Funding freeze pushes banks closer to the edge
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Funding freeze pushes banks closer to the edge

Despite a handful of deals from top-quality issuers, the senior unsecured FIG market in Europe remains on life support. Some institutions will soon have to swallow their pride and issue at record spreads. For others it could already be too late. Louise Bowman reports.


OVER COFFEE IN a sunny London square in October, the investment chief at a big institutional fixed-income investor distils the funding challenge in front of European banks into a stark statistic. The fund has drastically cut the number of banks whose bonds it will even consider investing in. "Of the 360 financial issuers that we could buy we probably like... maybe 25?" he tells Euromoney. Does he mean 25% of them? No, he means just 25 financials that he might even consider investing in, or less than 7% of the universe of issuers. That, for the remaining 93% of the industry, is a big problem.

Of course no bank treasurer could ever admit to having a funding problem. The industry is at pains to emphasize that while banks in Europe face a funding hiatus, the senior unsecured market is not closed. It is just prohibitively expensive. "For two-thirds to three-quarters of banks this market is absolutely open," reckons Eric Aboaf, treasurer at Citigroup in New York. Aboaf took on this role in April 2009 at the trough of the cycle in the US and emphasizes from his own experience the extent of heavy lifting that banks have ahead of them. But he says that being completely shut out of the market is a problem for only the most distressed banks in the most distressed geographies. "There are haves and have-nots. Most have multiple sources of funding."

In many ways, however, it is the deals that have come to the market since July that emphasize just how difficult this market has become. When Deutsche Bank issued a €1.25 billion two-year FRN at 188 basis points over mid-swaps on October 7 the market hailed the deal as a sign of senior unsecured reopening. Confirming this, it was quickly followed the next day by a €500 million two-year deal from ABN Amro at 130bp over Euribor.

The very fact that a two-year FRN from Deutsche Bank was a cause for celebration is a sign of quite the reverse. Follow-ups from Rabobank (a €1.5 billion seven-year at 125bp over mid-swaps), SEB at 117bp over Euribor for two years, Standard Chartered at 188bp over mid-swaps for two years and Svenska Handelsbanken at 170bp over mid-swaps for 10 years only serve to underline the high calibre of issuer to which market access seems to be limited.

Are lesser-rated banks not coming to the market because they won’t endorse high spread levels and new-issue premia on their deals, or because they can’t find buyers at any price? "September and October have clearly been challenging months for FIG issuers given the volatility in the broader markets," says Edward Stevenson, head of DCM FIG at BNP Paribas in London. "That said we have seen windows of opportunity across the covered, ABS and senior unsecured markets". It is nevertheless just as well that so many banks took advantage of benign market conditions in the first half of the year to pre-fund and thus have already raised much of their requirement for the year. One banker says: "Banks were pushing out their chests in May and June saying they had done maybe 80% of their funding for the year already. But the summer has come and gone and it’ll be getting touchy for any with much left to do between now and the end of December."

Banks have done private placements and other secured funding during the seizure in the public unsecured market. According to Andrew Sheets, analyst at Morgan Stanley, by mid-October European banks in the iTraxx index were already roughly 95% done with full-year funding.

The refinancing hump
Funding needs for iTraxx senior financial banks
Source: Morgan Stanley Research, SNL Financials, company data

But the more pressing question is the first quarter of 2012. "Redemptions in the first quarter of any year are typically the largest. The first-quarter redemptions in 2012 are the largest on record for European financials, at around €300 billion," says Oliver Sedgwick, head of FIG Syndicate at Goldman Sachs. "Typically issuers pre-fund redemptions three to six months in advance, so issuers would like to be using market opportunities to get ahead of their funding needs. Looking forward, once issuers get over the first-quarter redemption spike, funding needs should materially decline quarter on quarter in line with redemptions."

