Feeling the heat
Exposure to doubtful eurozone sovereign debt is putting an enormous strain on European banks. Until some of that uncertainty is resolved, many will struggle to raise funding. The next few months could prove to be among the most traumatic ever experienced in the sector.
European banks are feeling the heat of the eurozone sovereign crisis and many are struggling to fund themselves. Although most have largely met their 2011 targets, there are real difficulties in securing short-term funding, and prospects for 2012 are very challenging. Any equity offerings would face huge challenges, so the pressure is firmly on debt market solutions – and the choices are limited. With the experience of 2008 still very much in their minds, central banks will not allow short-term liquidity to disappear, but that does not deal with the underlying problems.
The most worrying issues are the dynamics around the term funding for banks. The index of bank funding costs is above its previous all-time high – even above the levels of 2008. There has not been any significant unsecured issuance since the beginning of July. Bankers are increasingly pessimistic about the prospects for senior unsecured debt issuance from European banks resuming this year.
The problem is a combination of issuers looking at the spreads required to get a deal away and investors being wary of buying, except from a small group of names. Investors’ preference at the moment is to keep their heads well below the parapet.
Shyam Parekh, head of EMEA FIG Capital Markets, Morgan Stanley said: “The bank term funding market has become a barometer for the sovereign and general eurozone situation. This could lead to a feedback loop where banks, because of their borrowing costs, have to restrict credit availability and then, as a result, further weaken the macro picture, exacerbating the sovereign dynamics.”
There is a lot of talk about recapitalisation of European banks. The IMF is due to publish a major report this month. Increased capital is going to be an important part of restoring confidence and stability in general, especially in peripheral countries.
Parekh said: “There is a perception that one can just add capital to the system and then the bank funding markets will automatically reopen, whereas it may not be that simple, given the issues around sovereigns, etc. Restoring bank funding may require a broader range of tools, including policy initiatives.”
Most of the bank issues that came to the market during the summer and early autumn were covered bonds that were successful because of the level of protection that provided by the underlying assets. But the use of covered bonds eventually starts to impair the rating of senior debt, so this avenue of funding is limited, even in those jurisdictions where investors still have a ready appetite for the product.
The situation in the senior unsecured sector is even more dismal. There were no major corporate issues in Europe from the last week of July to the second week of September. For the normally busy early autumn that was unprecedented and demonstrates how fragile markets are. Commentators are agreed that if good strong corporates are not getting away, banks are going to be struggling.
Looking at short-term markets for bank borrowing – which have recently received a lot of attention, especially for US dollar funding – there is increasing nervousness. However, there is a consensus that the situation is nowhere near as bad as it was three years ago.
Morgan Stanley’s Parekh said: “If you look at the short-term repo markets, for example, they are by and large working well and, even more importantly, there are central bank back-stop facilities for short-term liquidity, whether in euros or dollars, such that we don’t see the risk of a complete drying up of short-term liquidity as happened in 2008.”
There is a clear awareness among policymakers of the hard lessons learnt about liquidity drying up and an enormous focus on ensuring it does not happen again.
In terms of long-term debt for European banks, 2011 to 2013 are the peak years for redemptions, with 2011 being the heaviest. That applies to senior debt, covered bonds, asset-backed securities, subordinated debt and some of the old government-guaranteed deals that were issued in 2008–09. This is despite a significant amount of deleveraging .
Mark Geller, head of financial institutions syndicate at Barclays Capital, said: “The redemption profile for financials over the next years is significant. Issuers have been aware of this and are planning appropriately. Reducing the size of the balance sheet through deleveraging has been a feature of the market – this helps to reduce pressure on both capital and funding.”
For example, Lloyds put in place a few years ago a plan to reduce non-core assets by £200bn, of which the firm has reportedly offloaded roughly £120bn already. That has the benefit of reducing its funding needs as well as taking pressure off capital. Many banks have been looking at putting in place similar operations.
In terms of general funding, for 2011 many of the large national champion institutions have said broadly that they are between 70% and 100% done for the year. This prudence has come from the experience of living through the last couple of years, when funding markets have been closed at some stage each year.
Barclays Capital’s Geller said: “In recent years, banks have adhered to a prudent policy of doing funding when you can rather than when you need to. Banks were able to use the fourth quarter of 2010 and the first half of 2011 to get themselves into a good position on the funding side for this year. There will be continued vigilance around opportunities to get ahead of 2012 funding needs.”
Therefore at the half-year point many banks were well-positioned with respect to their entire year’s needs. They were also in a position to withstand a prolonged summer interruption, which has in effect materialised.
Looking forward, the year 2012 is another busy one for redemptions and a lot of banks would have liked to have used the fourth quarter of 2011 to issue plenty of long-term senior debt or covered bonds to get a good start on their 2012 needs. That looks increasingly unlikely to be a possibility.
Looking for the exits
What can unlock the markets from their current volatile state? The European Financial Stability Facility could be used to recapitalise banks and an expansion of its size to enable it to do that might be desirable. The EFSF could buy more sovereign debt in absolute terms; and the introduction of a common eurozone sovereign bond would reduce some of the sovereign risks – assuming the legal and political problems could be overcome. The cloud over the bank sector at the moment is the extent to which they were asked to hold sovereign debt as part of liquidity rules: these are exactly the assets which look difficult to hedge and to hold from a valuation perspective.
For banks looking to recapitalise, the IPO market is hardly open at the moment, and that is even more the case for distressed or parts of distressed banks. The Spanish just managed to get away a couple of IPOs for combined cajas in late July. But Bankia and Banca Civica each only raised a paltry €100m from overseas investors in their respective listings; Bankia raised €3.09bn and Banca Civica €600m from their IPOs.
As for secondary offerings or rights issues, equity capital markets for banks and financial institutions have recently been extremely challenging across the board.
Eric Richard, managing director of Credit Suisse based in Paris and co-head of EMEA in the financial institutions group, said: “The idea that any large primary capital placement of shares in the banking sector would take place in the next couple of weeks is fairly low. Valuations are very low and many issuers will tell you that they are disconnected from the intrinsic valuation of their company. Also there is a concern whether the market will be there for a very significant placement of shares, even for a good quality issuer.”
It might not be impossible for an issuer to place shares in the market in a primary or secondary offering, but it would only be attempted by a bank in a desperate situation.
Does this represent a long-term trend? Richard thinks not. “Especially when you have some clarity on the sovereign issue as a whole a lot of concerns would be lifted. Then there is the possibility of some large transactions being placed again,” he said.
Investors are very bearish at the moment and few are keen to go back into the market. They will need to feel comfortable about valuations, which are currently at a crossroads between pricing in disaster or a recovery based on a solution to the eurozone crisis.
Richard said: “Traditional investors will come back to the sector when they think valuation is right and when they can see what is ahead of them if and when there is a solution to the sovereign crisis. The level of capital in the system and what is the long-term normalised profitability of the sector remain worries.”
The longer-term prospects are not helped, of course, by the continuing regulatory debates. The key message coming from politicians and regulators is that taxpayers should not in future underwrite banks that get into trouble. Senior and subordinated debtholders may have escaped largely unscathed in the first stages of the crisis, but there is a determination not to repeat that in the future. Until there is greater clarity on the future regimes for dealing with distressed banks, both equity investors and bondholders will inevitably be wary.
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