After a bumper 2017, UK bank treasury departments are forging ahead with their funding and capital strategies. At the front of their minds is the end of the central bank’s liquidity schemes, ring-fencing complications, and the first UK senior non-preferred bond. Danielle Myles reports.

Miray Muminoglu

Miray Muminoglu, Barclays

UK financial institutions may lament record-low interest rates hitting their profits, but their treasury divisions have found a silver lining. The industry issued £130bn ($180.1bn)-worth of bonds in 2017, the greatest volume since 2011 according to Bank of England (BoE) statistics, as the buy-side lapped up anything offering a yield that might help meet their obligations to end investors. 

Banks were among the main players. Some even seized the opportunity to pre-fund part of their 2018 requirements, but this does not mean they expect things to quieten down this year. “The UK economy is far more resilient than many would have thought 18 months ago, and provided the global unwind of quantitate easing continues to be measured and well signalled we don’t necessarily expect a big deviation from the market conditions that we have seen over the past 12 months,” says Tom Ranger, Santander UK’s treasurer.

January issuance suggests he may be right. UK banks continued their tradition of capitalising on the quiet period at the start of the year, with Barclays alone raising about $7bn. Analysts and financial institution group (FIG) bankers forecast this year’s volumes to be on par with 2017, but the mix of securities will be different, debut issuers may emerge, and there are ever more regulations to navigate. 

Wholesale funding’s comeback

The biggest driver of 2018 issuance will be the BoE’s Term Funding Scheme’s cessation on February 28. This programme, along with its predecessor the Funding for Lending scheme which started in 2012, has given the country’s lenders access to cheap central bank funding, in return for pledging collateral and on the condition the funds are used to support the UK economy.

For the past six years many banks have used this in place of third-party funding, be it senior unsecured bonds, covered bonds or asset-backed securities (ABS). “With that coming to an end, the UK banking sector will probably be a bigger issuer of wholesale funding in the years to come – more likely in 2019 than 2018 – as they will need to refinance those borrowings,” says Sandeep Agarwal, chairman of Credit Suisse’s debt capital market solutions group for Europe, the Middle East and Africa (EMEA).

The most recent BoE statistics suggest some £150bn of outstanding borrowings must be repaid over the next four years. The need to refinance this, plus the fact that banks must return to normal fundraising avenues, means recent years’ relatively subdued market for vanilla funding will recover to normalised levels. Peter Mason, Barclays’ head of financial institutions and co-head of FIG EMEA, expects volumes to start recovering by the end of 2018, with an emphasis on covered bonds and ABS.

Lloyds and RBS, alongside building societies and the challengers, were the biggest users of the BoE schemes. They are expected to refinance sooner rather than later, to capitalise on record-low coupons and investor appetite. A notable absence from the upcoming wholesale funding rush will be Standard Chartered. The emerging market-focused bank did not use the BoE schemes as it could not satisfy the condition of on-lending to UK borrowers. Its foreign subsidiaries and branches will continue to tap local debt markets to raise the bulk of the group’s funding.

Ringfencing decisions

The bigger players’ fundraising decisions may be complicated by ringfencing rules that have required them to restructure. By the end of 2018, any bank with £25bn of UK deposits must keep its retail banking operations in a separate subsidiary to higher risk businesses such as investment banking. It means they can issue debt via at least three entities: the holding company (holdco), the ringfenced subsidiary, and the non-ringfenced subsidiary, each of which will have different credit profiles and their own funding needs.

Most ringfenced entities will be funded via deposits, covered bonds and mortgage-backed ABS, so their need to raise senior unsecured debt may be limited (although the fact that Barclays and Lloyds’ retail subsidiaries will have medium-term note programmes suggests it will not disappear entirely). Deciding how to fund the other subsidiary, some of which will not have the benefit of deposits or mortgages to act as collateral, is more complicated. “The question a lot of UK banks are dealing with is how to achieve the best cost of funding for the non-ringfenced entity. They are looking at their asset base, considering whether they raise funds directly or via the holdco, comparing secured versus unsecured format,” says Mr Agarwal, adding that the banks' funding models should become clearer over the next two years.

