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IFR: Yes. So Steve, do you support that notion that ultimately it’s all about the price?
Steve Sahara, Credit Agricole CIB: Well, I guess I said earlier that some of the issues of black box which have been coming out in different forms: people have explained what might be in the box. I said I was longer-term optimistic and agree that with stability and greater transparency, people can evaluate what they want to invest in.
And perhaps investors, who can view a simple bank that’s more utility-like and made up of visible corporate credit and safe mortgage assets, can feel comfortable that even if hierarchies aren’t reflected in any eventual downside, the downside is so improbable that they’re completely comfortable buying into that capital structure.
But that doesn’t exist. And that’s not how banks make money. There’s always something else that’s happening there. And that’s where the negative surprises come from. And I don’t know if the industry knows at the moment what that thing will be, beyond the safe assets, to produce the outsize returns. When we figure that out, if we figure that out, investors have to decide whether they want to be a part of that risk, in addition to the safe stuff. Because that’s where the downside’s going to come from when we look at hybrid capital.
Johan Eriksson, UBS: Another major irritant that I have is the black box topic. With a bank you have a business model that’s been there for a long time. Default rates are what they are, historically. You can speculate that they’re going to go up if you define default as entry into resolution. But on the other hand, you have lots of reasons to believe that it’s not going to go up given the buffers about the point at which a bank enters into resolution.
But what’s a black box applied to a corporate when you have maturity of patents in a pharmaceutical company for example, and a huge replacement risk relating to whether those patents are going to generate competition? It’s a massive risk. That’s a black box risk that I would be at least equally uncomfortable with comparing the black box nature of banking for example.
Any other corporate is exposed to these risks. It’s not a regulated risk. And it’s not a risk that people have thought of so much. But default rates are typically higher with corporates than financial institutions. It’s not only because many financial institutions have been systemically supported; on the insurance side, they’re not systemically important. They’re not typically bailed out. Default rates are very, very low.
David Marks, JP Morgan: The other thing is, as you say, in normalised markets everything is in the price. I mean none of us would be in this business if we didn’t fundamentally believe that. And I think you can look at certain jurisdictions, like the UK banks, and say the spreads of UK banks just have to come in. It’s unsustainably wide at this point in time. The problem, to be blunt, is that we just don’t have normalised markets for Spanish and Italian banks at this point.
So what I’ve heard investors saying is, “Yes, we completely agree that Spanish banks are extremely attractively priced at the moment. The problem is, if I get tapped on the shoulder, and I have to cut peripheral risk, I know I’m not going to be able to exit that position unless I write-off several points”. So, unfortunately right now, everything is not in the price.
Sandeep Agarwal, Credit Suisse: Although I must say that banks are fundamentally a credit positive environment. And that’s improving as we go along from what it was historically. I did try to argue with one large investor once about why corporate debt trades so much tighter than the banking sector because banks fundamentally are intermediaries and they’re losing their role as intermediaries if corporate debt prices so much tighter. Therefore disintermediation is the name of the game.
And the explanation that was given – and I think it’s a fair line of thinking – is corporate leverage is not more than let’s say half, typically. Whereas the banks, as we know, are leveraged at least 12 times or at least they try to be leveraged 12 times.
In an unsupported environment, which is what we had presumed in the previous cycle, that leverage deserves a little bit more in price. And that’s the reason why bank senior unsecured debt priced that much wider than corporate debt. It’s a logic that’s difficult to argue against if you just look at the default analysis and say, “Okay, this is what it may look like”.
The question then becomes: “what is systemically important and what is not?” because corporates are typically deemed not to be systemically important. And that’s the differentiating factor as to why that leverage is acceptable in the system.
And there I think the point that we have to realise is at the end of the day, big is beautiful in this environment. Perversely, whatever the regulators are trying to achieve, i.e. to make the banking system a bit more broken up and not too big to fail, unfortunately too big to fail is important.
You need to be too big to be able to understand that you can then run the leverage because systemically you will be supported. But you should have sufficient loss-absorbing capital that you don’t have to go to taxpayers to repair yourself. That’s the play. So that is one explanation I was given.
Johan Eriksson, UBS: I agree we get those comments. I disagree what benefit is seen from the point of view of the investor community, because they feel that they’re going to be penalised before governments act on systemic importance by actually supporting institutions.
But if you look for example at S&P’s capital ratio model, which I think is a fair assessment of the value of diversification, a bank such as HSBC or even a smaller but international diversified European bank, such as Nordea for example, risk-weighted assets are reduced by something like a quarter, or up to 30% or something like that for a more globally diversified bank versus a nationally-oriented narrow bank.
And from my point of view diversification is an inherent risk mitigating factor, which of course regulatory developments don’t favour. But I don’t think they necessarily need to although it’s obviously true that geographic and other types of diversification are explicitly rewarded in lower capital requirements.
Whether that’s going to be a feature of Basel IV or Basel V, at some point economic realities should be recognised in bank capital requirements as well. But I think from a market point of view, it is a factor. And I think we will return to a market that favours diversified and larger banks. Not necessarily because they’re systemically important – and there will be protection afforded as a result to senior unsecured creditors – but because it’s fundamentally better to have a diversified risk profile.
