Fear about what government support has meant for the financial system reached fever pitch in the second week of December 2009, when UK chancellor Alistair Darling shocked banks with his plans for a super tax on discretionary bonuses. The punitive strike went much further than anyone had even anticipated, affecting all banks operating in the UK – both domestic and foreign – and going beyond banks in which the government is a major stakeholder.
The move has crystallised industry fears about government meddling in banks’ affairs, particularly at those in which governments hold significant stakes or who have participated in guarantee programmes.
The UK’s may be the most controversial move, but it is not alone. In a bid to curb what he called “runaway bonuses” and “short-sighted behaviour”, the US Treasury’s pay czar, Kenneth Feinberg, has expanded his crackdown on pay packages at four companies rescued with taxpayer money to target the second tier of top earners.
Banks across Europe have also paid a high price for state aid. The European Commission (EC) has forced German banks WestLB and Commerzbank to halve their balance sheets and others, including Dutch conglomerate ING, Belgian bank KBC and the UK’s Royal Bank of Scotland (RBS) and Lloyds, to divest huge swathes of their businesses to avoid competitive distortion.
But banks argue that these actions are themselves distorting competition by creating a two-tier banking system, in which the banks receiving state aid are under so many political constraints that they will be unable to attract or retain the best talent, or put in place the best business models. Since it emerged that the UK Treasury was to take control of the RBS bonus pool, the bank has argued that ‘restrictive’ bonuses may prompt an exodus of good staff. CEO Stephen Hester told investors that the “politicisation” of RBS is damaging to its business and is damaging to the taxpayer, referring to its sinking share price.
Avoidance tactics
Determination to escape from government clutches is prompting dramatic action. Bank of America Merrill Lynch’s search for a new CEO has been stymied because potential candidates have proved unwilling to take on the role while the US government is able to impose pay restrictions or try to influence the bank’s business model as the price for its support. In a bid to break the stalemate, the bank surprised markets in December by announcing the repayment of the entire $45bn it owes to the Troubled Asset Relief Program (TARP).
As The Banker went to press, Citi and Wells Fargo were rushing to market with common stock and tangible equity offerings to pay back $20bn and $25bn, respectively.
In Europe, Lloyds – desperate to avoid further national or EC intervention, such as the forced sale of its insurance business in line with what has been prescribed for ING and RBS – turned to the capital markets so that it could steer clear of the UK’s Asset Protection Scheme (APS). In November last year, it successfully launched a £13.5bn ($22bn) rights issue and exchanged £10bn of existing bonds and preference shares for a new breed of hybrid securities, contingent convertibles – dubbed ‘CoCos’.
No exit strategies in place
With spiralling deficits, governments are just as keen to exit their commitments. According to the IMF, the total cost of the financial sector bailout is about £7100bn, equivalent to about one-fifth of the world’s annual economic output. While much of this may never be called upon – in addition to capital injections and liquidity support from central banks, the IMF figure also includes the cost of warehousing toxic assets and guarantees on debt – such a staggering figure still dwarfs any previous repair bill for the global economy.
But governments and banks face a complex task to extricate themselves from the life-support system put in place at the height of the crisis. While some investments are relatively straightforward to repay – TARP funds, for example, can be paid back as soon as government and regulators are assured that the business is stable and the capital base strong enough – the divestment of government stakes and the winding-up of guarantee schemes are open-ended commitments that will rely on investor appetite and economic recovery.
A report from PricewaterhouseCoopers (PwC) suggests that governments around the world will have to prepare for long-term involvement and ownership, perhaps up to seven years. “Divestment is not where most government strategies will, or can, begin because the environment is simply not right yet. A longer timeframe will be better for the taxpayer and better for the financial system as a whole because it will allow the system to be properly stabilised,” says John Sibson, leader of PwC’s Government & Public Sector division. “Even if institutions were in the pink of health, previous successful privatisations suggest that you sell assets in tranches because you tend to get better prices as the process goes forward.”
Bo Lundgren, director-general of the Swedish debt management office, who was minister for fiscal and financial affairs at the time for Sweden’s financial crisis in the early 1990s, agrees that governments are in for a long haul.
Mr Lundgren admits that the successful Swedish rescue plan – to which many governments have looked for lessons this time around – benefited from a more positive environment. European economic growth helped to push up real estate values in Sweden, improving bank balance sheets, he says, and the government had other mechanisms it could bring into play, such as devaluing the krone and ending the country’s fixed exchange rate.
“Today’s governments are faced with a much more complex, globalised challenge. And they must restore the financial system to health and rebuild investor confidence at the same time as fighting economic slowdown,” says Mr Lundgren.
Right time, right place
All governments face a difficult trade-off between achieving a good return for taxpayers and not undermining the value or commerciality of the institution. Despite the need to recoup investments, no governments have yet laid out firm divestment or exit plans.
