BANK CHIEFS ARE in denial. So are many of the bankers whom they employ, who earn their living advising other financial institutions on how to fund themselves.
Throughout the summer, all the way through to late September, the public markets for bank debt were firmly shut. There were, literally, no deals.
Bankers attribute this to a combination of factors. The huge uncertainty surrounding the eurozone was the main one. That had forced spreads out so wide that most banks were not prepared to pay them.
As the funding freeze spread, bank treasurers tried to convince Euromoney that their institutions wouldnt be too badly affected. They had pre-funded their 2011 needs in the first half of the year when the markets were much more receptive. They remained active in secured markets and in private placements.
The euphoric welcome to a handful of short-dated FRNs and longer-term bond deals by national champions reopening the new-issue market in October suggested that those bankers sang-froid was only for public show.
From the endless meetings across Europe throughout last month, it became clear that Europes banks would need to raise at least another 100 billion in capital. The market will need to be open to more than a select few if the private sector is to pick up the shortfall, which it almost certainly will not.
Amid all this confusion, it might be that something even more profound is going on that bank executives, while busy urging politicians to come up with a truly convincing plan for sovereign finances that will shore up their banks own assets, are contriving to ignore.
The bank funding markets face a crisis that goes far beyond the problems of Greek haircuts. Banks dont just need to adapt to new capital levels, they need to get used to much higher costs of that capital if its even available.
Both debt and equity investors, by refusing to fund banks and by selling banks shares down to such discounts, are going to force, perhaps quite quickly now, a substantial structural change in the banking industry of a scale that regulators have timidly hinted at phasing in over many years.
Bankers now talk of deleveraging and balance-sheet shrinkage. But what is about to unfold is more akin to a new Glass-Steagall: an investor-forced break-up of large, complex, universal banks into much smaller and more specialized institutions.
Bankers are worse than politicians
"The only people even more guilty of not getting it than the politicians are the bankers," says an adviser to the senior executives at a select number of large European financial institutions. "Bankers always complain about European politicians always being behind the curve and only ever coming up with the barest minimum plan to stave off the latest phase of crisis...but the bankers themselves are even worse."
This adviser has been frustrated by his clients unwillingness to see larger investor concerns about the banking industry that extend beyond the immediate worry over exposure to toxic sovereign debt. He says: "Debt investors have identified business models that are unsustainable and decided to stop funding them. Equity investors, similarly, are correctly pricing in forced dilution that could come in the next few weeks as European banks that are poorly managed and following the wrong business models are forcibly recapitalized."
This is where his frustration comes in. He reels off a string of suggestions he has made to bank clients to exit business and raise capital that they have rejected in the past few months in the name of retaining their long-term strategy to run diverse business models that supposedly sustain banks by maintaining a capacity to derive earnings from different sources.
One rejected a suggestion to enter negotiations to sell off its asset management division, another to dispose of a banking subsidiary in a volatile emerging market that the client bank decided it should retain because it might be a big source of profits in five or 10 years time.
Luxury of time
Banks, he suggests, dont have the luxury of time and would be well advised to raise capital as best they can rather than have governments forcibly inject it on punitive terms.
"Bankers complain that shareholders are unfairly undervaluing their shares at 0.6 times book or 0.4 times book just because of fear over sovereign risk. But when you really drill down through individual businesses, inside many of these banks there are clear signs of creeping devaluation. Businesses that the banks seem to think should be worth 4 billion are in fact probably worth only half that or less if recession takes hold. Shareholders are right."
His thesis is that debt capital markets bankers, who walk the line between bank treasuries seeking to raise funds and debt investors now pricing many of them out of the market, are picking up a sense of this.
"It may be that the banking industry changes back to the structure that prevailed in the 1980s. We may go back to a much more mixed banking system"
Asked if the few bank deals in October mark a broad-based reopening of the senior unsecured bank funding market, most FIG DCM bankers reluctantly admit they probably do not. David Lyon, managing director, financial institution capital markets at Barclays Capital, says: "We are living through a period of momentous change. It may take some time yet for investors to assess the risk on unsecured bank debt and what they require in return for it. Meanwhile we are in a huge deleveraging process."
And where will that end? "It may be that the banking industry changes back to something more akin to the structure that prevailed in the 1980s when there were a number of national champions and many more smaller, specialized lenders, some of which were asset financers. We may go back to a much more mixed banking system."
Its not immediately obvious how the big banking news story of last month, the collapse of Dexia, which was a specialist financer to local governments, fits this theory. However it emphasized the potential unsustainability of excessive reliance on wholesale funding. Dexia was very reliant on large volumes of often short-dated borrowing to support an asset portfolio of supposedly low risk-weighted but also low-return local authority loans.
If other banks take this as a warning sign to scale back businesses that rely heavily on constant access to short-term funding, that should see many of them reduce trading activity, rein in their commercial and investment banking divisions, put greater weight on their deposit-gathering retail banks and take a more disciplined approach to return on assets.
Georg Grodzki, head of credit research at Legal & General Investment Management, a UK firm with £362 billion ($576 billion) of funds under management and a large investor in the bond markets, explains why it has been underweight bank bonds since last year. "We took a cautious view on banks, given regulatory uncertainties and growing concerns about their sovereign exposure," he says. "Even though banks were recapitalized after the crisis the goalposts were still moving and the issues of Basle III and bail-ins as well as unsustainable funding spreads were looming large."
Other concerns that kept Legal & General underweight stemmed from the poor investment case banks were presenting to existing shareholders and prospective providers of new equity capital from 2010. Banks had struggled to articulate convincing plans to restore decent returns on equity, in any way comparable to those achieved through excessive leverage in the run-up to 2007.
Euromoney has reported before on how banks cannot achieve a return on equity above their cost of equity when it costs them more to borrow in the wholesale market than they can charge to on-lend funds to corporate customers that are better credit risks.
Banks face an existential crisis
Its an existential crisis for banks, especially in Europe, where the financial system essentially consists of banks raising long-term funding from the wholesale markets and on-lending it at a spread to borrowers. By contrast, banks in the US play a less central role in credit intermediation and even small and medium-size enterprises raise funds directly from the capital markets.
Once upon a time banks in Europe clung on to this intermediary role through the subsidy of implicit government support. Now governments and regulators insistence that bank bondholders accept the risk of taking haircuts in the event of bank failure has fundamentally altered the terms of trade.
The policymakers approach is understandable. Bondholders should not expect a put to the taxpayer to protect against the consequences of their own poor credit judgements in lending to bad banks. But this kicks out from under the banks the entire support structure of their term funding. Investors must now price into the premium they charge banks for funding all the attendant uncertainty around the process of being bailed in by anxious regulators whose decisions, inevitably to be taken amid heightened stress over any failing bank, cannot be subsequently appealed to the commercial courts.
|Hitting where it hurts|
|Profit before tax sensitivity analysis to higher funding costs, 2012 estimate|
|Source: Company data, Credit Suisse estimates|
For bond investors, uncertainty around bail-ins has added an equity-style volatility to banks credit spreads and made them think more cautiously about higher so-called cliff risk: the danger that a sharp decline in a banks share price might blow out its credit spreads, close off funding other than from the European Central Bank as lender of last resort and so potentially provoke regulators to insist on a resolution of the bank.
If banks wont take one anothers credit, why should investors?
Is this an irrational or excessive fear? Hardly. It is one apparently shared by providers of finance even closer to the problem than bond investors themselves. Barbara Ridpath, chief executive of the International Financial Centre of Regulation and previously head of ratings in Europe for Standard & Poors, points out that banks own reluctance to take one anothers credit on an unsecured basis has been increasing with each passing year for over a decade.
"You can argue that it began in the 1990s when the banks all started using master Isdas to collateralize their swap counterparty credit exposure with each other. More recently weve seen increased use of collateralized repo as another means for banks to jump ahead of the queue in claims over senior unsecured creditors to banks. That means that banks arent even having to do much due diligence on each other or differentiate on pricing, even though they are best positioned to undertake that. Its hardly surprising, then, that other investors have taken their cue. Money market funds have asked for collateral. Bond investors have started to prefer covered bonds that are over-collateralized against good-quality assets. If banks arent willing to lend to each other on an unsecured basis and more and more of the collateral is pledged, why on earth would anybody else take their risk?"
Even before the sovereign debt crisis blew up last year, banks cost of funding was rising to the point of undermining the business models of many.
