FIG markets adjust to new realities

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The panel

Philip Alexander - Finance editor, The Banker

David Marks - Chairman of FIG debt capital markets, JPMorgan

David Soanes - Head of EMEA FIG capital markets and investment banking, UBS

Ralf Grossmann - Head of covered bond origination, Société Générale Corporate and Investment Bank

Eric Richard - Head of EMEA FIG investment banking, Credit Suisse

Marc Tempelman - Head of EMEA FIG financing and capital markets, Bank of America Merrill Lynch

The publication of official stress test results for 91 EU banks on July 23, 2010, was touted as a helpful step on the road back to healthy market conditions for banks to raise capital and financing. But the road is long, as five senior financial institutions group (FIG) capital markets and investment bankers explained at a discussion held shortly before the stress test results were published.

Volatile funding conditions, damage to balance sheets from impaired assets and a rolling wave of new regulations all push in the direction of banks continuing to deleverage. The Banker's Top 1000 World Bank rankings for 2010, published in July, showed total assets falling by more than $1000bn, with the top 20 banks in the world accounting for the vast majority of that deleveraging.

But this is not a genuine reduction in assets - rather, a transfer elsewhere. Governments have injected bank capital or taken on risk through asset-transfer or asset or liability guarantee schemes, increasing credit spreads for sovereign debt in the process. This in turn has made funding conditions tougher for banks domiciled in those countries. At the same time, central banks, and especially the European Central Bank (ECB), have expanded their own balance sheets massively through repo facilities and bond purchasing schemes.

"Deleveraging has not occurred," says David Soanes, head of FIG capital markets and investment banking in Europe, the Middle East and Africa (EMEA) for UBS. "If you believe that asset prices are a function of the leverage in the system, then if there is deleveraging, asset prices are going to come down. If asset prices come down, solvency comes down. So it's a very fine line between deleveraging (and removing the funding problem) and just creating a solvency problem.

"Only economic growth can solve this. And low rates, so that there's a decent chance of creating some of the atmospherics that can allow for some proper growth in capital to enable deleveraging to occur," he adds.

Tough funding conditions

In the meantime, the funding market is meting out what Mr Soanes calls "financial apartheid" between those banks that are able to access it and those that cannot. Funding conditions for Mediterranean banks, particularly those in Greece, Portugal and Spain, have become especially difficult as market anxiety about their economic prospects and public debt intensifies.

"Arguably, the Greek banking system was one of the best managed in Europe, but unfortunately, as we know, the state of the country's public finances was not the best in Europe. The microscope being put on the Greek public debt has obviously wounded the [country's] banking system considerably," says David Marks, chairman of FIG debt capital markets at JPMorgan.

However, he describes investor appetite as "barbelled", split between the safest assets such as top-rated government bonds and covered bonds at one end of the spectrum, and relatively high-risk assets at the other end such as emerging-market debt, high-yield issuance and even bank preference shares, which had been under a cloud following a wave of deferred coupons in 2009.

"It is striking that the one asset class investors seem universally less sympathetic to is bank senior paper. That is simply because the quantum that needs to be raised is so great: even though individually investors can accept that the paper is cheap compared with corporate paper, they are happy to remain underweight because they think it could get cheaper," says Mr Marks.

At the safe end of the scale, covered bond issuance has continued in core markets such as France and Germany. This is vital, says Ralf Grossmann, head of covered bond origination at Société Générale Corporate and Investment Banking, because it is allowing banks to fund at longer tenors than senior unsecured debt, easing the risks posed by a large wave of redemptions due in the next two years. But even for covered bonds, there are concerns about the peripheral countries of the eurozone, such as Spanish issuance of cedula bonds.

"The big challenge now is that we see a further deterioration of the asset quality in the [cedulas] pools. The banks can obviously mitigate that to some extent; they are just putting in more collateral, which then makes the instrument more expensive. And there is obviously a risk that the instrument may not be cost-efficient at some point in time," says Mr Grossmann.

These concerns are unfolding in a context where governments are also encouraging banks - especially those that received significant public assistance - to revive lending to the corporate sector as a way to stimulate economic recovery. Consequently, Eric Richard, head of EMEA FIG investment banking at Credit Suisse, emphasises the need for banks to keep their funding management as flexible as possible.

"If banks were cautious [in the past] and if they planned a couple of years back to be able to access any market, whether from a currency standpoint or secured or unsecured debt, they will be in a better position today," says Mr Richard.

Central bank dependence

While stronger markets may be coping with the tough conditions, this still leaves the have-nots in Europe's troubled peripheral markets. For them, says Marc Tempelman, head of EMEA FIG financing and capital markets at Bank of America Merrill Lynch, dependence on central bank liquidity shows little sign of abating.

"If you cannot access the proper markets these days, and not many institutions away from the national champion banks in the right countries can, then [the central bank] is a natural source of liquidity, and possibly one of the very few that you can access.

Central banks' liquidity for now is very important to keep the system running. And other than time, I'm not sure there is an obvious solution to this at the moment," says Mr Tempelman.

