Deep uncertainty over sovereign debt exposures and new regulation has locked many banks out of the senior unsecured funding markets, leading to a frantic search for solutions.

The reintroduction of a one-year repo facility by the European Central Bank (ECB) in October 2011 underlined the funding pressures bearing down on banks in the eurozone. Comprehensive data is only available to August, but it already shows that the decline in reliance on financing from the ECB that had taken place since mid-2010 has begun to reverse.

Perhaps even more worrying, the problem has spread beyond the emergency room patients in the eurozone periphery such as Greece and Ireland, to touch core banking systems such as those in Italy and France. Banks in both these countries have strong deposit bases, but even so, their use of ECB repo facilities more than doubled going into the third quarter of 2011 (see chart). By contrast with 2008, the market dislocation in 2011 has focused on sovereign debt, making ECB repo a tougher proposition.

“The ECB margins daily, so a eurozone periphery bank using the bonds of its home government as collateral must post more collateral daily as the value of those bonds drops, or reduce its ECB repo funding needs,” says Mauricio Noé, managing director in the European debt capital markets (DCM) team at Deutsche Bank in London.

Ted Lord

Ted Lord, head of covered bond origination, Barclays Capital

Unsecured funding struggle

The additional implication of the sovereign crisis is that government-guaranteed bank bonds, which reopened the market for bank funding in 2008, are a non-starter this time around. Yet the market for bank senior unsecured debt has been particularly troubled, as fears over the quality of bank balance sheets and their exposure to sovereign credit have combined with regulatory initiatives.

The EU proposals to create a special resolution regime for systemically important financial institutions (SIFIs) at the start of 2011 raised the possibility that unsecured bondholders could be 'bailed in', with their debt converted into equity to recapitalise a troubled bank. Going into June 2011, eurozone banks as a whole were probably ahead of schedule with their funding programmes, having completed about 70% of planned issuance.

But by the start of October, that percentage had hardly budged, and bank treasurers were starting to worry. US money-market funds, which had been a reliable source of funding at the start of 2011, also began to reduce exposure to eurozone banks, obliging the ECB to step in with the provision of dollar liquidity from August 2011.

“The dollar market may take a while to come back, which is a pity because many big banks were getting a lot of volume done at very economic levels. There is not another market that can replace it in terms of size, so you have to work a lot harder with many other currencies and markets to get the same volume of funding done,” says Mr Noé.

Uneconomic market

In a very short-lived window at the end of September, ABN Amro and Deutsche Bank both managed to access the senior unsecured markets with two-year floating-rate notes that were the first for almost three months. But for many banks, unsecured issuance remains uneconomic, especially since demand for credit will remain weak for as long as consumer and business sentiment is subdued by the eurozone sovereign woes.

“For banks, funding in a market that charges them more than it charges their customers is not a state of affairs that can persist. Balance sheets will shrink in the face of the refinancing risk of maturing bank debt,” says Paul Tregidgo, vice-chairman of debt capital markets at Credit Suisse.

In the short term at least, the largest issuers have been making use of the private placement market. Many banks appear to favour this format because it avoids putting a public price on new issuance that treasurers feel might validate today’s wide bond spreads.

Mr Noé says that, for the strongest European banks at least, there has been appetite for private placements from the largest investors, such as insurers and sovereign wealth funds, especially from Asia. And the less issuance there is on the public markets, the more that appetite grows.

“In order to get meaningful diversification, big investors need to buy in size, which they are sometimes less likely to get at a public sale. There is cash there, and investors can ask specifically for the kind of deal that they want in terms of maturity, structure and currency, rather than being presented with public deal terms that they have to say yes or no to,” he says.

Beyond a sovereign solution

There is general consensus that a forceful solution to the eurozone debt crisis, which takes in the financial positions of the worst-affected governments and banks side by side, is ultimately essential to restoring funding markets.

Peter Stage, head of credit research at £100bn ($157bn) UK fund manager F&C Investments, suggests that the authorities need to move beyond the European Banking Authority (EBA) emphasis on recapitalising banks, because capital needs cannot be adequately assessed without understanding the asset quality problems that different banks will face. This points to adopting a European bad bank approach, possibly similar to the US Troubled Asset Relief Program of 2008.

“Having some vehicle that can purchase those assets off the balance sheets, or ring-fence them or insure them, seems to us necessary to genuinely move us on. Some piecemeal recapitalising, while it might provide a short-term boost, will do little more than that. And capital will not do a lot of good if large sovereigns fall over, so prevention is better than cure,” he says.

But even assuming the sovereign crisis can be resolved, appetite for bank unsecured paper may not return to the pre-2007 highs. The concepts of bail-ins and SIFIs look set to create permanent changes in investor attitudes. While SIFIs will need to hold more capital, that could leave them with lower funding costs.

“Will banks have to change business models? I think they will have to because of regulatory impositions and market requirements. But some banks will have to change more than others. If that does happen, the larger banks will be the relative winners,” says Mr Stage.

Rise of covered bonds

One alternative to unsecured issuance, naturally enough, is to issue secured bonds which allow investors to recover collateral in the event of a bank default, instead of being converted into equity. The most established format is the covered bond, which offers investors the dual protection of a cover pool of assets to draw on if the bank itself defaults, and a supporting legislative framework in a growing number of countries.

The authorities in many countries appear to view covered bonds as a useful tool that may promote responsible lending by tying funding to the origination of good-quality assets suitable for a cover pool. This impression was reinforced by the ECB’s decision to resume its covered bond buying programme in October 2011, after a hiatus of more than a year.

The programme is designed to bring down covered bond spreads and make this a cost-effective funding format. Hours before the new €40bn round of purchasing was announced, the UK’s Nationwide found anticipation of the new programme stimulated good demand for a £1.5bn covered bond issue backed by mortgages.