"Even largely deposit-funded banks have not been able to restore their margins sufficiently to generate returns on equity that adequately compensate for their riskiness"
Grodzki says: "Banks first line of defence is their earnings power and this was being eroded by their high cost of wholesale funding versus that of their best-rated corporate customers." He adds: "Even largely deposit-funded banks have not been able to restore their margins sufficiently to generate returns on equity that adequately compensate for their riskiness. This was a concern even before widening sovereign spreads opened up another can of worms for banks with heavily government-bond-laden balance sheets.
"There were a lot of superficially positive developments in the last two years as banks reduced leverage, shed toxic assets and raised equity capital. But whether debt investors failed to recognize these improvements or banks did not do enough to shed assets more rapidly and raise more capital, their funding costs did not decline sufficiently to restore their business models and it is this fundamental question mark that refuses to go away."
A slow-motion bank run
These fundamental concerns wont be resolved soon even if positive outcomes from negotiations over the EFSF and the G20 summit provoke a rally in bank debt spreads and bank equity between now and the end of the year.
Roger Doig, credit analyst at Schroders, a UK-listed asset manager with £205 billion of funds under management, says that many bond investors are sticking with short-term bank debt of under two years remaining maturity only because they cannot sell it without taking a large mark-to-market loss. He says: "The decision has been taken to cut unsecured funding to banks with problem sovereign or other credit exposures such as real estate loans that investors suspect have only been kept current through forms of bank forbearance."
That drying up of the supply of short-term debt in turn gives pause to providers of longer-term financing to banks. Sell-side credit analysts argue that wide spreads on financial institutions bonds might look increasingly attractive to investors after banks undertake the recapitalization required by the European Banking Authority. However, it might be that any rally will be short lived and simply facilitate a further withdrawal of private-sector funding.
Doig says: "All that a Euro Tarp will do is buy time for investors, allowing them to run shorter-tenor bonds to maturity, at which point they will not roll over the funding. The increasing use of secured funding formats such as covered bonds and repo of which ECB funding is one version will put unsecured investors off as they are subordinated to the secured creditors. What were witnessing here is a slow-motion bank run. And I see nothing out there that suggests it will stop any time soon."
Doig is not the only investor who points out to Euromoney that banks response must go beyond the necessary but not in itself sufficient step of curing their bad assets.
"Youre seeing some of the French banks make significant cutbacks from investment banking in the US," he says. "They are the most prominent example of reductions in assets on such a scale that it amounts to a quite material restructuring of their businesses." He continues: "Due to Basle III most investment banks are already looking at restructuring. For universal banks short-term wholesale funding is mostly used to support corporate and investment banking and it could be that some banks will now greatly reduce those activities or exit completely."
He points out that banking consolidation is already under way, notably in Spain, and says: "If the answer for banks is going to be a broad move to deposit funding and retail assets then we will see further consolidation." And he concludes: "This may lead to a break-up of the big cross-border banks."
Equity investors lose faith DJ Stoxx banks index history Source: Deutsche Bank, Bloomberg
Cross-border banks face break-up
That might sound extreme. But the speedily drawn-up plans of French banks to shrink their US exposures in response to lost market access to US dollar funding (see Funding: French banks get that shrinking feeling, Euromoney, October 2011) shows that pressure can quickly come to bear on banks with big operations in countries where they lack a deposit base.
How might the restructuring of banks proceed? Perhaps the reorganization of Citigroup since its government rescue in the aftermath of Lehmans bankruptcy offers some clue, at least as to the scale.
Citigroup split itself in two, retaining inside Citicorp those businesses around which it will build its future, including retail banking centred on the emerging market middle class, transaction services and investment banking. Into Citi Holdings it cast a collection of non-core businesses, including some with decent earnings but no longer considered suitable for the banks future, including the Smith Barney brokerage, various consumer lending and real estate financing businesses in North America and Europe and others including legacy bad assets.
The bank has set out to run down the non-core businesses faster than it has grown those it sees as essential for the long-term strategy. That process has allowed it to reduce funding pressure as assets are allowed to mature or are sold for cash and business disposals free up equity.
Banks dont like journalists to describe the financing markets as closed to them. They say they can issue but choose not to at spreads of 300 basis points or so over swaps that lock in an uneconomic cost of funding. If this is not denial then it is mere semantics. Banks arent like corporates, whose treasurers must secure the finances required to achieve the corporate business goals and might choose to take some interest rate risk in the process. Banks are in the money business. Banks net interest margin is their lifeblood. It doesnt matter if banks can fund at an uneconomic cost because, before long, doing so would put them out of business.