However, €300 billion is quite a hump – albeit with an as-yet unclear volume of assets rolling off. "Additionally we believe that there is a relatively sizeable deleveraging effect at play," says Sedgwick. "We estimate that there were €1 trillion of non-sovereign bonds that matured last year and a similar number this year. For banks that are over 100% net stable funding ratio (NSFR) the proceeds from these assets can be used to decrease funding needs." Vinod Vasan, managing director and head of European DCM FIG at Deutsche Bank, agrees that the final 2012 funding number could still be manageable. "There is roughly €800 billion of term funding maturing next year but remember that banks have been trying to retire the expensive government-guaranteed debt part of that anyway," he says. "Some of that will be accretive to net interest margin when that rolls off." He adds that many of the assets funded by five-year issuance in 2007 and 2008 will also not be replaced. "Many European banks will continue to rely on the ECB for some time. They will do more covered bonds and other secured funding. So the actual amount of senior unsecured that banks will have to refinance next year could come out at nearer €250 billion to €300 billion. That could be manageable in a reasonable market."

It could be – but only for the higher-quality select few. Others face a painful funding crunch. Just how long and painful this crunch turns out to be depends on who and where you are – and how you fund yourself.

Although the bank crisis is regional in nature it is actually a series of national crises with very different characteristics and challenges for banks in different countries. The market sees the problems as systemic not idiosyncratic, however, and banks don’t really benefit from spread tiering. Access to the market varies widely across the region. Spanish banks, for example, face far tougher funding problems than many others not only because of sovereign concerns but also because of the volumes of cedulas encumbrance many carry. Cedula law in Spain demands that bank balance sheets have a minimum 25% overcollateralization level on their covered bond issuance and several are getting dangerously close to that: Unicaja (36.9%), Banco Pastor (32.4%) and Banco Popular (31.2%) as of June this year. And Caixabank’s level was down to 27.8%. Even Banco Santander has only 35% overcollateralization, which might curtail future issuance. "You simply can’t lend unsecured to many Spanish banks because of the hidden costs on the balance sheet," says Roger Doig, credit analyst at Schroders. This includes not only the encumbrance for secured issuance but also substantial hidden costs relating to real estate lending that mean their capital position might be weaker than it seems.

The large UK banks, on the other hand, benefit from being outside the eurozone and front-loaded much of their funding in the first half of the year, taking a lot of criticism at the time for locking in high spreads. They also have access to cheap dollar funding through large securitization programmes.

The mix between short-term and long-term funding has been a brutal distinction in bank fortunes as well, with French banks in particular being punished for their reliance on short-dated liabilities. The withdrawal of US money market funds from the market has revealed the extent to which some eurozone banks were reliant on them. Caught out by the evaporation of this dollar funding, many banks have turned to the collateralized repo market, where they have raised large volumes in private deals with US lenders to make up for the withdrawal of money market liquidity. In its September 15 news release designed to calm the markets Société Générale revealed that it had repoed €6 billion of CMBS and CLOs with maturity longer than six months for US dollar short-term funding.

"If you subtract seven-day CP from the excess liquidity mix of some banks you are looking at cash levels of single digits," says one banker. "We were shocked at just how short funded they are. The French banks in particular have found themselves in a position they were not expecting to – they find themselves almost more shocked than banks that were already in the high-beta camp."

The spectrum of bank creditworthiness stretches a very long way from such institutions as triple-A cooperative Rabobank to peripheral banks that are hooked into the European Central Bank funding lifeline with little chance of rehabilitating themselves. For many the realities of the senior funding squeeze will soon become brutally apparent. "There are a number of continental European banks for which I do not know whether there is a bid even at 400bp or 500bp over," says one bank treasurer. "I just don’t know if they could get a deal done."

And that is where the big worry lies. Yes, the riskiest banks can continue to rely on the ECB but how many will fail? "Banks may be less prone to liquidity heart attacks because there is no longer a stigma associated with borrowing from the ECB – liquidity has not evaporated, it has just been diverted through the central bank," observes one banker. "There are a lot of zombie banks that have not been able to fund for years." French banks had increased ECB borrowing by almost €20 billion to €86.7 billion by the end of October.