David Marks, JP Morgan: Well, I think it’s a combination. We’ll benefit from the fact that there is an aspiration, if the banks are no longer too big to fail, that there will be intervention that will protect creditors; not necessarily just senior unsecured creditors, that there is the portfolio effect. And there is better regulation. I think we all had, frankly, perhaps misplaced confidence in the quality of regulation, historically. Famous last words, but we won’t repeat that particular mistake of the past, going forward.
IFR: So what’s fundamentally changed in the quality of regulation?
David Marks, JP Morgan: Well, if you’re working in a bank right now you see it first hand. It’s not just a question of the quantum of capital that we all have to operate under now: all of those areas where banks deal with regulators have quintupled in size. The key missing piece of the jigsaw that is now being replaced is macro-prudential regulation. That was conspicuous in its absence most evidently in the UK but elsewhere as well. Notwithstanding the concerns around the moving of goalposts, macro-prudential regulation of risk weightings going forward has to be dynamically managed.
Sandeep Agarwal, Credit Suisse: If equity analysts tended to drive the capitalisation of banks, political rhetoric has taken over so I would say the regulators are bringing back some rationality in terms of practically achieving that. I think what is driving the whole system in terms of regulation is a general assumption that there will not be any more public solvency capital in the banking sector. Liquidity support can still come from the central banking community, as long as there are no losses imposed on taxpayers.
So political rhetoric is being rationalised through the regulators right now and I think that’s a positive thing. That’s perhaps the only positive thing I can say about the regulators at this stage. I think there is some semblance of trying to figure out what will work in the system, even though they don’t listen to all the suggestions that are being made, for sure.
Oliver Sedgwick, Goldman Sachs: Well, I think looking forward you’re also going to find a situation – you talked about equity investors driving capitalisation. I think there’s also an element of credit investors driving capitalisation. I think it’s interesting at the moment, where you’ve got very different levels of capital across Europe and you can compartmentalise that by geography as well, but there isn’t a consensus at the moment as to a particular level of capitalisation being able to achieve a tighter funding spread. Until we get to a stage where there’s enough look-through or confidence around risk weighted assets, what capital quality needs to look like, you can’t actually start to optimise models.
If a bank was told it needed to raise 2% more Core Tier 1 and could have 100 basis points tied to it in terms of funding, I think banks would do that in a heartbeat.
Georg Grodzki, Legal & General: Maybe one word should be mentioned here as well is supervision. I would dare to say that what went wrong with a number of these narrow banks – and we have had more narrow bank failures than we had failures of the other types of banks – was I think down to blatant naivety on the part of management, but also on the side of regulators.
The narrow banks which failed in the UK and Ireland were growing way too fast and nobody seemed to pay attention to that. Obviously the equity market liked it; again, stupidity. And credit investors were initially reluctant, but then sadly swayed as well, by ever-increasing profits. And they didn’t see that this was just not sustainable. It was actually bound to implode at some point.
So you need somebody with a brain to have a word with the CEO before he or she embarks on that daring take-over (speaking of RBS). But you can’t write into regulation that banks growing for several years above their market can’t do so without compromising risk. It’s just impossible.
There shouldn’t be any need to put that down in regulation because if the regulators are good supervisors, and have had experience in previous cycles, and with previous bank accidents, they know full well that sadly management sometimes doesn’t learn, equity markets definitely don’t learn, and credit investors are not reliable either.
So I would emphasise that regulation: a) shouldn’t be too complicated and clearly we have a complexity problem already; and b) they can’t replace an intelligent person watching what’s going on and anticipating the next type of risk. Because, let’s face it, regulations always suggest the last type of risk, and are not really able to anticipate what accidents can happen in the future.
And therefore we should not take too much comfort from tough regulations, and certainly not from complex regulations, and lean back and think “job done”. You still need people to watch banks, and sometimes look over their shoulders to make sure they don’t repeat very basic mistakes.
IFR: History suggests they do repeat their mistakes.
Georg Grodzki, Legal & General: They definitely will repeat them but this kind of stuff you can’t really capture with regulation. And again, that’s not just an investment banking problem. In narrow banking you have plenty of room for myopia, exuberance, optimism and greed.
Johan Eriksson, UBS: And narrow banks don’t just include credit-fuelled UK innovators. They also include Spanish and Danish savings banks which lack capital markets dependency. But they might have local politicians on the board, and in management. And they might be very good friends with the local construction companies, and what have you. The whole corporate governance morass in that type of bank is clearly contributing to the issues we have today, in Spain and Denmark specifically.
Sandeep Agarwal, Credit Suisse: One thing I would say is that I think as we ask a different class of investor community to start providing capital into the banking sector – and I’m not talking my own book here – management of any of the banks going forward should be responsible or be deemed and perceived to be responsible towards both equity holders and fixed-income holders.
I think that for too long the only mandate that management has deemed to have had is around equity and working for shareholders. If this is all about lending confidence to the markets about how management will behave in the cycle, I think management should be owning fixed-income risk as well.
