as a small 30 year deal in the US, adding liquidity to its curve and completely re-pricing it in the process.
Leading the dialogue
When banks do return to the funding markets they will find an investor base that is impressed with the country’s response to financial instability. UK banks are seen increasingly as a defensive play in the financial sector, a view that has been enforced by a push for tighter regulation.
“Feedback received from institutional investors suggests the UK banks are a key overweight in both funding and regulatory capital asset classes,” says David Carmalt, head of financial institutions, DCM, Lloyds Bank. “The improvement in the credit profile of these institutions and the rapidity with which they have worked to adopt new liquidity and capital standards all works in their favour.”
At the forefront has been the Prudential Regulation Authority, which opened its doors on April 1 to replace the now defunct Financial Services Authority as the Bank of England’s city watchdog, and set out to implement Basel III capital ratios and the new 3% leverage ratio faster than everyone else.
“The PRA has been leading the European dialogue on things like total capital levels and particularly the leverage ratio,” says Houlot-Hillary. “That is going to have a big impact in 2014 as its view on capital is really transforming the strategies of banks. They will have to look at their existing capital structures and work out how they are going to transition into a new regulator-led capital structure.”
It is hard to argue that a better capitalised bank is a worse investment, but a valid concern for investors is whether tough regulation will drag on the profitability of UK banks as the economy picks up.
“Investors take comfort from well regulated issuers,” says Hague, “but it is fair to say that issuing capital is expensive relative to senior funding, even for the strongest issuers.”
The UK’s financial custodians have sought to temper that concern. In his first speech as governor of the Bank of England Mark Carney said liquidity rules will be relaxed once the eight biggest institutions all meet a 7% common equity tier one ratio under Basel III, in order to stimulate lending.
Investors marking the PRA’s card will have one eye on the situation at the Co-operative Bank, which is set to attempt a controversial exchange offer in October that would convert its subordinated debt into senior bonds issued by the bank’s parent The Co-operative Group. If the exercise fails — and there is no shortage of opposition — the regulator may have to reveal how hard it is prepared to hit senior bondholders in a bank rescue.
Parking the supertanker
FIG syndicates are optimistic about UK bank issuance before the end of the year and throughout 2014. There is certainly plenty of capital that needs to be issued or replaced, but bankers also report a desire from UK banks to pre-fund for 2014 in senior unsecured.
“Senior should be the market where we see supply increase first, because it much more readily fits in with the primary loss absorbing capital (PLAC) consideration,” says Hague. “With one eye on the PLAC, another on encumbrance ratios and another on their modest funding requirements, I expect UK banks will look to issue senior where possible.
“RMBS will remain a popular source of funding but it is difficult to see covered bond supply recovering as quickly.”
The UK economy grew by 0.7% in the second quarter of this year, and the Office for National Statistics expects an identical figure for the third. The economy has now recouped nearly half of the 7.2% of output lost during five consecutive quarters of contraction in 2008 and 2009.
The buyside is growing more confident about the economic recovery. When Bank of America surveyed investors in the second week of September they found that 54% wanted companies to boost their capital spending, the highest figure for eight years.
Deposits are cheap and reliable, but banks are keen to see them fall to kick off that virtuous circle between cash withdrawal and increased economic activity. It is only that economic activity that will enable them to increase lending, and by doing so return to the public markets they know and love for a reason.
“A number of banks and building societies we speak to describe the control of retail funding inflows as being like trying to steer a supertanker, as it is very difficult to rapidly alter the level of deposit taking,” says Carmalt. “One of the benefits of funding in the wholesale markets is borrowers are able to be highly prescriptive as to the quantum they raise at any given point in time.”