“The ECB feels now, as it did before, that we can only have a true economic recovery in Europe if there is a mechanism for financing mortgages and public infrastructure in an efficient manner. When the capital markets freeze up, both of those goals are hurt, so restarting covered bond purchases is designed to restart that process, which the previous round was very successful at doing in terms of bringing down spreads,” says Ted Lord, head of covered bond origination at Barclays Capital.

Broad investor base

Thomas Mercein, Credit Suisse

Thomas Mercein, global head of DCM, Credit Suisse

Although more stable than unsecured debt, covered bond spreads have widened enough to broaden the potential investor base. Mr Stage at F&C says the firm’s credit funds have begun to take a much greater interest in covered bonds, which were previously viewed purely as a rate-sensitive product for liability-matching investors.

Indications that covered bonds will receive favourable treatment for capital risk-weighting and liquidity coverage purposes under both the Basel III banking regulations and the Solvency II insurance regulations have also strengthened appetite among insurers and bank treasuries.

“The covered bond investor base is growing significantly, the sterling covered bond market has produced 12 deals from scratch, including some for second-tier players such as Coventry Building Society. Investors are more focused on secured funding due to Solvency II regulations and bail-in legislation, although if the spread between unsecured and covered bonds becomes too wide, that will change,” says Edward Stevenson, head of financial institutions group DCM at BNP Paribas.

Mr Stevenson adds that the adoption of covered bond legislation in new jurisdictions also allows banks to tap a wider range of liquidity pools, and to raise longer-term funding than in the unsecured market. Norway’s DNB Nor issued a covered bond into the Australian dollar market soon after Australia had passed enabling legislation. And Mr Lord believes this is just the start.

“More countries are now looking to establish covered bond legislation so that their banks can participate in this market, we are seeing moves in India, Morocco, Saudi Arabia, Mexico and Brazil. This is signalling a general shift towards bank funding that will be much more collateralised, and unlike asset-backed securities, there is a much clearer legal framework and rules on what can or cannot be done,” says Mr Lord.

Even for assets that are not considered suitable for conventional covered bonds, banks are looking at so-called structured covered bonds. In Germany, banks are examining the possibility of placing small and medium-sized enterprise loans into cover pools. These bonds would not have the backbone of the pfandbrief legislation, but Mr Noé believes they could still be a useful and affordable funding tool as they should price inside unsecured debt.

But in many jurisdictions, there are limits on what proportion of assets can be placed into cover pools – the UK recently raised its limit from 4% to 6% of the total. And Mr Stage says there is a tipping point where encumbering too many assets for secured issuance pushes the cost of unsecured debt to uneconomic levels.

US exceptionalism

The one major jurisdiction that has so far failed to adopt covered bond legislation is the largest of all – the US. A bill has been tabled several times, most recently alongside the 2010 Dodd-Frank financial reform act, but has met several obstacles.

Eurozone banks - Funding from Central Bank

A large hurdle appears to be opposition from Federal Deposit Insurance Corporation (FDIC), which understandably fears that encumbering high-quality bank assets in cover pools would leave depositors with the less liquid, more troubled assets in the event of a bank default. Since FDIC guarantees those deposits, it would be the main creditor struggling to recover money from less attractive assets.

Given the possibility of bail-in under the Dodd-Frank legislation, US investors might find the covered bond format attractive. And the securitisation market, although more active than in Europe, is still a long way from staging a full recovery. But for now, says Anna Pinedo, a partner in the capital markets division of law firm Morrison and Foerster, banks would have to settle for a structured covered or secured bond format, which has its disadvantages.

“From a Basel III risk-weighting perspective, they are unlikely to be treated as favourably as conventional covered bonds, and there are still a number of concerns with what would happen in the event of a bank insolvency. We are seeing some alternative proposals to transfer collateral to a third-party to make it more secure in a bankruptcy context,” she says.

Secured bonds would also find it difficult to compete with covered Yankees, the dollar-denominated bonds issued by foreign banks in jurisdictions that already have covered bond legislation. Even if US investors are growing more nervous about eurozone paper, there have been successful issues from less troubled jurisdictions such as Canada and Australia, including a record-breaking $5bn covered bond issued by Toronto Dominion in September 2011.

Surplus liquidity

At the moment, US banks are not suffering from the absence of local covered bond legislation. Indeed, wholesale funding is not such a focus of investor attention in a market where many banks are repaying bonds at maturity in the face of weak customer demand for credit.

Marlin Mosby, bank analyst for independent US investment bank Guggenheim Securities and a former chief financial officer of second-tier US bank First Horizon National, calculates that large-cap US banks had a surplus liquidity position of $330bn as of mid-2011, compared with a liquidity deficit of $78bn in mid-2008.

“US banks have increased their deposits after FDIC coverage was increased to $250,000 per customer, and because stock market volatility has encouraged people to park their funds in the banks. We do not see anything like the pressure cooker there was in 2008 when spreads spiked up on us dramatically, and some banks are more worried about deposit inflows because they cannot put the money to work,” says Mr Mosby.

While bank treasuries or off-balance-sheet conduits were significant buyers of bank paper in the eurozone, the US has always had a more established base of investment funds backed by real money. Recent US money-market fund aversion to eurozone banks should not be seen as the sign of a fundamental shift in US bank funding conditions, says Thomas Mercein, global head of DCM at Credit Suisse in New York.

“We have a reasonably mature and sophisticated investor base, so there has been some tactical reallocation when investors think some asset is more attractive on a relative value basis, but the identity of investors has not changed substantially. In fact I would argue that the large investors have been getting larger,” he says.


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter