North America: US banks urged to lever up
It was considered the remedy for bank risk – force the banks to issue equity and delever.
However, in the US, where bank debt levels have been most reduced, that decision is proving to have unintended consequences and calls are growing for banks to change tack.
Analysts, bankers and policymakers are concerned that the decrease in senior unsecured bank debt is putting more risk into the system, as well as leaving investors without a core asset class.
|Former Federal Deposit Insurance Corporation chair Sheila Bair, who now heads the Systemic Risk Council|
"The good news is that the US banks are reducing their reliance on repos and other volatile short-term funding," says former Federal Deposit Insurance Corporation chair Sheila Bair, who now heads the Systemic Risk Council. "But the problem lies in the fact the banks are not always reissuing their senior unsecured debt and instead are relying more on insured deposits to fund themselves." That did not seem much of a problem when interbank funding markets dried up and any bank with a high loans-to-deposit ratio looked vulnerable. But radical changes to banks’ funding simply shifts risk to different points in the structure.
Bair tells Euromoney: "Unsecured debt is an additional source of protection for the government if a bank fails. As banks let their long-term debt roll off, it means that the US government that guarantees the deposits is now more exposed in the event of a bank failure than before."
According to Dealogic, issuance in US dollar-denominated unsecured bank debt longer than five years was down around $40 billion in 2011 to $191 billion, and this year to date looks set to be flat or slightly less.
However, even with that gross new issuance, redemptions are increasing, making net supply even more reduced than first appears from the primary market numbers.
In June, there was $60 billion in issuance, but $38 billion of redemptions. Richard Bove, senior analyst at Rochdale Securities, says: "American banks have got rid of about $174 billion in debt in the last four years."
More FDIC redemptions are coming during the next six months. "Banks are awash with liquidity," says Travis Barnes, head of US financial institutions debt capital markets at Barclays in New York. "A lot of them don’t need to refinance their TLGP [temporary liquidity guarantee programme – FDIC-guaranteed] debt, so they can just let it roll off and use their own liquidity."
Policymakers in the US and Europe are beginning to ask if banks need to be forced to start issuing. Bair and a group of prominent academics have suggested to the Federal Reserve Board that large bank holding companies have a capital stack that combines equity, subordinated debt and long-term debt that is equivalent to 30% of tangible assets. The average, says Bair, is about 21% at the moment.
In Europe, similar noises are being made. The recent draft directive from the European Commission on crisis resolution called for a 10% guideline for bail-in-able debt.
Banks will not take the suggestion lightly. The cost of issuing debt is considerably higher than holding deposits – roughly 4% to 5% for debt for US banks compared with 15 basis points for deposits.
Bair says: "Because banks have to pay a higher rate by issuing long-term bonds, they will want to rely more on deposits. It would have to be up to the supervisors to enforce minimum requirements for long-term debt issuance."
Meanwhile, a report by Credit Suisse analysts suggests the costs to European banks of the higher leverage, in addition to other factors proposed by the EC, could rise to an extra €31 billion a year.
The reduced outstanding of bank debt is also troubling investors, particularly in the US, who are keener than ever to buy exposure. Analysts say investors are more comfortable with bank credit risk than they were last year.
Moody’s downgrades are no longer hanging over the sector and were better than expected, generally inching official ratings down towards the implied levels at which bank credit already trades in the CDS market.
Reductions for comfort
The move to force banks to hold more capital and cease riskier activities reduces returns to investors in bank equity but has comforted bond investors. "We are seeing a lot of money coming into the bond markets looking for a return, but we are not seeing much in financial supply," says Barnes.
That’s a problem, says Bove, as investors cannot find similar high yields in other asset classes. BB&T redeemed $3.1 billion of trust preferreds in June. "Those yields were 6% to 7%, and now those investors are being handed back cash – what are they going to do with it?" asks Bove. "Where will they find yields at those levels?"
Improved credit fundamentals and scarcity have pushed up US bank bond prices. According to Barclays, financial-sector bonds with 10-year maturities and longer delivered a 14.18% gain year-to-July 13. That compares with 7.76% for equivalent industrial bonds and 7.39% for treasuries.
Bove says investors are bidding up US bank debt in their search for yield, explaining why US banks’ borrowing costs are going down in spite of Moody’s downgrades. US Bancorp’s 10-year offering last month priced at a coupon of 2.95% – the lowest coupon for a bank 10-year maturity since Lehman Brothers’ collapse, and beating its previous coupon of 3% for a 10-year bond it issued in February.
"This is the environment where bond investors feel more comfortable," says Barnes. "Issuers don’t need the liquidity but bank debt is trading at levels wider than pre-crisis. I’m not sure when we will get back to pre-crisis levels but it appears as though investors are more comfortable with overall risk/return profile and receptive to the supply."
He adds: "It’s ironic that investors now really want bank debt, just when the banks no longer need funding."