A window of opportunity for bank funding

Moribund in the second half of 2011, the bank funding market was given a new lease of life at the start of 2012. According to data from information provider Dealogic, in the period up to 7 February there was more senior unsecured issuance than in the whole of the second half of 2011.

A mainstay of bank funding that fell out of favour in 2011 as investors turned to safer funding options, such as covered bonds, European banks raised £1.45bn (€1.74bn) and €26bn in the senior unsecured markets in this period, versus just £489m and €14.4bn, respectively, in the entire second half of 2011.

What changed the game was the European Central Bank's (ECB's) first long-term refinancing operation (LTRO) on December 22, 2011, in which 523 banks across Europe took in €489bn in much-needed liquidity.

“While the LTRO has not taken term funding and capital issues off the table, fears about the refinancing cliff, particularly in the first quarter, have all but evaporated,” says Vinod Vasan, head of European financial institutions group (FIG) debt capital markets (DCM) at Deutsche Bank. “It has been an enormous shot in the arm for markets by putting a bid on all risk assets. Markets wanted quantitative easing and, with the LTRO, they effectively got it.”

Window of opportunity

The safety blanket provided by the LTRO has proved a boon for investors, who were faced with an overhang of supply given the material redemptions in early 2012. Mark Geller, head of financial institutions syndicate, Europe, the Middle East and Africa (EMEA), at Barclays Capital, says banks are leaping through an open window of opportunity. “The message from the market has been, if you want to issue, and you are able to print, then take this opportunity,” he says.

But the question is whether the LTRO is a panacea for European banks' funding requirements in the long term. The bulk of the senior issuance so far has been concentrated in banks operating in AAA rated sovereign jurisdictions. “Comparing issuance year-to-date with the same period last year, it is much more concentrated. However, we have started to see supply from a broader range of issuers and an increased risk appetite from investors, which is encouraging in terms of the outlook and better than anticipated given the volatility we saw in the second half of 2011.” says Mr Geller.

One example of this is the €1.5bn offering of 18-month bonds on January 31 from Italy's second biggest bank, Intesa Sanpaolo, the first benchmark offering of senior debt from one of the country's lenders since July 2011. It priced to yield 295 basis points more than the swap rate, down from initial guidance of 300.

By sticking to the short end of the curve where there is most demand, it is clear that Intesa took the easier path; but the fact that it could tap the market at all in unsecured format is seen as a positive sign by bankers.

Investor reassurance

David Marks, chairman of FIG DCM at JPMorgan, says the LTRO has helped to create a “virtuous spiral”, in stark contrast to the negative spiral that markets had been in for several months previously. “Investors have been reassured that there will not be a liquidity crisis; that there will not be a capitulation trade, when banks pay as much as they have to in order to get access to the market,” he says. “The LTRO has also supported the secondary market, which had seen investors in complete retreat.”

The growing importance attributed to banks' access to funding by equity investors was made quickly apparent in bank share prices, which saw a significant lift after the LTRO. Similarly, investor sentiment towards peripheral eurozone sovereigns improved. On January 12, Spain managed to print €10bn of three-year paper (upsized from €5bn), priced at 3.4%, compared with the 5.2% at which it issued in December 2011. The following day Italy also held a successful auction, selling €3bn of benchmark securities due in November 2014 at a yield of 4.83%, lower than the 5.62% set at the last comparable bond auction.

The real test of the LTRO's restorative powers, says Mr Marks, is whether the Yankee market is open to European banks. The US-based dollar market has been largely closed to many European banks for several months, causing French banks, for example, to pull back from dollar-based activities such as commodity and trade financing. How upcoming Yankee deals perform is seen as crucial, but bankers have been given heart by two recent successes.

While Rabobank reopened the dollar market for eurozone banks in mid-January (and returned in early February to issue another $3bn of 10-year paper), bankers were far more excited about a February deal from ABN Amro.

