A changing landscape
Fears of counterparty risk have reshaped the landscape for banks involved in sovereign debt deals.
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Many issuers are looking to reduce their exposures to certain institutions, while all are paying more attention than before to the credit quality of their counterparties. Will this trend lead to the exit of many banks from the business, while increasing the grip of a small number of top tier banks on the market?
The European sovereign debt crisis has changed the game for SSA bankers. Issuers are re-evaluating their priorities, and their relationships with the banks they deal with.
The process of awarding mandates for debt transactions has changed significantly within the past decade, said Sean Taor, head of DCM at RBC Capital Markets.
“Ten years ago, before bookbuilt transactions became the norm, banks competed most often on price alone,” he said. Today there is a more level playing field with regards to price, due to the greater liquidity and number of outstanding bonds in the market, and the bookbuilding process.
“Relationships are key now,” said Taor. “Relationships and the understanding of an issuer’s needs are very important, and with that distribution capabilities, underwriting ability, and swap pricing.”
The ravages of the crisis have taken a toll on the banking sector: counterparty creditworthiness has become a significant consideration, whereas before 2007 banks were universally regarded as safe investments. Before that time, when the market was far more generic, there was little differentiation between banks and their ability to execute a sovereign debt transaction. Since then, differences have begun to emerge between banks in terms of service levels, distribution and secondary flow capabilities, he said.
The biggest changes have come since the Lehman collapse, particularly in the second half of 2011, when the sovereign crisis morphed into a bank crisis, against the backdrop of an increasingly draconian regulatory outlook. Basel III in particular was driving the cost of finance up, forcing some banks to scale back their ambitions in the business.
With private placement or MTN deals the bank service comes as a package but the game is changing for benchmark deals, said PJ Bye, global head of public sector syndicate at HSBC. Issuers can strip out unwanted counterparty exposure, mandating separate banks for swap deals and cutting the lead manager out of the deal. This has blown the mandating process for benchmark deals wide open, meaning even banks that are unable to provide a full swap can compete for the mandate on benchmark deals.
“We are in a transition period,” said Bye. “Not all the banks are pricing in all the changes. The larger players are trying to accommodate the new environment by modifying their risk management systems. And the smaller ones think they can charge more aggressively to win market share.”
Issuers will continue to mandate smaller banks while the pricing incentive remains, he said, but eventually these banks will have to adapt their models to better reflect market realities.
Experience is crucial for banks competing for mandates. “Since the crisis issuers have taken more comfort knowing they are dealing with a well capitalised bank,” said Ulrik Ross, global head of public sector global markets at HSBC.
“Issuers know execution risk is higher now and they need to be able to demonstrate to investors they have done everything they can to ensure their deal is a success.”
Many banks have focused too much on execution when covering clients, and too little on how to add value away from the yearly benchmark, said Ross. “There is only a handful of banks that take a more long-term and holistic approach to client relationships, and those are the ones, we believe, that will be the long-term winners.”
“Issuers will consider league table positions and which similar deals banks have worked on in the recent past before mandating,” added Bye. Often the balance sheet will be a crucial factor: issuers typically prefer to work with banks that can offer them a greater level of certainty, without resorting to pre-placing most of the deal in an auction.
“Secondary market activity is of utmost importance nowadays,” said Horst Seissinger, head of DCM at KfW. For benchmark transactions, banks’ distribution capabilities remains one of several criteria that must be taken into account, he said, though for smaller deals a simple bidding process might be sufficient. But the secondary market factor is potentially decisive.
“Investors have become more sophisticated in recent years, which has seen more of them use intermediaries,” said Seissinger. “We have actively responded to this development, in terms of how we maintain relationships with the banks, and this demonstrates how important the issue of secondary market performance is to us.”
Borrowers have always used benchmark business as bait to extract the best private placement opportunities from banks, or to build up goodwill in expectation of favourable treatment in the future. While this remains true to some extent, the days when a benchmark deal could be given to a third-tier bank lacking in a top distribution platform, as a reward for favourable pricing on another deal, are over.
“We need to know the bank will be able to sell the deal within the marketing period,” said Seissinger. This has become a more intense task in itself: where marketing periods used to last for three days, they have been increasingly compressed into mere hours.