A major consideration will be the issuers’ respective credit ratings, as this will affect the coupon demanded by investors. Logically, retail subsidiaries should have a higher rating – and therefore cheaper funding – than a subsidiary that houses, for example, trading and leveraged finance businesses. Giles Edwards, a senior director in financial services ratings at Standard & Poor’s, notes that the agency’s preliminary rating on Lloyds’ non-ringfenced subsidiary LBCM is a notch below the group’s main ringfenced entity, partly due to LBCM’s narrower and more volatile business model. “We expect a similar situation with RBS’s non-ringfenced subsidiary [NatWest Markets],” says Mr Edwards, before quickly adding: “We are assessing banks on a case-by-case basis, though.”

Barclays is a case in point. Capitalising on the discretion regulators have offered banks on where they house businesses that sit in the middle of the risk spectrum, Barclays opted for a broad ringfenced subsidiary that includes the business and deposits of large corporate and wholesale clients. This is one reason why S&P has given its ringfenced and non-ringfenced subsidiaries the same preliminary rating, which lays the groundwork for a flexible funding model. Miray Muminoglu, the bank’s head of capital markets execution, says both subsidiaries, as well as the parent, will be active in the capital markets.

“Our holdco will raise TLAC [total loss- absorbing capacity]-eligible funds and downstream them to the subsidiaries, and the ringfenced and non-ringfenced bank may occasionally tap the markets for their own operational funding needs, be it in unsecured format or secured format, via covered bonds or securitisations,” he says.

Regulatory capital headstart

With balance sheets in better shape than ever before, bond sales to satisfy capital requirements will be similar to 2017. The November of that year marked the first time in four years that no bank failed the BoE stress tests, and none of 2017’s regulatory actions – including Basel IV and the lifting of countercyclical buffers – requires banks to raise significant amounts of capital.

Most of the heavy lifting for the lowest ranking debt in the capital stack is over, with most UK banks having nearly filled their additional Tier 1 (AT1) bucket – equal to 1.5% of risk-weighted assets (RWA) – and 2% Tier 2 buckets. As for the minimum requirement for own funds and eligible liabilities (MREL), which implements the global TLAC standard across the EU, the BoE was an early adopter, so UK banks are ahead of their continental peers. The most extreme example is Standard Chartered, which needed to raise the equivalent of just $2.5bn in 2017.

“Going back to 2011 we have a history of doing $5bn to $7bn a year of funding and capital issuance from our holdco,” says Standard Chartered head of term funding and executive director Richard Staff. “But contrary to UK peers, last year was actually around our lowest public benchmark issuance for quite some time.”

AT1 and Tier 2 volumes are tipped to dip slightly across the industry in 2018, although the first round of AT1 refinancings could emerge, given that these instruments were first issued in 2013 and can be called after five years. The bulk of upcoming regulatory issuance will be the higher ranking MREL. The biggest UK banks are aiming for MREL of about 29% of RWA, and most must continue issuing this year to bring themselves closer to that target. The majority will do this by replacing other types of debt as it matures, which means MREL will lead to minimal net new issuance.

A possible exception is HSBC. It is one of a number of European banks that are flush with deposits and have a large chunk of equity, and so have not relied on senior unsecured or lower Tier 2 debt. These lenders will have net new MREL issuance, and they must decide how to lend, invest or otherwise put to work this money they would not normally have raised. “That’s the question for deposit-heavy banks around Europe that don’t historically have vast amounts of long-term wholesale debt,” says Mr Edwards. “It will be interesting to see how these various groups use MREL productively, rather than just allowing it to inflate their balance sheet and having a negative carry.”

Senior non-preferred lands

While the bigger UK banks have been building MREL for years by selling holdco senior unsecured debt, their EU peers – which lack a holdco and so are satisfying MREL via a new type of operating company debt called senior non-preferred (SNP) – started in early 2017. SNP’s establishment as an asset class means there has never been a better time for UK banks to raise MREL. As Santander UK’s Mr Ranger notes: “We find that the holdco MREL product from UK banks is now far better understood across Europe as there is an equivalent product being issued there. It means our investor base for MREL has increased over the past 18 months in continental Europe.”

