FIG ROUND TABLE: THE PARTICIPANTS
Brian Caplen editor, The Banker
Herman Hintzen chairman of insurance for Europe, Morgan Stanley
Geraldine Lambe capital markets editor, The Banker
Mike Nawas global head of fixed income capital markets, ABN AMRO
Anthony Fane head of financial institutions debt capital markets group, BNP Paribas
Brian Caplen: Where are the hot areas; where you are going to put your resources in 2006? Mike Nawas: I expect to see M&A activity in 2006 back to the levels we had six or seven years ago. There will be more activity on the leveraged buy-out (LBO) side: not only the traditional private equity firms, but also hedge funds and, potentially, banks as well, taking principal views on takeovers. The M&A activity on the equity side will also clearly fuel debt financing over and above the recapitalisations that you would typically see; the high-yield market will grow rapidly in Europe and potentially in Asia as well.
In terms of 2006, I believe the overall credit and rates environment will be relatively stable, so on the trading side I believe it will not be such an exciting year. You will have to see it more on the origination side of the business and that means activity will come from M&A and economic growth in general.
| Anthony Fane: From a fixed income perspective, there are two major things driving growth in the financial institutions group (FIG) world. First is the increasing maturity of the European investor base. Seven years ago, they did not buy subordinated debt; now they are buying hybrid capital from emerging market banks. That is an enormous change. |
Second, there is the lowering of foreign exchange barriers, where they existed. Emerging market countries are enabling their financial institutions to raise capital from outside and facilitating a certain amount of balance sheet realignment, which is occurring; Japan is a very good example of that.
We will therefore see more of a funding demand from emerging market banks – with the possible exception of eastern Europe, where a lot of the banks have already been acquired, so they are not funding on their own. India and Thailand have just announced Tier 1 regulations. BNP Paribas has just done a transaction for a Malaysian bank and another one for a Korean bank. I think emerging markets in the whole Russian and Far Eastern geography will provide a lot of FIG issuance, this year and next year. We also saw a deal in January from Mizuho.
There is more of a question about whether it will be up in core Europe. Notwithstanding what is happening in Italy, the expected cross-border growth in M&A has not happened. I imagine that core balance sheet growth creating issuance growth in core Europe is probably not going to be the key driver of growth.
| Herman Hintzen: I agree but I would argue that a lot of the core European banks, faced with a low inflationary, mediocre-growth environment are very aggressively buying high-growth assets overseas. What you will see is the recapitalisation of Asia and parts of even the US system happening through European acquirors. |
MN: That is very interesting, because a premise to that would be that the valuations of the stock of those European institutions that are acquiring allows them to purchase companies in countries where there are higher growth rates, and so far the equity markets in bank stock in Europe are not fantastic. HH: Yes, but it does depend what you are talking about. On the one hand, you have the HSBCs and the Erste Banks, which say: ‘This is strategic; I need it and no matter what I’ll pay for it’. Erste Bank does have a multiple advantage; HSBC has a relative size advantage. On the other hand, there are banks including BNP, Barclays and even ABN AMRO that are waiting to jump on opportunities in emerging markets. The key there is: if you have a mid-range multiple, do not buy too big, because you do not want to have both a multiple disadvantage and a proportional disadvantage. Nevertheless, the asset growth is not in Europe so banks will be tempted to buy in central and eastern European and Far East markets at solid multiples.
BC: About 18 months or two years ago, CEOs were very non-committal about cross-border mergers. Have things changed and was Santander/Abbey the kick off point?
HH: Bank equities are well rated so the companies have good multiples so they can acquire. Credit spreads are tighter than ever and everyone has been able to drop their credit provisioning; everyone has made money on trading credit at the same time, so both balance sheet and off balance sheet positions have risen in value.
As a result, earnings, capital and liquidity are higher than ever, driving M&A momentum. At the same time, yield curves are shifting towards a horizontal position; credit spreads have little or further downside; expense efficiency has little or no upside; most banks may not be able to get an acceptable return unless they acquire.
AF: At the time, Abbey was undergoing quite a lot of change. I think Santander was quite opportunistic and it bought very well. It represented a fairly unique opportunity to get into the UK market at the time. I am sure that the rationale of that trade was more about the fact that it was quite an opportunistic target, rather than all cross-border mergers work, per se.
HH: I would second that. UK players could not consolidate any further because of political and regulatory barriers, leaving the target for a foreign firm to acquire. The UK banking market has an attraction of profitability due to the absence of excessive mutual or government-sponsored competition in British banking. Santander spotted an absence of local and major foreign competition and was able to snatch it relatively cheaply. We have yet to see whether the synergy story pays off.