While much attention has focused on funding stresses among banks in Europe, conditions have been equally dire in the US. But Eric Aboaf, treasurer at Citigroup, certainly gives the impression of being more comfortable with this state of affairs than some of his European peers.
"The US banks went through such trauma in 2007 and 2008, so in 2009 and 2010 their loan books came down, their trading books came down," he says. "They de-levered. But you cant just do this overnight or in a couple of days. It takes time to de-leverage. At Citi Holdings we had $800 billion of assets in 2008 and weve taken that down to $300 billion. That creates a real tail wind of liquidity. And most US banks have done some version of that. Its allowed us to reduce reliance on commercial paper programmes and overnight Fed funds borrowing.
"Now weve got so much cash that were taking some criticism because we dont earn much on it. But it gives us a lot of insurance."
He adds: "Some European banks are starting to realize theyve got to change their funding mix but this is a very expensive time to do it and so they have to de-lever. That takes at least a year, if not longer. And its very hard to make these kinds of adjustments in the midst of a crisis when whats going to get you through are the right decisions you took a year ago or two years ago, not the decisions youre forced to take now."
If European policymakers ever decided that it would be desirable to shift from the European model, where banks supply between 70% and 80% of credit to companies, with the rest coming from the markets, to the exact reverse, as the system prevails in the US, it is unlikely that they would ever seek to achieve this shift against a background of looming recession, sovereign defaults and bank failures. But it appears that is what the disappearance of bank funding is about to enforce.
The numbers appear daunting. RBS analysts suggest that European banks balance sheets have almost doubled in the past 10 years to 26 trillion in aggregate, which is equivalent to 235% of GDP. To get them down to 190% of GDP will require banks to shed over 5.1 trillion of assets, given that equity investors are unlikely to flood into banks shares amid such fundamental uncertainty over their resilience, earnings power, business models and regulatory burden.
Who might step up to buy these assets? Insurance companies aggregate balance sheets are only 7 trillion and fixed income accounts for half that total, with new premium income of maybe 0.5 trillion a year to be put to work. Insurance companies are already long bank risk and under regulatory pressure to reduce this exposure. They could take up maybe 15% of the slack, maybe 10%. US banks have a lot of cash, as do lenders in the Middle East and Asia but its hard to see what would impel them to step forward now as Europe faces contagion effects from the sovereign crisis and potential recession.
|How much de-leveraging do we need?|
|European banks assets, includes only publicly listed banks|
|Source: RBS Credit Strategy, Bloomberg|
Banks, in the meantime, are beginning to sell their better-quality assets that the markets value close to par, leaving them potentially with higher proportions of more questionable loans on the balance sheet, according to RBSs loan traders.
It all looks rather tricky. But theres no point giving in to despair.
Allan Yarish is a portfolio manager at Channel Capital, an FSA-authorized asset manager with $10 billion of credit portfolios under management that as well as managing portfolios also conducts capital markets business. In September it arranged $1 billion of multi-year secured funding for a universal bank at a more attractive cost than it could achieve in other funding markets.
"Portfolios of corporate and retail loans are among the most stable assets there are," says Yarish. "And the success of covered bonds shows that investors like bank assets. Its just banks that they dont like."
He continues: "What makes banks risky is the degree of leverage in their balance sheets. Yes theres stress on some assets, but not all of a banks assets magically become more risky just because of the banks own structural problems." He suggests there is every reason to believe that other providers of credit, including presumably specialist credit asset managers like Channel Capital itself, could fill some of the gap in bank lending, if banks continue to shrink towards the size of their deposit bases.
Banking conglomerates face extinction
In purely corporate terms the big banking model is beginning to look a bit like a dinosaur. "In most other industry sectors apart from banking, conglomerates long ago became very unfashionable," says Yarish. "They were hated in the stock market for being complex, opaque and inefficient. Why should banking be any different?"
He continues: "The mantra in financial services has been that it requires scale and diversification. But does it? A credit fund can be more focused and specialized on allocating capital within a certain asset class, say corporate credit, and managing concentrations and diversification, without also doing retail lending, or wealth management, or trading or providing M&A advice." Loan mutual funds have long been a feature of the US financial system. Europe might see a role for them.