The ECB announced two new Long-Term Refinancing Operations (LTROs) in October – one for 371 days and one for 406 days. Total borrowing at the October 26 auction was €101.5 billion, with 181 bidders for the 12-month LTRO (far lower than the 1,121 that bid in the June 2009 LTRO). But for how long can the ECB substitute itself for the interbank lending market? The day of reckoning for banks dependent on the ECB is inevitable (by October 19 the use of emergency overnight ECB lending had risen to €4.8 billion). And the rest of the industry now faces a material repricing of its wholesale funding costs – a repricing that will force many to reappraise their entire funding mix and even their business models (see Shrunk and disorderly: Why banks face a painful transition to a smaller future, Euromoney November 2011).

Changing the mix

What a bank has to pay to raise funds in the senior unsecured market is perhaps the most fundamental factor in its business model. "The senior unsecured spread defines a bank’s franchise and the senior secured spread is its last line of defence in terms of market funding," says Georg Grodzki, head of credit research at Legal & General Investment Management. "If banks are forced to issue at spreads which they cannot pass on to their customers they risk losing their raison d’être."

"If you are a European treasurer, you are going to have a bit of cold feet about validating these spreads. It would be seen as a sign of desperation – that you don’t have the resources to wait"

Eric Aboaf, Citigroup

Eric Aboaf, treasurer at Citigroup in New York


They are therefore understandably reluctant to issue into such a volatile and unpredictable market as this unless they have to. "If you are a European treasurer, you are going to have a bit of cold feet about validating these spreads," Aboaf concurs. "It is a double-edged sword. It would be seen as a sign of desperation – that you don’t have the resources to wait."

There are standard tactics on the banks’ playbook for coping with a funding squeeze.

The first and most obvious alternative outside the capital markets is to increase deposit funding. This is, however, an expensive game to play and has generated damaging deposit wars in several jurisdictions, most notably Spain, where predatory pricing is pushing several savings banks out of business. A slew of aggressively priced savings products from Spanish banks offering interest rates of 3% to 4% has prompted the finance ministry to clamp down on those offering rates more than 1.5% above Euribor. Taking on expensive deposits could prove counterproductive for vulnerable banks as these funds are rarely as sticky as they might seem – as UK bank Northern Rock found out in 2008.

Banks will have to tap the wholesale markets, and the first port of call to avoid senior unsecured will be secured funding. For banks in continental Europe this means covered bonds but for those in the UK the option of securitization is also there.

For those with available collateral, covered bond spreads offer a big saving over senior unsecured. And although rising senior unsecured spreads have to some extent dragged covered bond spreads with them as they have gapped wider, the secured option is still a good place to start. It is, however, in no way a replacement for senior unsecured funding.

Many bank funding models would traditionally involve 50% to 60% of long-term issuance through benchmark trades, with the balance from structured finance or covered bonds or both. "You cannot offset benchmark issuance through secured funding," says Aboaf. "You can scale it up a little bit. But double it? Not a chance."

Covered bond issuance dried up along with senior secured over the summer but reopened at the end of August with a 10-year trade from ING and a surprise €1 billion deal from UniCredit. There has been a steady stream of issuance from northern European, Canadian and now Australian issuers but the market has been far from immune to the senior unsecured jitters. UniCredit Bank Austria postponed plans to issue during the week of October 20, citing market volatility as the deterrent. (The deal was subsequently launched after the EU summit on October 27). But while banks might be able to turn up the dial a bit on covered bond issuance, the inevitable collateral questions over the encumbrance on the balance sheet and structural subordination of senior unsecured bondholders will keep the percentage of individual bank funding via covered bonds to tight limits. In February this year Bank of America Merrill Lynch calculated that if covered bond issuance is equal to or more than 40% of total assets on the balance sheet, senior unsecured noteholders might have zero recovery in a default. This scenario might seem fairly far-fetched but closer inspection reveals that at least 49 covered bond issuers already have outstanding covered bonds equivalent to 40% or more of their balance sheets.