MN: I am also sceptical about synergies. I’m certain, though, that the size differential is an important factor. If you were to talk about a merger of equals, I believe few CEOs would be interested in that, nor would shareholders, because synergies are even harder to achieve in such a situation. It has to be clear who is taking over whom, and whose systems, credit policy and forward strategy will predominate. That is why Santander/ Abbey worked.
Geraldine Lambe: What about Germany? The market is different but it is completely unconsolidated and investment banks have been building their resources there.
HH: The revenues – whether on deposit, current or mortgage accounts – that banks can make in Italy are higher than in Germany. Germany is a classic low-margin/high-cost/income ratio country, which is reflected in the pricing of recent M&A deals. Italy has become very expensive but it is a more profitable market.
The question is: what kind of executive are you? Are you a restructuring specialist, who is not afraid of running a low-yield bank because you know you can squeeze cost and externalise non-productive assets? Or are you somebody who likes growth and cross-selling? Going into a country like Italy, pension privatisation means you are going to have an enormous savings and pensions environment, which will largely be captured by the banking network. They are quite different opportunities.
BC: So is Germany only about buying portfolios of non-performing loans or bad assets, or at some stage are we going to see a proper shake-up in the actual sector?
| MN: If the theory is correct, we should probably also look at private equity firms, the ultimate restructuring artists, acting in the banking sector. We saw J C Flowers take over NIB Capital in the Netherlands. Is Germany an interesting hunting ground for private equity firms? I believe it is on the banking side. |
In restructuring banks – especially in the German and French environments, where social and economic dynamics make it hard to carry out restructuring – could it be easier for a private equity firm to undertake it than for a retail bank, for example, whose brand name in households is critical to its success? Perhaps it needs somebody, an ‘outsider’ if you like, to restructure, take profit and sell it to a more long-term player. AF: You have to remember that more than 60% of the loan and deposit volume is in the hands of either state-owned, public legal entities or co-ops and mutuals. Yes it is fragmented, but among organisations that are not particularly focused on capital efficiency and return on equity. This creates a return-on-assets (ROA) market, where the ROA is no more than 30 basis points, and that is why the return on equity and the cost/income ratio are what they are in Germany. But I don’t see how a private equity player could buy a stake in a Sparkassen, for example.
GL: Will Basel II have any impact on M&A in emerging markets?
MN: It will shift the pattern of emerging market M&A activity in the FIG sector. If a lot of emerging market banks were to apply real economic capital valuation to their asset base, it would drive completely different equity requirements. We will definitely see hybrid capital coming up as an instrument and banks also struggling with their asset base. As a result, there will be portfolio sales and opportunities to acquire. There may even be governments and regulators pushing positions by well-run national banks to salvage their own banking sector.
If you were to look at the valuation of quite a few Chinese banks with a view to putting in a stake, it is questionable whether that would be a good investment based on current asset value. It is much more of a strategic play.
HH: A big Basel II issue is related to bank ownership of insurance companies. They will have in their bank capital base the book value of an insurance company at historic cost, and the deduction against capital is from the total capital ratio. Under Basel II, first you have to market the insurance company, so it is no longer booked at historic book value; instead you will have to come up with an embedded value (EV) concept and 50% of that goes straight against Tier 1. This will create some gaps in Tier 1. This will be an issue for some of the large French and UK banks.
AF: Plus you have to throw in Solvency II, because that on its own is going to create capital needs in some life insurance companies, and property and casualty insurers.
BC: If we take that proposition, what sort of capital raising would that lead to?
HH: It is very difficult to see the entire picture of a banking company. You need to understand the composition of the bank assets and the economic capital allocation as well as the asset velocity, then you have to bring in the insurance equation. You cannot state that everybody will need to raise capital, but those that have an insurance captive are quite likely to require more core capital under Basel II than before.
AF: And what sort of capital – equity, straight debt or hybrid – depends on what can be defined as core capital. There are several sides to this. First, techniques for realising capital within insurance companies are increasingly sophisticated. Second, if a bank is facing a capital need, the issuing of hybrid capital or equity may not be the most efficient way of doing it.
Spain is a perfect example. Banks there cannot issue any more hybrid, because, even though they have balance sheet growth of, on average, 10%-12%, they are all up against or over the limit of 30%. They are not that keen on issuing equity and there are much more efficient ways of liberating capital. I can think of a number of countries in Europe where, quite frankly, predicting significant hybrid flow, for example, looks an uncertain business for a variety of reasons, including being at their limits.
