No more level playing field as the cost of bank funding goes up

Banks must come to terms with higher costs of funding, putting some at a competitive disadvantage to their peers for the first time. The worst hit might have to rethink completely how they fund themselves.

The table shows where selected wholesale and investment banks’ five-year credit default swaps traded at the start of 2007, when just 15 basis points was the spread between what investors demanded on exposure to the least risky and the most risky. At the end of 2007, the cost of funding implied by CDS was much more widely dispersed, with some 135bp between the tightest level in our sample, for BNP Paribas, and the widest, for Bear Stearns.

For years, banks and trading firms had no problem expanding their balance sheets and trading books as low-cost interbank liquidity was abundant and the securitization markets grew.

European structured credit-funded issuance increased from less than €50 billion in 1998 to more than €450 billion for 2006. So analysts at Merrill Lynch point out that by the middle of last year, large European banks were operating with an average loans to deposits ratio of 130%. With €9.7 trillion of customer loans partly funded by €8.3 billion of deposits, that leaves European banks with an €1.4 trillion funding gap. The cost over the risk-free rate of filling that gap is going up.

Calm and then the storm – How banks’ cost of funding diverged

Selected banks five-year CDS spreads

Source: Markit

Those buyers are no longer there. When will the securitization markets revive? Not before the third quarter of this year, if at all, guess many investors. And even if they do, banks, which were funding at 5bp to 10bp over Libor at the start of this year, will be lucky to raise funds under 50bp over Libor in 2008. Even Goldman Sachs, the firm that continues to produce sparkling earnings while others flounder, saw its five-year CDS trade at 46bp at the start of this year. That’s not as bad as Merrill Lynch, trading at more than 100bp, but wider than a stricken UBS, at 41bp after the announcement of its rescue capital-raising.

Central banks seemed to have done a good job of reviving short-term interbank money markets over the holidays and into January. Short-term repo markets remain open. But banks will need to think carefully about spreading financing across the term-funding, secured, short-term and customer deposit markets. That brings costs, including building or renting the relevant distribution capacity.

By January, the scramble was on. Bank funding officials were scouring the markets, even drawing up the documentation for private placements of Islamic financing with Gulf banks.

The unwelcome alternative to diversifying their funding is for banks to deleverage, shedding earning assets. The markets will do part of this job. Loan growth will slow as credit standards tighten and economies weaken. But shrinking is not what banks are in business for. Meanwhile not only investors will be poring over their funding plans: regulators have learnt to their cost the danger of permitting banks to maximize profits by cutting funding costs and depending on cheap but limited sources of funds that appear reliable only until the moment they evaporate.

Net interest margins will be under pressure.