Senior unsecured bondholders’ concerns about the growth in secured issuance are thus very real. France and Germany have no restrictions on the volumes of covered bonds their banks can issue. And investors are also wary of the potential future claim on the asset base that replenishing of these cover pools will necessitate.

If covered bond encumbrance is too great, the alternative is securitization, for which collateral requirements are less onerous. EU regulatory hostility towards securitization has effectively closed off this secured funding option for many eurozone banks (with the exception of the Dutch). But UK banks – Santander UK in particular – have been active in the RMBS markets, taking advantage of strong dollar demand for their programmes. Two RMBS deals from Santander and Lloyds this year have included large US dollar tranches: $3.775 billion and $2.6 billion respectively. "UK banks are taking advantage of dollar demand for their programmes but there is a finite amount that you can do," says one banker. The investor base for US dollar UK RMBS is dominated by roughly 10 big buyers and they have been prepared to write big tickets for this risk. The recent Nationwide Building Society trade in October effectively reopened the UK RMBS market, with a $3.5 billion equivalent deal, 90% of which was sold to dollar accounts. RBS has also tapped US investor appetite through its Arran vehicle in a deal in which JPMorgan hoovered up the majority of the $725 million one-year notes and Citi most of the approximately $600 million equivalent 4.6-year notes. Wells Fargo was co-manager on the deal and is likely to have taken a large chunk as well.

It is thus likely that lending activity in banks that can issue ABS will migrate towards securitizable assets. UK building societies are also tapping the covered bond market in size despite the cost of the euro-sterling swap. Nationwide recently placed a €1.5 billion five-year covered bond at 130bp over mid-swaps and Coventry Building Society debuted a three-year €650 million deal in late October at 130bp over via BAML, Danske Bank, HSBC and LBBW.

Secured funding is, therefore, an option for banks but one that will be quickly closed off as collateral constraints kick in. "It is inconceivable that secured funding can replace unsecured issuance," admits a source in the treasury team at a large UK bank. "You don’t have to look at too many balance sheets to realize that the volumes needed are simply not available."

While the public markets may be shuttered on the funding side, some eurozone banks are exploring liability management exercises to shore up capital and thus reduce funding requirements. Both BPCE in France and BES in Portugal have undertaken such trades – both banks for which senior unsecured issuance would not be easy. In late October BPCE launched a buyback of €1.8 billion perpetual hybrid tier 1 securities callable between 2014 and 2017 below par, a deal that could increase its common equity tier 1 capital by up to €600 million. BES has announced a debt-for-equity swap of subordinated securities at between 61% and 100% of par, thereby adding up to 147bp to its core tier 1 ratio.

More peripheral banks are likely to follow this lead but it is fiddling while their funding costs burn. There is, however, also the option of the private market. Banks that don’t want to be seen validating high term funding spreads in public can simply do it in private. Getting comprehensive accurate data on how much business has been executed privately is tricky but there has been a definite uptick in private placements since the public markets froze. "We are seeing decent volumes in the private market, with 10- and 20-year deals being done," notes one DCM banker. "National champions are getting decent volumes done through private placements, equity-linked deals and FX plays."

Rolf Enderli, group treasurer at Credit Suisse

"What has happened during this crisis makes you realize just how quickly a bank can shift from being an acceptable institution to lend to into a non-acceptable one. Five years ago funding was easily available for almost all banks. Now we realize that funding is a precious resource that we have to be very careful with"

Rolf Enderli, Credit Suisse

An interesting aspect of the flow of private deals is the extent to which they are reverse enquiry. The stand-off in the funding markets has not only left the banks searching for alternatives but has also left investors searching for alternatives too. "Private placements have continued and in most cases are the result of where we have been approached by third parties," explains Rolf Enderli, group treasurer at Credit Suisse. "It is not that investors are unwilling to buy paper, it is just that for some of the larger deals everyone is so cautious."