ABN's $1.5bn, five-year bond was viewed by many as the dollar market's 'genuine' reopening. Rabobank is the only European lender to retain one AAA rating (from Moody's) and so enjoys a particularly high status with investors, while what is left of ABN Amro is still being rehabilitated after the bank was divided up in the disastrous three-way takeover in 2008.

“ABN was a key test in reopening the Yankee market to the mainstream national champion banks in Europe. Even with the LTRO pressure valve, Europe FIG financing requirements remain very high, the Yankee market has been a key source of both funding and capital in the past. We need it,” says Mr Marks.

Second thoughts

The market is also keenly anticipating the second LTRO on February 29, just after The Banker went to press. The level of take-up is the subject of much discussion. At the ECB meeting in February, governor Mario Draghi made it clear that there is no stigma attached to using the LTRO and clearly suggested that he wants banks to use this facility aggressively.

A recent Reuters poll suggested banks would bid for €400bn, but forecasts range from €75bn to €800bn and there is still talk of €1000bn. In other words, no one has any idea what the outcome will be. However, many suspect that there is a 'sweetspot' that could have a real impact on market confidence.

“Too little [take-up] and investors will worry that banks are either a little complacent or do not have enough eligible collateral; too much and they will fear that banks are a bit desperate,” says Paul Young, head of DCM, EMEA, at Citi.

Whatever happens, most bankers believe that the carry trade witnessed after the first LTRO – where banks parked the proceeds in short-dated instruments, largely sovereign debt – will be revisited after the second round. If government bonds look to be well supported, then banks with access to unlimited funding through the ECB at 1% will be strongly tempted to boost flagging earnings by buying government paper yielding 4% or more.

Mr Young believes the carry trade will have natural limitations, however. “Bank CEOs will ultimately have to stand up and defend their balance sheets and investors will not see large carry trades as prudent use of funding given last year’s experiences, so this will impose a natural cap on size,” he says..

Finding the sweetspot may be tricky. And if markets do not feel good about take-up, this could undermine what confidence has been built up. “Investors believe that a good amount [of LTRO funding] is going into risk assets, which has prompted them to buy. As investors have anticipated a big LTRO and they have bought risk assets on the back of that, there is some room for the market to fall if it doesn't materialise,” says Deutsche's Mr Vasan.

Divisions remain

Whatever the positive impact of the LTRO, there are still 'haves' and 'have-nots' in terms of funding. The obvious 'have-nots' – Greek and some other peripheral country banks – will have to make full use of the LTRO to meet financing needs. For obvious 'haves' – high-rated banks in high-rated countries – the markets are open. For those in between, it is a balance of cost and access, says BarCap's Mr Geller.

“There is a divide between those who can and those who can't access markets,” he says. “For some, the question is whether [the divide] is demand- or issuer-driven. Is access determined by investors' willingness to buy paper, or the fact that spreads are too wide to make it economic?”

There is also the question of the growing encumbrance of the European financial system – both through use of covered bonds and because of the collateral posted by banks participating in the LTRO.

“We're fully expecting that to accelerate because of the LTRO,” says Mr Vasan. “Asset encumbrance has an impact on depositors and senior unsecured debt, but it is mitigated by the fact that it is now less likely there will be a downturn in the markets or a liquidity crunch, so the system as a whole is in better shape, which is one reason that unsecured deals are also attractive.”

In broader terms, the question is now whether the LTRO represents a more long-term fix. Banks' term funding is still an issue and Europe still faces huge growth challenges even if a full-blown crisis is avoided. A February research note from Morgan Stanley suggests the markets may still be in for a bumpy ride. It points to ECB data which shows that euro-area lending fell in the previous month, down 1.8% on an annualised basis. It also quoted BIS data which show a 9% quarter-on-quarter decrease in eurozone bank claims on Asia excluding Japan.

Morgan Stanley analysts concluded: “While we may have avoided a broad credit crunch, the 'great deleveraging' in Europe seems far from over. The LTRO will slow but not stop the process.”