The UK’s second-tier banks and building societies also have MREL requirements, but because they lack a holdco structure they are looking to French, Spanish and Belgian banks for inspiration. “We are in touch with several UK issuers on this point and we expect to see some SNP deals from smaller players later this year,” says Mr Mason.

Unfortunately they are likely to encounter the same stumbling blocks as the Europeans, including outstanding Tier 2 bonds that do not cater for a more senior-ranking category of subordinated debt, such as SNP. “Whether they fix that through contractual [means], or simply replace that Tier 2 entirely once it comes up for call, is what some of the continental banks have been dealing with and what the UK issuers will have to look at in the future,” says Mr Mason.

Brexit bullishness

The consensus is that UK banks are not being penalised in the primary bond markets for Brexit uncertainty. The UK benefited from 2017’s EU-wide AT1 rally, and Mr Agarwal says they continue to price in line with their peer group and access the volumes they need. Mr Staff adds: “We always worry what the buyer base will be like every time there is a Brexit headline, but the fact is we have had very strong support from all our constituent investors in Asia, Europe and the US.”

His comments are supported by Philippe Bodereau, a portfolio manager and global head of financial research at Pimco, who believes that “Brexit doesn’t massively impact the fundamental story” for fixed-income investors. “If anything, the cloud of uncertainty has given the BoE an excuse to be quite hawkish on capital requirements which is a good thing from a credit perspective,” he says. The fact that UK regulators are so demanding is one reason he likes UK bank paper.

UK issuers may be happy with the primary market, but most of their bonds are trading wider than their direct European peers. Mr Bodereau believes this will soon come to an end, however. “I think UK bank spreads will outperform this year, particularly senior holdco,” he says. “They have traded at a discount following Brexit, particularly sterling bonds, and have lacked the sharp tightening of the rest of the market. So in general, there is a decent pick-up for UK bank beta versus Europe.”

Currency strategies

Bankers believe the pound’s depreciation has boosted the market for sterling bonds. For foreign investors, these coupons and redemptions look juicer in their home currency, and Dealogic data shows that UK banks’ 2017 sterling issuance was up nearly 50% on 2016. It raises the question of whether the market will weaken as sterling steadily appreciates, although early 2018 issuance suggest this will not be the case.

“The first month of the year saw a flurry of sterling deals, including covered bonds and senior holdco, by UK and international FIG clients. It’s too early to tell, but it does seem that sterling is going to perform pretty well,” says Mr Mason. “Brexit seems to have given the market a bit of a shot in the arm, which continues to this day.”

Irrespective of sterling’s moves, treasurers claim they are carrying on business as usual. “Obviously it’s very relevant to the bank’s overall business, but in terms of funding strategy, I don’t think it makes a material change in the mix or tenor,” says Barclays’ Mr Muminoglu.

Meanwhile Lloyds treasury’s head of public senior funding and covered bonds, Peter Green, says the group continues to focus on diversification. “The US dollar and euro markets remain ‘core’ funding currencies for the group, in addition to the sterling market and a range of strategic and non-core currencies,” he says. “From an issuance perspective, we remain largely currency-agnostic. We maintain a global funding programme, assessing value for funding on a swapped back to sterling basis.”

Challenger headwinds

The UK's challenger banks face their own set of hurdles. Many of them have aggressively expanded their loan books in recent years, and are thought to be at the centre of the BoE’s recent warnings about the rapid growth of consumer credit. This has led to some wariness from investors “We are a bit more cautious in the second tier where there are some banks that have seen rapid growth, particularly in consumer lending,” says Mr Bodereau. “That’s where you would expect to see the first cracks if the UK moves into a different stage of the credit cycle for small and medium-sized enterprises or consumers.”

The bond market has not, to date, been a big source of funding for these banks, but they may consider it as an avenue to help repay BoE drawings which, alongside deposits, have been one of the key sources of liquidity. The end of this scheme is one of their biggest challenges. “Some of the newer banks have only operated in an environment where there has been access to low-cost, central bank funding, so may face longer term funding cost pressures as net interest margin can be expected to reduce,” says UK Finance’s prudential policy director Simon Hills. 

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