Spreads in the private placement market have drifted in line with the public market and these deals are also expensive. "Structured notes and private placements are more expensive than they were in the past," concedes Enderli, "but they are certainly not at the level of CDS spreads." It is hardly surprising that investors are badgering the banks to do deals. "Investors are yield hungry and even strong banks are paying 300bp for structured deals," says Aboaf at Citi. "If you can lock that in for five years you are a very happy investor."

Walter Gontarek is chief executive at Channel Capital, a London-based credit fund that has specialized in arranging tailored secured funding transactions for European banks. "Significant efforts have been made by the banks to look at alternative sources of liquidity management," he says. "There is an abundance of private deals going on – this is happening in billions."

The structured note market is busy but again this can in no way bridge the yawning gap left by the absence of senior unsecured. Structured notes are a high-end private banking product not a core funding tool. "Structured note issuance is predominantly client-driven and flow has continued quite strongly," says Enderli. "It is a source of funding that continues to be available to us in various currencies and gives us some feeling that the process isn’t broken."

But when banks have to rely on the equity-linked market to reassure themselves that the bank-funding process isn’t broken it most probably is. Deutsche Bank had to pay in the high 100bp for two-year funding and a bank such as Barclays Capital would probably pay 200bp. Rabobank paid 125bp over mid-swaps in October – a new-issue premium of 25bp. This for the best-rated bank in Europe, which was paying 65bp to 70bp six months ago. The billion dollar question that the market faces is whether or not these spreads will narrow once acute sovereign stress subsides or whether this is the new normal.

The case for banks

"The sum total of equity raised by European banks was several hundred billion but despite optical improvements funding spreads did not materially decline," says Grodzki at LGIM, who has struggled to make an investment case for banks for some time. "If banks have to worry about the cost and availability of funding more than their customers do then what is the point of them?" he asks. "There was two years of recovery in 2009 and 2010 and the banks ticked a lot of boxes. But funding spreads did not recover and kept the business model under pressure."

This goes to the heart of the funding crisis that the banks now face. It is easy to trace their current funding challenges to the acceleration of the eurozone government funding crisis over the summer and thus to assume that if sovereign distress subsides bank funding stress will subside along with it. But sovereign indebtedness is almost a sideshow when it comes to the huge chasm of risk assessment that lies between the banks and the investors that have traditionally funded them. When asked what he would need to see happen to again consider investing in Europe’s banks, Grodzki’s shopping list is a daunting one: "Investors want bail-in legislation postponed, a revision of risk weightings, the removal of ring fencing and other fundamental flaws in the regulatory framework, for example references to credit ratings, to be addressed and central banks to continue providing liquidity." And all those things simply aren’t going to happen.

The maturity problem
Bank debt maturity profiles
The incredible shrinking market
European bank issuance
Source: Moody’s, Evolution Securities

Debates over the efficacy and desirability of all these initiatives have plagued the market for years and bear no repeating here. But what they add up to is the enduring problem that Europe’s banks now face: investors simply do not know how to value them. And because of this they don’t want to buy them.

The prospect of bail-in legislation with regulatory discretion is particularly divisive. "If you are extending five-year senior unsecured you will be under a legislative framework that has bail-in language," explains Doig at Schroders. "For the institutions in the market with clear tail risks this essentially closes the market on an unsecured basis," he claims.

Different investors have different motivations, however, and it is wrong to assume that all are so vehemently opposed to bail-in. "The fixed-income world is in collective denial that if you buy a bank bond you might lose money," says Jamie Stuttard, head of international bond portfolio management at Fidelity Investments. "It is a great thing that we are moving towards the concept of bail-in. It is a healthy development. Fixed-income investors have adopted the mentality that the government will always bail them out for far too long. Existing senior unsecured bank bonds are cheapening up to where the new world should be, so the extra spread required for bail-in should be small."

