As the financial crisis enters its second year, The Banker invited the heads of financial institutions groups at major banks to discuss what needs to be done. Writer Charles Piggott

Click here to view an edited video of the discussion

The Panel

 David Marks, Head of FIG capital markets, JPMorgan

 Ian Gladman, Co-head of FIG EMEA, UBS

 Richard Boath, Head of financial institutions, investment banking and capital markets, Barclays Capital

 Shyam Parekh, Head of FIG Capital Markets Europe, Morgan Stanley

 Rolf Petermann, Head of FIG, Dresdner Kleinwort

 Ambroise Laurent, Global head of FIG, BNP Paribas

 Brian Caplen, Editor, The Banker

 Philip Alexander, Finance editor, The Banker

 The collapse of Lehman Brothers was a cataclysmic blow, not just to the financial sector, but to the entire global economy. Bankers say that despite bank bailouts, government guarantee schemes and monetary easing, the future of many financial institutions remains unclear. Still, the heads of financial institutions groups (FIG) at six leading banks report that government intervention is starting to stabilise the financial system and that the financial markets are opening again.

 However, bankers say financial markets are still struggling both with opaque capital structures and the huge size of banks' balance sheets. And as fast as banks write off bad assets and reduce their balance sheets, they are also trying to maintain capital levels imposed by regulators at a time when it is hard to raise new capital.

 The FIG chiefs describe a devastated financial landscape laid to waste by multi-trillion dollar losses in the past two years. They think government measures are starting to work, but remain concerned in the longer term over where the vast sums of non-government capital will come from to support banks' oversized balance sheets. Finally, FIG chiefs see rays of hope in the first post-Lehman equity deals and the re-opening of some sectors of the bond markets.

Watch the video 

This is an edited video of the discussion from The Banker's Markets section. Click below to view more:

The health of the system

 Ian Gladman, co-head of UBS's financial institutions group for Europe, Middle East and Africa, says: "What is striking is the sheer speed at which some of these economies have changed path. To think of the 30%, 40%, 50% change in export levels that you've seen in some statistics recently – I don't think any of us conceived that the huge economies around the world could react so sharply to this shock. Looking back, it feels as if [the collapse of] Lehmans was a heart attack, not just to the financial system, but to the whole global economy."

 BNP Paribas' global head of FIG, Ambroise Laurent, is candid about the health of the financial system: "First of all, I think we should emphasise the fact that there is no longer a financial landscape, but a financial ruin. The industry is in a very, very difficult situation and on top of that, a certain number of very significant institutions are struggling to have a future."

 Even formerly healthy banks are struggling. Mr Gladman says: "Bank stocks are trading on average at about 60% to 70% of their tangible book [value], with some as low as 20%. I don't know whether the full impact of the impending global recession is already reflected in valuations, but they are very low."

 On the one hand, banks are trying to reduce balance sheet leverage by offloading assets and raising capital, but they are also being asked to bring off-balance sheet items back on the balance sheet. And at the same time, they face a staggeringly high cost of capital as investors struggle to come to terms with current losses on their portfolios.

 Many institutions face an unclear future given the level of non-performing loans, impaired assets and credit losses, says David Marks, JPMorgan's head of FIG capital markets. He says: "When analysts are running those numbers, the numbers they are coming out with are so big it raises the spectre of nationalisation for a number of institutions. At which point I think, the analysts are challenged because it becomes much more of a political call."

 There are rays of hope, however. Mr Marks sees the collapse of Lehman as the defining event which galvanised governments into action. He says: "We saw, at the end of September and October, a flurry of dramatic policy initiatives – be they bank stability packages, monetary policy, or the beginning of fiscal stimuli."

 Mr Laurent says government measures are starting to work: "The liquidity squeeze is – thanks to the central banks' intervention – a little behind us. Funding instruments are coming back. We have reopened the covered bond market, we have reopened the unsecured senior market and I expect much more to come."

 Both Mr Laurent and Barclays' head of financial institutions, investment banking and capital markets, Richard Boath think that government-led asset protection schemes have helped and may offer a way forward. Mr Boath says: "I think we will see a lot more asset protection schemes from governments, not to stabilise the situation, but to get [banks] lending which is their over-riding, macroeconomic objective."