Other banks are hamstrung by the circumstances they found themselves in following the crisis. “It must be very hard for a bank like RBS, to be constantly told by its biggest shareholder that they shouldn’t even be in the business at all,” said one DCM banker in London.
“At times it has felt that the market was heading towards a cliff, but the politicians couldn’t even see the sea”
While some banks are scaling back in the business, or are increasingly seen as outside an inner core of top tier banks that are seen as leaders in the business, other former titans of the business have been forced out altogether. Before the crisis there was Lehman and Bear Stearns, as well as ABN AMRO and Dresdner, all of which were big players in the market. The overall reduction in competition in the business is likely to make it more expensive for issuers.
However, it has also created opportunities for new players to come to the market or for existing smaller players to scale up their ambitions. RBC, for example, has invested heavily and has the strength in the secondary market to have established itself as a major force. Banks such as Societe Generale and Credit Agricole have also increased their market share relative to five years ago, while the likes of DZ Bank have emerged as newcomers to establish a strong reputation.
The next tier of banks can compete for positions as co-lead manager on benchmark transactions for the biggest SSA issuers. A strong European distribution or, preferably, global distribution capability could be enough to get a smaller bank a seat at the table, but the ability to lead manage such a deal remains a more exclusive club.
Regulation: ultimate appetite suppressant
Regulation is arguably the biggest problem facing the industry right now. Legislation in the US and Europe requiring banks to hold more capital against certain businesses is making it less profitable for banks, making them more selective about the business they do and causing the number of banks competing in the space to dwindle further.
The sense that politicians do not understand banking or the possible implications of some of the solutions they are considering is palpable: “At times it has felt that the market was heading towards a cliff, but the politicians couldn’t even see the sea,” said Taor.
However, there is cause for optimism, said Taor. “Things are looking more positive in terms of legislation. The regulators are more mindful of the potential negative impact some of the ideas that have been discussed would have, and a wider arena of people are now being included in the discussions. There are still challenges, for example the question of whether banks should hold more capital against their sovereign exposures. But you have to say that the very fact that it is still being discussed is a good thing.”
With quantitative easing and the LTROs having helped markets to stabilise and with interest rates signalled to remain low for the foreseeable future, there is a lot of good news out there right now, Taor added.
Banks won’t have as much leverage or capital as they have in the past and will be more cautious, so liquidity will be lower in the longer term. Pre-crisis, banks were operating with as much as 60 times leverage, but that is no longer feasible, so the return on equity for banks will be lower.
But banking remains a profitable business, and sovereigns are set to be indebted for many years to come, which means there will be a steady pipeline of work for those in the business of organising those transactions, either through new issuance or refinancing. It will therefore remain a competitive business among banks, even if a smaller number of banks ultimately compete.
Looking for a better mix
Many banks have reduced headcount and consolidated their DCM activities. Several veteran DCM bankers have left the industry, and as a result there are fewer experienced syndicate and DCM professionals around, said Sean Taor, head of DCM at RBC Capital Markets. It naturally stands to reason that those that remain will populate a smaller cluster of banks, and these banks will increasingly come to dominate the syndicated sovereign space.
According to one SSA issuer, investment banks need a better mix of people, with experience supplemented by younger, hungrier people. This would help alleviate some of the operational risk that was always there but has become clearer since the financial crisis. Some banks’ DCM teams are reliant on one character, and if that person happens to be away at important moments over the course of a deal being worked on, it can have serious implications on the success of that deal, said the issuer.
In reality it may not be so simple. Building a successful public sector business requires consistency, said Ulrik Ross, global head of public sector global markets at HSBC. “You need to know your customers very well and it takes years. You need to have seen a number of business cycles and know how to advise your clients with regards to marketing and execution of deals in tough situations.”
Investment banking for the public sector is not just about execution but equally about best advice, solutions and creativity – in asset liability management, risk, capital, rating and general stake holder questions, Ross added. “These things were less of an issue before the crisis but they are vital now. These are things the up and coming generation of people will still have to learn, you really need experience.”
While many younger bankers will have learnt a lot from their experiences in the past five years, that will not necessarily mean they are ready to take control in the next cycle, if the markets see another shock. “They will certainly have learnt a lot, but that will still not be the same as having been involved in the senior level discussions where the big decisions are taken,” said Ross.