Shrunk in the wash

IFR Top 250 2014
10 min read

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The financial crisis nearly caused the end for many of the banking names that pepper the high streets of Europe. Most survived in one shape or form, thanks to a bewildering array of bailouts, nationalisations, forced mergers, and radical rights issuances. Slowly, the worst of the financial crisis faded.

Europe’s debt crisis, which nearly spelled curtains for the continent’s single currency, ebbed. Quietly, the banking sector reverted to type, regaining its strength, parcelling out loans to favoured corporates, and underwriting stock offerings.

Or did it? Much has been made of the importance of a third round of post-crisis stress tests – the first one was a dud, the second adequate – set to challenge banks later this year. Political capital has been lavished on a vigorous rebrand of the European Central Bank, seen by Brussels as the only institution capable of keeping the region’s lenders in line. Political leaders hope that when the record books are written, this will mark the year when Europe’s banks finally and definitively turned the corner.

Yet if that is the intention of regulators in Frankfurt – and in London, Paris, and Madrid – it may have come a little late. Europe’s banks aren’t what they used to be. Nor are they likely ever to reclaim their full, flawed, pre-crisis glory.

One reason for this is the steady decline of the lending market. The number of European corporates using the loan market to meet the majority of their long-term funding needs – a process once as inevitable as the following of night by day – has fallen systematically since the financial crisis. Many of those firms, as capital hungry as ever, are opting to tap the far deeper pockets of bond investors.

The transformation has been startling and swift. Debt capital markets, once an afterthought for capital-hungry European firms, are now foremost in their thinking, a process that Demetrio Salorio, global head of DCM at Societe Generale, calls “nothing short of rapid and amazing”.

Paul Bial, head of debt advisory business at Robert W. Baird, said: “There is more momentum in the bond market than the loan market right now.”

DCM issuance by corporates in the 18-nation eurozone topped US$171bn in the current year to May 28, up from US$82.5bn for the same period in 2008, according to Thomson Reuters data. The lending market contracted sharply over the same period, with total loans disbursed by eurozone-based financial services firms slumping to US$203bn, from US$537bn. High-yield debt issuance has popped even faster, hitting €55bn (US$74.5bn) in the first five months of 2014, up from €30bn in the same period a year ago, and virtually nil in 2008.

Several factors are playing out here. The first is diversification. Corporates now know they were top-heavy on loans in the run-up to the financial crisis.

“That was an important lesson to learn,” said a senior financial institutions banker working for a leading eurozone lender. “Companies in Europe realised they could no longer go on funding themselves using basically just one source of funding – loans – and that the bond market offered them a far more stable source of financing at generous rates.”

Corporate momentum

In 2013, reckons SG’s Salorio, bond markets met between 40% and 50% of total European corporate funding needs, up from barely 10% at the turn of the century. “You can argue that we will continue to see corporate bond issuance rise,” he said. ”Within two or three years, European firms are likely to be 75% funded by the debt markets in any given year, bringing them in line with their US corporate peers.”

Robert W. Baird’s Bail said that much of the momentum had come from larger European corporates increasingly willing to turn their back, for now, on old-fashioned vanilla bank loans.

Morven Jones, head of DCM, EMEA, at Nomura, said that since the global financial crisis, “investors are more comfortable with different types of credit, willing to invest in longer-dated maturities than the loan markets typically offer”.

Second, mid-sized and mid-ranked corporates can now raise capital at attractive rates. With interest rates still hovering around record lows in many parts of the developed world, even corporates once hobbled by, say, a Triple B rating, can tap bond investors keen to lavish funding on anything that moves. Unrated issuers are also enjoying their day in the sun.

“With issuers of all stripes being offered attractive funding across the entire capital markets space, it makes sense to diversify your funding by turning to debt-market investors,” said Hugh Carter, head of corporate bond syndicate at Commerzbank.

The need to lend

The final element at play here is the third and, European officials hope, final round of stress tests. Since the financial crisis, regional lenders have sought to find an equitable balance on lending, struggling to decide when to open their loan books and when to keep their powder dry. The ECB has made clear it will punish lenders deemed incapable of surviving a complex set of adverse scenarios, from deflation to renewed economic slowdown.

But banks that don’t lend serve little purpose, and frequently find themselves overlooked when clients are seeking candidates to underwrite stock and bond sales.

“Corporate bond issuers do not generally award bond mandates to banks that do not lend to them, or who do not have a significant position in their lending pool,” said Commerzbank’s Carter.

Banks find themselves in an invidious (to lend or not to lend?) position in the face of upcoming ECB stress tests, a situation that is “likely to cause bond issuance to [continue to] tick up, at least in the near future”, said Bail.

Either way, all these factors point to a single, defining phenomenon at play: the systematic sidelining of Europe’s once-proud lenders.

“We are seeing a true disintermediation of banks,” said Salorio. “We strongly believe that this is not a temporary trend, and that disintermediation is here to stay. Corporates have fundamentally altered their funding needs.”

European funding markets, the SG banker said, have since 2008 become more “American”, with corporates ever more content to turn to capital markets to meet funding needs.

Robert W Baird’s Bail points to a specific example of disintermediation at work within the leveraged finance space. Buyout firms looking to complete acquisitions are increasingly turning not to banks but to debt market funds, which offer plentiful capital at low rates.

This unitranche funding model, he said, “is competing directly with some of the banks that are out there, so you can argue that banks are to an extent being disintermediated”.

A recent example was €110m in unitranche financing provided by GE Capital and Ares in March 2014 to fund the purchase of Netherlands-based medical equipment maker DORC by Montagu Private Equity. GE and Ares created a joint €1.75bn fund for unitranche financing in November 2012, deploying between €50m and €100m per deal.

Banks remain relevant, of course. When Verizon Communications bought Vodafone’s 45% stake in Verizon Wireless in September 2013 for US$130bn, it turned to a quartet of trusted lenders, including Barclays, as the only European lender, to provide the bulk of the bridge financing.

Commerzbank’s Carter testifies to the “clear willingness” of European banks to stretch their loan books when key clients come calling. And there could be another twist in the tail here. Interest rates will ineluctably rise as Europe’s economy slowly returns to form, pushing up the cost of debt market funding and making the loan market, relatively more attractive.

“If the broader European economy continues to pick up steam, it will mean that borrowers will likely need to access capital either way, and they will look to both bonds and loans to fund their needs,” said Bail.

But most clarion voices see European lenders increasingly becoming focused providers of specialist lending services, giving clients everything from project and trade finance, to revolving credit facilities and bridge financing, to foreign exchange and cash management. The old days, when Europe’s totemic lenders were essential to keeping the region’s leading corporates funded and oiled, are probably gone for good.

“Even if conditions improve in the future, as interest rates rise and banks pass the ECB’s stress tests, I believe there will be resistance from companies using loan markets to finance themselves,” said SG’s Salorio.

Banks will become providers of specialised lending services focused on short loan tenors, while the bond market, said Nomura’s Jones, has now become “the most efficient route for mainstream corporates to mobilise large amounts of capital”, while delivering “constant access” to long-term funding.

It may not be the future that European lenders, many of which remain a shadow of their former selves, once envisaged. But at least they have survived to fight another day. That is something at least.