HH: The issue is that, if you have a capital problem, you can go and get new capital or you can release it from your asset base. I think that everyone will try to raise capital and release it at the same time, depending on tax, accounting and regulatory issues. It will always be a mix, but there is a role for credit derivatives, securitisation, collateralised debt obligations (CDOs), collateralised loan obligations (CLOs) and even equity derivatives in big capital release exercises. It is not as binary as saying: ‘I have a hole; I need to go and get new capital’.
MN: We can link this back to M&A. The real victims of Basel II will be the smaller banks or emerging markets banks, particularly non-mortgage-oriented banks and those with non-granular portfolios. Banks that have a large proportion of unratable assets, that do not have the more sophisticated systems of credit monitoring or the expense base to take care of it all may well become acquisition targets.
HH: Yes. Mid-cap banks that have a large, unratable portfolio become increasingly non-viable. You can have mid-cap banks, such as the National Irish Bank (NIB) and BNP, that have either a large government or trading content or a large mortgage content, but you cannot run a mid-cap bank with a lot of small and medium sized businesses (SME) and retail customers.
MN: Another way of driving this kind of capital thinking in emerging markets is to change the legal framework to allow for tools such as hybrid capital and securitisation. If we think back about Europe, one of the big drivers towards thinking about economic capital was the creation of securitisation technology – banks started to think about mortgage lending in terms of its value if it was securitised. By the back door, if you like, you would create better capitalisation and valuation of the banks instead of by regulation.
BC: What sort of role do you see banks playing as providers of advice in the liquidity area? What sort of problems will banks and other financial institutions ask you to deal with in terms of liquidity?
HH: I see the emergence of liquidity issues in pension funds and insurance companies due to a search for yield. And as a management focus it could be higher up the agenda. You could say that as more asset management product is created and as the playing field between asset management, banking and insurance is levelled and the consumer goes for unbundled product with a clear investment element, you can see surrenders coming in, especially in certain books of business, such as classical endowment product. These surrenders imply a need for greater liquidity and I do not think the financial system has thought that through enough.
GL: To what extent are we going to see new product development by banks for pension funds and insurance companies? We have, for example, seen at least the development of products such as longevity bonds for pension funds.
HH: We have seen the securitisation of term and whole life portfolios and mortality securitisation. There is also talk about securitising reinsurance recoverables. This involves securitising receivables outstanding to the reinsurance community and is a significant liquidity item in non-life insurance balance sheets. Depending on the size and complexity of insurance claims and disputes, it can sit on the balance sheet for a long time.
The debate, therefore, is how can we take this big receivable – with no yield attached to it, that is capital weighted, is potentially there for a long time and is ever increasing – and remove it from the balance sheet? That is the recoverable securitisation debate.
In the life insurance sector, more and more insurance companies are becoming structurers of assets with a life policy wrapped around them, and in that debate they can take their own or somebody else’s asset management product or a structured derivative. Banks become wholesalers catering to insurance companies, which, to lighten the capital load, are no longer interested in taking all the policyholder’s money and investing it at a risk to the shareholders. That whole business, therefore, gets unbundled and you get some in-house funds, some third-party funds and some products manufactured by banks.
That has just begun to take off and the more solvency regulations there are on pension funds and insurance companies, the more it will grow. I think it is one of the next big things in the investment banking industry and a lot of it will be through derivatives.
MN: Going back to liquidity for a moment, insurance companies have also not used liquidity as a commercial instrument yet. They might be considering entering the banks’ area of commercial paper (CP) back-up facilities, both on asset-backed and corporate CP, because their regulations would be slightly more favourable than for banks under Basel II.
Rating agencies are amenable to large, highly rated insurance companies being CP back-up providers, as long as they have a demonstrated liquidity track record and an ability to raise liquidity quickly, ie overnight. That could be an interesting area over time.
HH: I agree, but there are some obstacles. Insurance companies still find it difficult to take on so much single name risk. Unlike banks, they would never dream of taking $100m unsecured exposure on the chin, unless they had reinsured some of that. Insurers are much more conservative about risk than banks. Nevertheless, we may see them begin to syndicate it throughout their own system – some of these big insurers do have credit insurance subsidies.
AF: Our industry is also concentrating on getting the risk out of the system entirely. Cat bonds are a classic example. This is particularly true in the reinsurance industry, where the risks are few and they are highly concentrated in a certain number of providers. They all have the same risk basically. If you look around the world and say this industry or insurance capacity is going to need to grow by a certain percentage per annum, someone is going to have to hold the risk in the end.
There is a cat bond market in America, but there is a problem: it is very small and specialised, and the investors that are in it know what risk they are taking and will only take it at the right price, so you haven’t transferred risk. You have to a certain extent because the cat has been provided by someone else, if at a very definable risk price. However, as the investor base grows, I am sure we will see more of it.