Some quick deals have been done – for a price. In August last year, for example, on the same day that US Federal Reserve regulators seized troubled Texas lender Guaranty Bank, it simultaneously brokered the sale of the bank’s branches as well as most of its deposits and assets to BBVA Compass, the American subsidiary of Spanish bank Banco Bilvao Vizcaya Argentaria. However, the government had to agree to absorb most of the losses on $11bn (or more than 90%) of the Guaranty assets included in the deal.
Other deals are easier and more profitable to negotiate on the fly. In mid-December 2009 it emerged that RBS was preparing for an early disposal of its profitable Global Merchant Services business – which handles more than 5 billion card transactions each year and is the fourth largest card-processing business in the world – having received clearance from the EC to do so as part of its restructuring. The bank has received more than 30 expressions of interest in the unit, and intends to produce a sales memorandum for potential buyers in January, leading to an auction. Private equity firms Apax Partners, Advent International and BC Partners are among the parties to have expressed an interest. The bank hopes to raise £3bn through the sale.
John Crompton, head of market investments at UK Financial Investments (UKFI), the entity created to manage the UK government’s stakes in financial institutions as well as the sale of its wholly owned entities (Bradford & Bingley and Northern Rock), says it is still too early to lay out a timetable for exit. UKFI’s threefold task, he says, is to sustain and create value, execute an orderly exit when the time is right, and make sure any such exit maintains financial stability.
“We have explicitly not been set a timetable,” says Mr Crompton. “We have been given a set of objectives and we must determine an exit plan that fulfils those objectives. The type, size and frequency of transactions will depend on the readiness of the capital markets to put capital to work, the performance of the banks in question, and the question of what happens to their share price in the meantime. It is unreasonable at this stage to make concrete plans.”
Mr Crompton says potential investors – with whom UKFI has a regular dialogue – will be looking for bank-specific landmarks. “Investors have acknowledged that the right management teams are in place, and are now waiting for a return to profitability and an expectation that the bank can begin to pay dividends. Our job is to be in a position to execute when the market is ready.”
Ben Davey, co-head of the UK financial institutions group at Rothschild
Banks in the EU do not only have to answer to their own governments. As well as being told what they must sell or scale back in order to comply with EU competition laws, European banks in receipt of state aid have been given a four-year deadline (with the possibility of a one-year extension) in which to fulfil the EC-mandated instructions. But Mr Crompton denies that this makes UKFI’s job more difficult, or decreases the likelihood that the UK government will see a fair return on its investments.
“The banks in question may not have chosen to make those divestments, but at least it removes uncertainty around the business and sets a starting point for the businesses going forward,” says Mr Crompton. “And the deadline is such that there will be no fire sales. There should be enough time to get assets into a saleable shape and to ensure they go out into a market that’s ready to buy them at a fair price.”
Payback beginning
When Sweden rescued its banking sector it had to commit almost 4% of its gross domestic product. However, it recouped all of its investment – some argue it even made a profit – and governments involved in today’s crisis are also beginning to see returns (see table, page 90).
While the net cost of UK support measures will not be known until the Bank of England begins to sell the assets it has acquired during the crisis, emergency loans to the country’s banks and building societies have yielded hundreds of millions of pounds in interest payments so far. Including quantitative easing measures, the Bank of England, wholly owned by the UK Treasury, is likely to earn at least £4bn for the year – almost five times the previous record of £880m set last year – from the £200bn in assets it now holds. Half of any surplus will be directed to the UK Treasury.
Netherlands-based ING, which received a €10bn injection and guarantees on €21.6bn of US mortgage-related assets, announced in early December that in addition to repaying €5bn of core Tier 1 securities, it will pay a coupon of €259m and a premium of €347m to the Dutch government, via a €7.5bn rights issue, planned for December 21.
In the US, taxpayers have already earned a $3.6bn profit from dividends on the $45bn investment in Bank of America (BofA), and analysts estimate that the US Treasury could bring in as much as $1.3bn from the 211 BofA warrants it holds. It has already reaped $936m from the sale of warrants it received from JPMorgan, and $146.5m for Capital One’s warrants. The proceeds – the price decided by a Dutch-style auction – provide an additional return to the dividend payments received on the related preferred stock.
The fact that banks are in a position to pay back government investments with interest demonstrates the success of government rescue, says Ben Davey, co-head of the UK financial institutions group at Rothschild. Moreover, the Lloyds deal marks a significant step change in the emergence of alternatives to government capital for some banks, he says.
Investor appetite
“There are now windows of capital and particular applicants who can source that capital more cheaply than they could from the state, which is the perfect result for two reasons,” says Mr Davey. “First, it confirms for the EC that the framework adopted by the various states has been broadly right on pricing, because [funding] has swung back to a preference for capital markets; and from a markets perspective, investors now understand the metrics that others have taken in assessing the risk, and are applying their own methodologies.”
Despite this positive trend, market appetite will be difficult to predict – and some institutions will find it easier than others. The price and pace at which BofA filled its $19.3bn orderbook, for example, demonstrated that shareholders see upside in BofA and value the cutting of TARP ties more highly than they worry about dilution. Royal Bank of Scotland, on the other hand, 84% owned by the UK government and with hefty divestments to come, still promises too little upside for potential investors.