Regulatory change

 Bankers also expect regulatory change, acknowledging the extent to which both governments and regulators have been damaged by the crisis. Regulators may have failed to realise that banks can become too large for one country to be able to rescue. In the UK and Switzerland, government authorities have been shocked by how big certain banks had become relative to the size of the overall economy.

 Most regulators – with the possible exception of Italy, Spain, Turkey and Brazil – also failed to spot the complications brought about by cross-border asset structures. Shyam Parekh, head of FIG Capital Markets for Europe at Morgan Stanley, says: "If you have international regulation, it can only work if it is married with an international body that can also be a provider of last resort. You cannot have one without the other."

Losses and recapitalisation

 Banks now face the task of massive recapitalisation, with the help of governments where necessary. However, paradoxically, the spectre of nationalisation that is hanging over the financial sector has made it harder for banks to raise new capital because of the uncertainty it creates for investors. Investor losses, which are already high, would be compounded by further nationalisation.

 Bankers say it will be difficult for banks to raise enough new capital to replenish actual and anticipated losses in the years to come without government aid. UBS's Mr Gladman says: "The problem is just the sheer quantums involved. The issue is the [asset] losses around the world. I think the first International Monetary Fund [IMF] estimate of total losses was about a trillion [dollars], and most people are saying it's now somewhere between two and three trillion [dollars]. And that's going to be distributed around the world's banks, and you have then got to have a debate about how much of that will need to be raised back."

 Barclays' Mr Boath says European banks have already raised about €175bn in capital since July 2008, of which 62% has been in the form of equity. Overall, 57% of all the capital has been provided by governments.

 Mr Gladman describes how banks went first to the markets to raise cheaper capital by issuing hybrid equity. However, as the market for hybrid instruments closed, banks were forced to issue more expensive preference shares until that market also closed. Their next port of call was the sovereign wealth funds, but after investors began to absorb bank losses, the cost of capital became too high.

 Investor uncertainty over complex capital structures has made it almost impossible for banks to raise equity capital in anything but the most basic – and expensive – form. Mr Gladman says: "If the bank sector needs to re-capitalise because of losses, then you need core equity to absorb those losses."

 Mr Boath questions, given the current "challenged" environment for hybrid debt, whether the markets will allow banks to roll over hybrid debt instruments. "We may see hybrids beginning to tail off as a component in overall Tier 1, and it is then down to equities and preference shares. And then again, the question is, will the market be prepared to refinance outstanding preference shares issued by banks in an equally challenged environment? So, I think, this will focus even more attention than hitherto on equity Tier 1. In terms of solvency, and in terms of loss absorption, that's the key ratio."

 JPMorgan's Mr Marks agrees that the market is struggling to understand the distinctions in banks' capital structures and how banks absorb losses. At the same time, investors are equally worried about government nationalisation and massive share dilution, which also makes it harder for banks to raise pure equity capital. Bankers agree there is little point in replenishing losses with any hybrid capital instrument that includes an obligation to repay someone in 10 or 20 years time.

 "It's a case of 'apples and oranges'," says Mr Gladman. "If you put in a form of capital that counts as Tier 1 but is senior to real equity, as you lose money, it is written off against the equity. And ultimately, what you are doing is actually gearing up common equity. So that is why common equity has become much more volatile – the cost of common equity has clearly gone absolutely through the roof because it is like a volatile option on the risk of default. And that, in essence, is also why the UK government ended up exchanging preference shares into common equity, because, if you have got losses, you can only write that off against something that absorbs losses."

 On the basis that government will be paid back for recapitalising banks, recent government capital injections can be seen as bridge equity rather than permanent equity. At some point, banks may need to convert government capital into pure equity that can effectively absorb losses.

 With the exception of certain government bail-outs, the market for non-equity capital has closed. Mr Boath says: "Investors have, broadly speaking, lost confidence in hybrid Tier 1 and preference shares. And I think you will increasingly see capital coming from a combination of governments and existing shareholders, those that are inclined to support the banks in which they are invested. But what we don't expect is to see the credit markets return any time soon to put non-equity capital into banks."