A CoCo-type instrument should be very much part of management ownership, as much as it is a part of the distribution characteristics that we’re talking about of these instruments. That I think will lend confidence to the whole environment, that people are incentivised to work in a similar direction.
David Marks, JP Morgan: I’ve always been an advocate, perhaps as a function of the job I’ve ended up doing, that bank management should be paid in debt options, not equity options. It would have been interesting to see, if that had been a management performance metric, whether we would have experienced some of the mistakes we’ve suffered.
Banks will always operate, maybe it’s not with 10 times leverage, maybe it’s eight times leverage but bank models have always been leveraged. And therefore management’s interests need to be differently aligned from that of the corporate sector.
Georg Grodzki, Legal & General: I certainly welcome that proposal of somehow linking bank management’s pay to senior credit spread levels. That should be put on the agenda of all the reforms now being called for.
IFR: What are the things that keep you awake at night around the bank capital structuring and restructuring debate?
Steve Sahara, Credit Agricole CIB: I think the biggest issue has been the delay in providing clarity. Everyone can play the game if they know the rules. But nobody really knows the rules.
David Marks, JP Morgan: Yes, I would agree. I think the worst environment is the one that we’ve suffered for much of the second quarter, where we limp along. We need certainty. We need certainty on so many different points. It’s not just around the design of capital instruments. It’s around the clarity around the sovereign debt crisis, etc. It’s the slow death I fear the most.
Oliver Sedgwick, Goldman Sachs: It’s a case of every regulator wanting to have a level playing field. I don’t think any of the players actually know what the playing field is. That’s really what the agenda is: deciding what you need to do as a bank. If you’d had a situation where, to take it back to regulation, we knew what the bank capital instruments were going to be, what they’re going to look like, and that had evolved much sooner, then I think you’d find banks much more proactive.
Johan Eriksson, UBS: I think we know much more than that. The outstandings are relatively tightly defined, and we know when we will know. I think there’s a tendency to allocate blame for the current issues and uncertainties around the banking sector – which I still think is substantially related to sovereign and extraneous factors at this point – to uncertainty around regulation.
I don’t think the uncertainty around regulation is that great. I think we have enough clarity. It’s just that obviously it’s not implemented. Bail-in comes in 2018. But unless there are material changes to current drafts, which we don’t expect, other than write-ups in Additional Tier 1 instruments, I think we have what we need.
What worries me? Sovereigns and the extraneous factors. I think the banking system is on track to being fine.
Sandeep Agarwal, Credit Suisse: To me the biggest fear is not around the capital or the capital design. It’s the liquidity issue. In an environment where there are too many left-field events coming into play, some of them could really play a big part in terms of creating a set of events and crisis that could be prolonged enough that it will cause more failures. I think we are in an environment for the next couple of years that is very distasteful. I worry that liquidity may just be the biggest single issue right now.
Marc Tempelman, Bank of America Merrill Lynch: Right. We haven’t seen any banks fall because of lack of capital.
Georg Grodzki, Legal & General: I’m concernedthat we are going to slide further down a path where the risk appetite of mainstream investors at least, will continue to shrink, and these investors will retreat more and more. We’re retreating geographically from, say, the European periphery. We’re retreating in terms of type of instruments: we won’t touch hybrids, maybe subordinated, but probably not. In the future maybe not even senior.
Depositor preference in the UK clearly is the strong writing on the wall. We understand that the regulatory authorities seem to be somewhat indifferent to the possibility of a UK banking system which is totally free of senior unsecured debt. They would seemingly accept that scenario as a palatable outcome so why should we even hold senior debt in banks if the regulators think of it either as obsolete or useful bail-inable capital?
So we’re retreating from lower ranking forms of capital. We’re retreating from certain types of geographies. We’re retreating from the banking sector. Overall I think we can say that we’re retreating even from the sovereign sector.
And I can see that process is still being self-reinforcing. We haven’t really seen a slow-down in the pace of that retreat and that can’t be a good thing. Of course it’s not good news even for equity investors that IPOs are failing and that companies in need of disposals to raise money have to postpone them.
And despite the abundance of liquidity, there is less and less available where it’s actually needed. And that drives this strange discrepancy between extremely low yields on certain types of assets, and rising spreads and falling prices on other types of assets.
I don’t know where the counter movement or the force is coming from which will correct that, or at least halt or slow down that process because central banks have tried their best. But more and more liquidity is drifting to fewer and fewer assets and it’s becoming less and less efficient to support those assets, or to fund those investments which everybody wants to be funded.
So I think we’re in a conundrum here. And that’s going to affect banks probably more than any other institutions, even though liquidity is not so much of a concern for banks these days because they’re being told almost 24/7 to put facilities in place and stand ready.
But this issue does apply to corporates. And if you look at some of the peripheral non-financial corporates which have US$5bn, US$10bn of bond maturities next year, they don’t have access to the ECB, at least not yet, you sort of wonder how they’re going to get it done if their credit ratings drop further and their numbers look wrong.
So I just don’t see any exit yet. I hope somebody else can find one.