Not all investors share his enthusiasm, however, and there has been very little trading in the secondary market, with portfolio managers simply crossing their fingers and hoping that they get to the maturity date rather than have to crystallize losses. As soon as haircut language is introduced, tail risk will become an issue for all but the most secure banks and the credit curves for the rest might invert.

Resistance to bail-in will be an equal if not more crucial ingredient than resolving sovereign distress in establishing whether the senior unsecured bank bond market can heal itself. "Admittedly banks are joined at the hip to the sovereign debt crisis," says Grodzki at LGIM. "But the bail-in proposals deterred debt investors just when there was a window of opportunity for banks to bring funding spreads down to sustainable levels and that opportunity was missed. Investors don’t want government bail-outs, but they don’t like extra risks from discretionary regulatory interventions either," he claims.

It is easy to assume that it will simply come down to price – and for many investors it probably will. In such a yield-starved environment the kind of returns on offer from bank paper will be hard to resist, and investors have shown enthusiasm for the liability management exercises that are coming through. "If you have a risk appetite and are in a credit fund you might want to look at tier 2," reckons Doig. "If you have a tier 2 bullet with must-pay coupons and a fixed maturity you might be able to work out a scenario where it makes sense – although some bullets have quite a long duration, which makes them potentially volatile in price terms."

Whether or not this calculation can be made for bail-inable senior unsecured is another matter but for some it certainly will. "There is an inflexion point where investors will be willing to take the risk on bail-in for good-quality banks," says David Lyon, managing director, financial institutions capital markets, at Barclays Capital. But that inflexion point remains frustratingly elusive as long as the regulations are unclear. "It is not that credit investors do not want to buy senior unsecured – they do, and many are buying covered bonds only grudgingly," says Matt Carter, managing director and head of FIG DCM at RBS in London. "They simply don’t know how to value senior unsecured because of regulatory uncertainty over the mechanism of bail-in. It is a balance between the fear of losing capital and the fear of being underinvested. Each bit of clarity shifts this balance in the right direction."

Cliff risk

Investor reluctance might be attributable to lack of visibility rather than fundamental aversion but for the banks the cause is academic. They simply cannot afford for their funding lifelines to be disrupted for much longer. They are approaching a funding precipice. "The wholesale term funding market is teetering on the edge for a large number of European banks," says Keval Shah, head of FIG Syndicate at Citi. "We may have to manage an extended period of volatile and unreliable markets."

Even if EU leaders can agree on recapitalization to 9% core tier 1 it is unlikely to have any effect. Increasing capital ratios have proved remarkably ineffective in improving funding costs. "If you look at core tier 1 ratios versus cost of funding the outcome is very random," says one banker. "Italian banks have 10% capital ratios and look at their cost of funding." Intesa SanPaolo undertook a €5 billion rights issue in April this year that took its core tier 1 ratio to 8.5% and its total regulatory capital over 10%. But in September its CDS were trading at 422bp and UniCredit’s at 426bp.

The banks that come through this will all be running with high-single-digit common equity tier 1, which can only be a good thing. It is just a question of how many of them there are and how disorderly the process of banking sector shrinkage and consolidation will be. "You can’t change your business model overnight to higher funding costs," says one banker. "We need a period of elevated spreads for the market to get used to the idea that we have to pass this on."

Time is a luxury that Europe’s banks do not have. It is one of many aspects of the way in which they work that can no longer be taken for granted. "What has happened during this crisis makes you realize just how quickly a bank can shift from being an acceptable institution to lend to into a non-acceptable one," says Enderli at Credit Suisse. "Five years ago funding was easily available for almost all banks. Now we realize that funding is a precious resource that we have to be very careful with."

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