Hopeful indications

 Dresdner Kleinwort head of FIG Rolf Petermann also thinks the lack of clarity in the structure of some hybrid capital deals – and the fact that some deals have not been called, coupons have not been paid and losses have already been absorbed – has caused great uncertainty among investors.

 "Once we see some market stability, then banks in particular will have the ability to start optimising their whole capital structure and funding mix," he says.

 "There is a ray of hope in the fact that we've seen the first good issues in non-government backed senior five-year and even 10-year [deals]," he adds. However, he says, investor appetite for larger deals with any form of financial engineering is limited. "There is this massive lack of trust, investors got burnt too much."

 BNP's Mr Laurent also sees signs of life returning to the capital markets: "Standard Chartered issued common equity at the end of 2008, Santander tapped the equity market after Lehman's failure and, more recently, UniCredit issued an instrument with the support of their usual shareholders," he says.

 Says UBS's Mr Gladman: "There are many banks that have still got two-trillion [dollar] balance sheets. Those are massive balance sheets on relatively small amounts of equity."

 Furthermore, banks have built large off-balance sheet exposures. Bankers estimate this unregulated 'shadow' banking system at anywhere up to $10,000bn dollars. Mr Gladman says: "Basically that's either collapsed or come back onto the balance sheets of the banks. And as fast as the banks try to de-lever, then you get things such as procyclicality that push the leverage ratios [and the capital requirements] back up."

Factoring in risk weightings

 Banks are also having to factor in higher risk weightings or default assumptions putting more pressure on their capital. The client of one FIG banker saw the capital allocation for a certain portfolio rise from €1bn to €15bn in the space of just one quarter, due to a fall in the internal credit rating of the underlying instruments.

 "As much as banks try desperately to de-lever their balance sheets all these factors keep pushing them up," says Mr Gladman. "It is going to drag on for quite some time to come because it is incredibly difficult to shrink bank balance sheets as quickly as you might want to – either because selling down assets can create losses which banks can't afford to take because it will hit their capital, or because risk-weighted assets rise as credit quality falls, or because commitments come back on balance sheets and/or are drawn upon."

 Barclays' Mr Boath agrees: "The real problem is that, if you are selling assets, be it to a government or to a bad bank, you are crystallising the losses, which is why there seems to be much greater focus around various balance sheet guarantee or insurance schemes at this point in time. Perversely, this may be politically easier to sell, because you are not crystallising the cost upfront."

 Philip Alexander, finance editor of The Banker, says that distressed debt traders are finding banks reluctant to sell impaired assets and crystallise losses while valuations remain so low. This policy of holding impaired assets in the hope that markets will rally restricts banks' capacity for new lending but, he adds, the alternative of taking a fresh hit on the banks' capital is equally unpalatable.

The way forward

 Dresdner Kleinwort's Mr Petermann says: "I've never seen in my life such a bid/offer spread in literally all major asset classes. The worst situation is where you are forced quickly to sell into a market where there is no buyer. So that is why I think the ING [government protection] scheme – for those assets where it works – is a very clever one, and is possibly one way forward."

 But not all countries are suffering the same level of financial damage as that seen in the UK. Brian Caplen, editor of The Banker, says: "There are some markets around the world that are much less badly affected by the crisis. If you are talking to Turkish bankers they are relatively bullish. They had a crisis about three or four years ago, the regulator stamped on them and wouldn't let them do any sort of off-balance-sheet activities and they claim they are still earning a 20% to 25% return on equity."

 In the midst of a devastated financial landscape, the wisdom of some regulators is shining through. FIG bankers agree that some countries have managed to avoid the excesses that led to the crisis in the first place. BNP's Mr Laurent says: "The Italian and Spanish banks are better off than the others. Canadian banks are another example, and also Brazilian banks."

The issues

 - The health of the system

 - Regulatory change

 - Losses and recapitalisation

 - Hopeful indications

 - Factoring in value-at-risk

 - The way forward

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