However, other participants on the panel were more optimistic that market conditions might normalise gradually. In June 2010, the ECB closed its one-year repo facility. Of the €443bn in ECB one-year repo transactions outstanding at the time the facility closed, only about €240bn was rolled over into a new, shorter-term facility. Yet the prospect of a further €200bn to be refinanced did not cause disruption to the market. At the same time, the ECB also ceased buying covered bonds.

"The first reflex could be that the party's over, but it has turned out that there was indeed a smooth transition into the new world, and we saw [covered-bond] transactions in the first week without any support from the ECB whatsoever," says Mr Grossmann.

Regulatory change

However, the slow unfolding of Basel III banking regulations since a first consultation draft was published in December 2009 is dampening the market. Participants note that the declarations by the G-20 governments at Toronto in June 2010 shed little new light on the final shape of the rules that are due to be published in late 2010.

Mr Soanes feels there is a difference of approach that remains to be reconciled between central banks and governments. The central banks aim to ensure that banks have sufficient capital and liquidity to withstand a future crisis, but the governments are attempting to regulate the sector so tightly that there can never be another crisis on the scale of the recent one.

The December 2009 consultation paper on Basel III received about 270 individual responses from a wide range of financial institutions, professional services firms and banking associations. An update paper published by the Basel Committee governors and heads of supervision in July 2010 attempted to address some of these responses, but the task is very complex.

"The [consultation] responses were very specific about those institutions. The impact of a change to the treatment of deferred tax assets is different at this bank from how it is at that one down the street, even between seemingly similar-looking institutions, and it is the same story with all the capital deductions - from software through to pension deficits. It really showed how difficult it is for the regulator to get a handle on such a diverse group of sheep," says Mr Soanes.

The round table's participants point out that new Basel rules on accounting for minority interest in Tier 1 capital measurements also affect certain banks, while leaving many others untouched. Groupings such as the Raiffeisen or Sparkassen models in Austria and Germany are particularly vulnerable to this, as the central or wholesale bank for the group has often raised Tier 2 capital in the market and used the proceeds to inject Tier 1 into the smaller members.

But there are also some Basel III proposals that affect most major banking groups, and some are deemed by the panel almost impossible to implement without choking off new bank lending. The terms and conditions for defining bank leverage ratio limits, net stable funding ratios and bank liquidity buffers cause particular concern. The Basel Committee initially proposed allowing only a narrow pool of assets for inclusion in the liquidity buffer - excluding, for example, covered bonds - but the July 2010 update agreed that this definition should be broadened.

"To have a diversified liquidity portfolio clearly makes sense. If banks only put in specific government bonds, then if one big institution needed to sell its liquidity portfolio and it was only constituted of gilts or OATs [French government bonds], you could have, say, $30bn in the market in one day, which could create volatility," says Mr Richard.

Rethinking bank capital

On the definition of bank capital itself, it is unclear how far the cohesion of major financial jurisdictions is holding together, or whether the implementation of Basel III capital requirements will become fragmented. The direction of travel is evident - banks will need to hold more and higher-quality capital, and hybrid issues must demonstrate that they can genuinely absorb losses on a permanent basis. But the eventual treatment of hybrid Tier 1 and Tier 2 capital is a source of uncertainty inhibiting market activity.

"One of the bizarre consequences of the December 2009 press release [on the Basel III consultation paper] was that, in fact, it hindered recapitalisation, because people did not know what the treatment of the instruments they were going to issue was going to be. They did not know whether they were going to be grandfathered [allowed to continue under the old rules] or not, so while market conditions were actually pretty attractive in the first four months of the year, deals that would normally have happened did not," says Mr Marks.

A further central theme of the proposed Basel reforms is building a cushion to absorb tail-risk losses. Already, different approaches are emerging on the question of contingent capital. The enhanced capital notes issued by UK bank Lloyds in November 2009 convert from subordinated debt to equity if the bank's capitalisation falls too far. And the subordinated debt issue by Rabobank of the Netherlands in March 2010 would involve a permanent write-down in the face value of the debt if the capitalisation trigger were breached.

Mr Tempelman says: "The question is: at what level of cost does it become efficient for a particular institution to issue [contingent capital]? For now, to be honest, the overriding consideration before they issue any of it is that they'd like to know exactly what kind of treatment they are going to get for it. This is probably why we've seen so few examples [of contingent capital issuing]."

However, Mr Marks is more optimistic that must-redeem deals with a clearly defined loss-absorption trigger could be a competitive alternative for bank capital-raising.

"In a sense, it helps politicians and regulators to ensure sufficient quantum of capital and stability and integrity of bank balance sheets, while at the same time providing something that is cost-effective enough that the cost of credit to the broader economy does not hinder growth," he says.

Other Basel III proposals include allowing regulators to set a 'bail-in' point, at which senior creditors would be obliged to take a pre-determined hair-cut to keep the bank solvent without taxpayer assistance. But participants on the panel question whether, if an institution ever exercised a 'bail-in', the resulting recapitalisation would actually help restore access to funding markets.