A credit fund can be more focused on managing concentrations and diversification in a corporate loan portfolio, without also providing other vaguely connected banking services. Banks say they benefit from diversification, but do customers benefit from banks cross-selling many services to them?
As a credit investor in its own right, Channel Capital itself has been switching out of the debt of European banks.
Walter Gontarek, chief executive of at the firm, says: "Two years ago, high-grade senior unsecured FRNs were a bigger part of Channels investment portfolio and well matched against its floating liabilities. Recently, we have been more selective with Canadian, Australian bank paper and highly rated European agencies."
In his conversations with large European asset gatherers, Gontarek sees others taking the same view.
"In recent meetings with our German clients including insurance companies I noticed almost no new subordinated debt investments. They told me they are even more cautious with senior unsecured bank debt. My take-away is that senior unsecured spreads will settle higher and thats a permanent trend in the market for the foreseeable future."
Wherever that funding spread settles 120bp, 150bp, 200bp, or higher banks must try to re-set the terms on new additions to the asset side of their balance sheets and pass it on to borrowers.
Strong customers wont pay it. Weak customers might have to. But that raises more questions over the long-term trend in the loan quality of banks that are already selling their better assets to raise cash. Can they build a sustainable business model at higher funding spreads and at what spread will investors buy back into unsecured bank bonds?
"Until the market and regulatory uncertainties are effectively removed, including bail-ins, disposals and capital levels, then for many of these European banks there is no price point at which we would go back in," says one fund manager.
A smaller, better future?
So what does the future hold for the European and indeed global banking industries? It is easier to outline a vision for the industry five years from now than to predict how it will get there or what it might look like in mid-2012.
The long-term vision is that banks will become both much smaller and more specialized and differentiated, as they were years ago in the mid-1980s, before Big Bang, successive waves of financial innovation and finally regulatory failure that saw banks grow to such high multiples of asset size to GDP.
In the days when there were 10 sub-sectors to the FIG sector in the US financial industry each populated by a number of competitors asset managers, broker dealers, credit card firms, wealth managers, regional banks those specialists tended to trade on PE multiples of 15 or 20 times when the conglomerate banks, like Citi, traded on 10 times earnings. Smaller, specialist banks can be more valuable.
Investors might be cottoning on to this and telling banks they cant go on as they have. It is no longer in investors or, arguably, in customers interest to persist with the model of diversified, complex banks that rely on cross-selling multiple products to customers to hide their inherent inefficiencies. Customers, almost by definition, will not find themselves dealing with the best provider, although some might accept a price for bundled services as long as these are at least adequate.
For investors, though, the terms of trade look far less compelling. Investment banking paid off big time for banks in 2009 when companies de-levered and recapitalized. But it would require many more such good years to pay for the losses in the bad. One bumper year in five raises the question of whether its worth staying in the game. In any case investment banking staff drain out more of the returns in the good times, leaving less for investors who have to fund the very substantial infrastructure costs of participating in these markets: "paying for the gaming tables" as one FIG banker puts it.
It is very difficult to sell CIB businesses. Who would buy one now? Banks might even argue that if the financial industry changes so that capital markets take on a more prominent role in credit intermediation than the banks, then it makes sense to retain such franchises for the long term.
Luxury of choice
Which banks might still be around in six to 12 months to exercise the luxury of that choice is unclear.
Plenty of market participants tell Euromoney that the only way the European banking system can roll over anything like the big hump in liability maturities due next year is for governments to start guaranteeing their debts again. If they dont, the risk is of a sudden and wrenching collapse in balance-sheet capacity to extend credit, cratering already weakened economies.
Banks are going to be examined and forced to raise billions of euros of equity capital by regulators that private-sector investors have no strong incentive to provide other than to prevent dilution at distressed price levels. Those that need more capital than they can raise quickly from private sources will either be nationalized or, even though this wont be explicitly stated, they will go into run-off.
The second option might even be preferable.
"Believe me, Ive worked at banks that were nationalized and thats no fun," says a veteran banker. "The reason why you should get on and break up the bank is that if you dont the communists will be in here running it. And not only will they not pay you... theyll have your head on a pike."