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Monday, 23 October 2017

Adapt or try harder

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An increasingly estranged relationship exists between European banks and the companies they once funded.

“We live in two different worlds/That’s why we’re so far apart. You made your world out of vows that are broken/I built a world in my heart.” The venerable American crooner Hank Williams’ words could have been woven explicitly to describe the increasingly estranged relationship between European banks and the companies they once funded.

Once upon a time, the interests and needs of lenders and corporate borrowers across the region were, as the Chinese phrase goes, “as close as lips and teeth”. Banks, operating in a deregulated and highly leveraged world, lent to corporates of all shapes and sizes, who gobbled up money then came back for more. But that was before a financial crisis that transformed – and continues to transform – the relationship between funding provider and funding subscriber.

Banks, particularly the European garden variety, simply aren’t disbursing as much capital as they once did. Total lending by regional banks slipped to US$819bn in the first nine months of 2014, from US$858bn in the same period a year ago and more than US$1trn in 2011, according to data from Thomson Reuters.

The list of reasons behind this seismic change is long and complex. Stiffer regulations have ratcheted up the cost of lending for banks already struggling to slash headcount, trim costs and adapt to a slower-growing world. Many emerged from the darkness only to find that valued corporate customers, unable to secure capital from traditional lenders at critical moments, had turned to the bond markets for financial succour.

Facing new threats

“As a result of the banking crisis, many borrowers realised they couldn’t just rely on bank lending – they needed to diversify their borrowing sources in order to better manage any possible future financial shock,” said Demetrio Salorio, global head of debt capital markets at Societe Generale. Even banks desperate to lend found themselves often outgunned by the debt markets on price.

In the aftermath of the financial crisis, many expected the banks to bounce back to reasonable health sooner rather than later. Lending would resume in force as corporates returned to the hand that had always fed them. That has not happened

“We originally saw this as a cyclical change. But many, certainly in the legal community, are now wondering whether it will be permanent,” said Tom Budd, co-partner-in-charge in London at law firm Gibson Dunn. There has been, he adds, a general “loss of loan issuance appetite among US as well as European banks”.

Nor does the problem have any kind of short-term solution. Disintermediation in the banking market is playing out over a period of years not months. Many of the tougher regulations designed to underpin and circumscribe the activity of banks for decades to come – Dodd-Frank, leverage ratios, the Volcker Rule, Basel III – “won’t come fully into effect until 2018 or 2019 or beyond, so it’s more of a drip feed process, with banks changing slowly over time”, said Russell Schofield-Bezer, head of debt capital markets, EMEA, at HSBC.

“We are probably two or three years into a 10-year process. Look at it on a quarterly or an annual basis and you may miss the bigger picture.”

There is also a fundamental long-term change under way, in terms of how corporates meet their funding needs. Banks aren’t entirely out of the picture, of course. They continue to lend strongly to their most hallowed blue-chip clients, while many make much of their renewed willingness to lend to small and medium-sized enterprises.

Faded attraction

True or not – many point to a paucity of credit demand among European SMEs, and even many larger regional industrial firms, while many smaller corporates, said HSBC’s Schofield-Bezer, have opted to “cut back on long-term investments and to husband capital” – that overlooks a few simple facts about the state of the banking sector in general.

For one thing, bank loans just aren’t as attractive as they once were, for either lender or borrower. Banks’ required equity capital has almost tripled since 2007, “pushing up the returns a bank needs to make on lending in order to obtain a minimum return on an enlarged capital base”, said SG’s Salorio.

And while banks have spent the last few years retreating or, at the least, being forced by regulators to stand very still, the debt market has grown and metastasised.

Bonds, like cars or chocolates, now come in a variety of tempting forms and flavours, offering endless variations on returns, coupons and spreads. Some are tailor-made for investors looking to match specific maturities, others for those seeking a quick return, giving borrowers access to an entire new universe of potential investors.

Senior secured high-yield bonds are also becoming more commonplace in Europe, replacing standard bank lending facilities.

“I do business with an increasing number of hedge funds lending into the mezzanine space,” said Corinna Mitchell, a London-based partner who specialises in cross-border transactional banking at international law firm Dechert. “It’s a little riskier, and it generates higher returns, and it takes place at an end of the market in which banks still fear to tread.”

Filling abandoned niches

Banks are also being outflanked by their non-bank peers. In the US, roughly a quarter of all loans to mid-market firms – corporates with less than US$500m in annual revenues – are extended by shadow lenders and specialist debt funds set up, said Gibson Dunn’s Budd, expressly “for the purpose of taking part in a market banks were deserting”.

“One of my clients is a US insurance firm, which is doing commercial real estate lending. We didn’t have those guys lending before the crisis, but they compete now with the top retail banks”

An August 2014 survey by Private Debt Investor found that just three private debt funds – Lone Star Funds, Oaktree Capital Management, and Apollo Global Management – had raised US$73bn in just five years to invest in alternative credit. Dechert’s Mitchell also points to a recent surge in non-bank lending.

“One of my clients is a US insurance firm, which is doing commercial real estate lending. We didn’t have those guys lending before the crisis, but they compete now with the top retail banks.”

To many, the emergence of such new and variegated forms of funding is both desirable and inevitable. Banks still cling desperately to a maxim of safety-at-all costs, wary of inviting more opprobrium from the public or politicians. Some, to be fair, are carefully dipping their toes into riskier asset classes.

Finding a taste for risk

Dechert’s Mitchell points to a recent trade finance facility involving a Middle Eastern conglomerate and European and local lenders.

“The trading house wanted a US$800m facility but once the banks saw what they were looking for they got excited and upsized the facility to US$1bn. So this was the Middle East and commodities and cross-border trading – plenty of risk involved – but suddenly there was appetite for that debt exposure.” The conclusion: banks desperate for higher returns believe risk levels have fallen to a slightly more acceptable level.

But that will only get borrowers so far. A recent report by Standard & Poor’s estimated global borrowing needs at US$73trn through to 2018, but placed the maximum lending capacity of banks at just half that level.

Nor is the challenge of disintermediation unique to Europe. Lenders are also being shunted aside in the likes of Africa, Central Asia, and even China, where, said SG’s Salorio, “borrowers are increasingly interested in diversifying away from banks and into a booming primary debt market”.

This creates its own set of knock-on risks, notably concerns about the derivation of long-term strategic funding. Right now, said Salorio, even reasonably good mid-sized corporations can successfully source up to four-fifths of their funding needs through the bond markets. But he fretted about the effect of disintermediation on other slices of the financial sector such as project finance, where, he said, it would be some time before we saw the emergence of a “fully-developed [European] project bond market”.

Looking ahead, few expect to see much in the way of change. Banks will remain an important component of the lending landscape, integral to meeting the funding needs of the world’s leading corporates. They will learn to cling to new regulations while boosting their capital base through the issuance of Additional Tier 1 debt.

But these institutions, once leaders of the pack, are now first among equals at best: a component of the global lending market; a passive follower of prevailing trends rather than a trend-setter. More than ever, traditional banking providers and their once loyal corporate borrowers live in two different worlds – that’s why they’re so far apart.

To see the digital version of this report, please click here.

To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.

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