There is general agreement among the panel that, while the scale of the needs is difficult to assess, the overall effect of Basel III is likely to be to give additional momentum for banks to raise core equity. As with bank debt, appetite for bank equity is uneven, and emerging markets appear to attract more interest than slower-growing US and western European markets.

Agricultural Bank of China's record-breaking June 2010 initial public offering (IPO) was an example of the interest shown in emerging market bank equity. Mr Richard also points to the example of Santander Brasil's IPO in 2009. The latter could set a precedent for Western banks to let their emerging market operations raise capital directly, rather than being financed out of stretched domestic balance sheets.

But Mr Soanes notes that Bank of Ireland has also achieved a successful rights issue, even in one of Europe's more troubled banking markets. This suggests that "for the right investment case, there is a market. The issue is really the deterioration in funding conditions, and bankers themselves have not worked out what the implication of that is yet," he says.

Exit the state

This deterioration in funding conditions could in turn delay the process of divestiture for governments that injected equity into banks at the height of the financial crisis. Mr Marks notes that, whereas perhaps 90% of government capital injections to banks in the US have already been repaid, the proportions are reversed in Europe, where most government stakes are still in place. In many cases, Mr Grossmann adds, those banks rescued by the state are also undergoing significant restructuring.

"It is currently quite difficult to raise capital through transactions, let alone to sell a stake in a bank where the overall outlook is unclear - [the questions asked are:] What will be the business model? What will be the earning prospects?" he says.

"My understanding is that governments - at least on the continent [mainland Europe] - have started to set some sort of deadline when they think they should sell, or there should be some disposal of at least part of the bank. But to me it seems unrealistic that those deadlines can be met."

Mr Richard adds that governments will have to balance the desire to set an exit timetable for their core equity stakes against the need to avoid exiting at a loss. Moreover, volatile economic conditions that could lead to further loan losses, coupled with the advent of tougher Basel III capital requirements, could push the exit plans still further into the future.

"The worst that can happen is that you, as a government, authorise or acknowledge that a given bank in which you have injected capital is good to go, and should be authorised to redeem, only to find six months later, nine months later or one year later that that institution has to go back to the well [for more support]. So there is a degree of understandable prudence on the part of the stakeholders," says Mr Tempelman.

Consolidation challenges

In theory, the pressure to raise additional capital should propel some degree of merger and acquisition activity to reduce the number of less well-capitalised banks. Already, the Spanish government is encouraging the caja savings banks to merge, and has passed a law allowing these previously customer- and municipality-owned banks to sell shares with voting rights.

"Pressures for profitability will definitely drive economies of scale as a means of regaining P&L [profit and loss] that has been lost in the funding markets," says Mr Marks. "And I think we are also seeing the emergence of global lines of business, be they investment banking, treasury services, asset management or private banking, so it all looks very obviously a trend towards consolidation," he adds.

Mr Richard agrees, saying that most of the European banking sector remains as fragmented as it was before the financial crisis, with few pan-European institutions. This raises the question of whether there will be cross-border consolidation, rather than consolidation among domestic players in each economy.

However, members of the panel doubt that banks with stronger funding profiles and home markets would want to expand into the more troubled eurozone periphery at the current time. And these banks' pre-crisis forays into those countries, often involving opportunistic lending at the margins to win market share, tended to lead to poorer asset quality among foreign-owned banks than among their domestically owned rivals.

"The evidence to date, anecdotal as it may be, is that in some of the challenged jurisdictions, the foreign banks are actually exiting fairly quickly. In terms of disclosure, banks are very quick to say that their exposure to a particular country is only X amount, so adding to those exposures at this point does not seem appropriate," says Mr Marks.

The same dilemma holds true for cash-rich banks in Asia or Latin America looking to invest abroad. Panellists feel that emerging market banks would logically prefer to continue using their capital in their own, high-growth markets, where balance sheets are still expanding rapidly, rather than purchasing expensive branch networks in slower-growing markets. However, the strategic desire to transfer banking technology and techniques from more mature western European markets into emerging economies might justify this type of expansion.

Meanwhile, the political and regulatory pressures following the crisis could also push banks in the opposite direction, towards demergers and the sale of certain business lines. Mr Richard says regulators are likely to intensify scrutiny on the location of high-risk business lines - for instance, trading books - within cross-border banking groups, to avoid the build-up of systemic risk in their own jurisdiction.

"You might see some banks deciding that their business model is not suited to the new regulatory environment and they will decide to, or be forced to, execute on separating some activities. That may mean splitting into two pieces and merging one piece with somebody else. It is very possible that two [currently joined] businesses might not fit together any more in terms of the cost of carrying the capital of one business versus carrying the capital for the whole of the institution," says Mr Richard.

The issues

- Tough funding conditions

- Central bank dependence

- Regulatory change

- Rethinking bank capital

- Exit the state

- Consolidation challenges

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