There is a huge amount of capital needed to get governments out of the financial system. According to Lazard, governments globally have invested capital in various securities in excess of $600bn (not including guarantees). Set against industry losses of more than $1600bn and capital raisings thus far of about $1300bn, that leaves the global industry still undercapitalised by about $300bn and with about $600bn to repay to governments just to return to pre-crisis capital levels.
While markets have clearly become more comfortable with some bank stocks throughout the year – in Q2 last year, for example, a record $80bn of bank capital was raised, largely in the US – there is still a long way to go, says Gary Parr, deputy chairman of Lazard. “For governments to exit the landscape, we will need many more record quarters to raise or refinance the roughly $900bn needed simply to return to pre-crisis capital levels. And with regulators demanding higher levels of capital, that is just the starting point,” he says.
Gary Parr, deputy chairman of Lazard
Some banks are also paying a price to get deals away. ING’s rights issue, for example, is being done at up to 50% discount, while Lloyd’s contingent capital issue is paying 150 to 200 basis points more than the subordinated debt it is replacing.
Moreover, outside of the biggest institutions, market support cannot be counted upon until investors believe there are no more surprises. This is not yet the case. In November and December 2009, more than 30 banks failed in the US, bringing the total in the Federal Deposit Insurance Scheme so far to 133. As The Banker went to press, Austria was forced to nationalise Hypo Group Alpe Adria to prevent the bank’s collapse and a spillover into the wider financial system. Even counting those banks in good shape, it is unlikely that total industry earnings will exceed losses for another couple of years.
Crowded markets
The timing of exits will be critical because governments could also be selling equity into crowded markets, says Hank Calenti, director of financial institutions credit research at Royal Bank of Canada. “There is an upward revision of regulatory capital requirements in terms of both quantum and quality, and we will probably see the introduction of higher levels of prudential capital around liquidity,” says Mr Calenti. “As a result, it will not just be banks seeking to exit government stakes looking to raise capital. Otherwise healthy institutions could also be looking to issue.”
With a flood of assets into the market expected as banks hive off businesses to raise money, exit non-core sectors or make forced sales, government-backed institutions will also be competing with healthy banks looking to raise capital to fund opportunistic acquisitions.
“For those with excess capital, there will be a world of opportunity out there,” says Mr Parr, adding that he has never before seen so many businesses for sale or in the pipeline to be sold. “But there will be a lot of competition for capital as banks paying back governments go head to head with those adding to capital bases or filling war chests.”
CoCo model?
Some believe that for banks with limited ability to raise equity, Lloyd’s CoCo offering could offer an alternative strategy for paying back government money. While CoCos do not count as core capital for Basel Pillar 1 purposes, they do count towards regulatory stress tests – the threshold that banks must exceed if they are to get governments out of their capital structure.
But CoCos are not an option for those banks which are in the deepest trouble. David Marks, chairman of the financial institutions group at JPMorgan, says that investors will only be willing to participate in an offering if they see “appropriate” levels of capital in the institution already.
“Investors are looking for a minimum 200 basis point buffer between the trigger point and the level at which management have said they will maintain core capital,” he says. “The new standard for core capital is 8% to 9%; if we take the trigger for convertibility to be 5%, and without government support a bank’s core capital ratio is at 6%, for example, then that bank would need to raise at least 1% of equity/core capital to be able to issue contingent capital. This may not be a feasible option for some banks.”
Conversely, says Mr Marks, investors are most interested in CoCos from those banks that have come through the crisis in good shape – which have a core capital ratio of about 8% to 9% and a resilient business model – and who are looking to reduce core capital levels to about 7% to increase efficiency. “CoCos provide a sensible mechanism for sound institutions to protect against tail risk, but [also] to reduce core capital to more economic levels,” says Mr Marks.
Long way to go
As banks rush to escape over-bearing government scrutiny, there are some fears that they may be exiting government support too soon and could be at risk if there were another dip in the economy. It has emerged that Citi was granted massive tax breaks to ensure it could afford to exit the TARP fund.
As banks once again begin to think about ways to increase capital efficiency and the backlash grows over any kind of interference in compensation structures, it is clear that governments and regulators around the world are still struggling to balance measures which restore health and stability to the banking system, achieve a positive outcome for taxpayers, and do not distort competition.
Most have no plans to exit their most troubled institutions anytime soon. But Lazard’s Mr Parr suggests that one neglected element of the government exit from the financial system is the potential impact of the debate about ‘too big too fail’ and ‘too big for the country’. He believes that as governments and banks begin to sell businesses, restrictions will be placed on who can acquire them in a bid to put limits on the growth of the biggest institutions and to foster competition.
“It is clear that governments would rather see some of the smaller players get bigger so that they can better compete with larger banks. In some smaller countries where institutions became almost too big for the governments to take on, there could be absolute limits on a bank’s size going forward. This raises an interesting question about the impact of where a bank is domiciled determining how big it can get. That completely changes competitive dynamics.”