Following the Financial Stability Board’s recommendations of draft rules on banks’ total loss absorbing capacity (TLAC) published in the run up to the Brisbane G20 summit last month, debt capital markets bankers have been working on likely assumptions around new supply of additional types of capital, from AT1 up to senior unsecured.
Last year and for most of 2014 one technical support for the price of bank senior unsecured debt has been negative net new supply as banks delevered. It remains to be seen how the market will price such senior debt if supply now grows to comply with TLAC requirements.
Demetrio Salorio, head of debt capital markets at Société Générale CIB, says: “There has been discussion of whether losses to restore a bank to viability might be applied to just a specified portion of their senior unsecured debt, say 2.5% to 3%. And we have been talking about a new special category of debt that is bail-inable, possibly with shorter maturities and regularly rolled over.”
Price
How might markets price this?
“You have to see the asset quality review, the stress test and the single supervisory mechanism in Europe all as part of a process that also includes resolution regimes,” says Salorio. “This process has vastly improved the stability of European banks. Back in 2007, the banks funded for five years through senior unsecured at spreads around 15 basis points while operating with just 2% of equity. Today, senior trades at 45bp but banks have 10% equity. Maybe after the markets absorb the stress tests, improved supervision, comparable regulatory standards and the TLAC requirements, then even if that includes 3% of senior unsecured, maybe senior spreads sink to 35bp.”
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| Ultimately consolidation needs to happen for the stronger, better managed banks to take out over-capacity, save costs and protect margins Maged Latif |
That’s the optimistic view. But maybe senior spreads will widen. Deutsche Bank analysts model a 25bp funding cost increase on the existing stock of senior unsecured debt as TLAC requirements come into focus and then a requirement for those banks, now predominantly deposit funded, to issue more wholesale debt to be TLAC compliant. They calculate that this might consume a low-to mid-single-digit percent of European banks’ 2016 operating profit. That’s manageable. But it’s not very welcome with earnings already low and it’s certainly not much of an incentive to new providers of equity, hoping for improving net interest margins.
Even more troubling might be the cost of shifting bank legal structures towards the US and UK model of holding companies to be issuers of new TLAC-eligible senior debt liabilities.
Gerald Podobnik, head of capital solutions at Deutsche Bank, tells Euromoney: “The legal restructuring of banking groups into holding companies and operating subsidiaries is quite complex. It would need shareholder approvals; it might require share swaps and revaluations of group operating companies with possible tax implications. It would be the operational equivalent of doing a big internal M&A deal. It would be surprising if many in Europe are terribly keen on this.”
Aside from their concerns over the implementation costs of transforming legal structures, the fact that banks themselves are still not keen on M&A is another warning signal to investors in bank equity.
The need for consolidation to restore the European banking system to viability seems obvious. Alberto Gallo, credit strategist at RBS, points out: “Mid-sized and small banks in Germany and Italy in particular remain vulnerable, fragmented and high in number (1,813 and 680 respectively), preventing economies of scale. Control of these banks remains tightly held in the hand of foundations or the public sector, which is not a negative per se, but it has discouraged consolidation and reform.”
Negative returns
He points to IMF analysis suggesting Germany’s Landesbanken earned on average a negative return on equity, not just in the years since the crisis but even through the boom between 2000 and 2009. Over the same period Germany’s Sparkassen and Italy’s cooperative banks also earned a mere 3.6% and 4.8%, respectively.
Gallo argues: “Mid-sized banks which lack capacity to generate core earnings need structural reform to consolidate, reduce costs and improve profitability – more than another round of recapitalizations.”
Even as policymakers fight their good fight against too-big-to-fail banks, some are taking up this call. Andreas Dombret member of the executive board of the Deutsche Bundesbank has the grace to admit that while only one German bank failed the ECB and EBA adverse stress test, five German banks would have failed if the Basel III capital definitions that enter into force from the end of 2018 had been applied.
He further points out that net interest margins for German banks have been in structural decline for much longer than the current round of repressed policy rates. “Although the total number of banks in Germany has already been declining for some time, the German banking market continues to be relatively dense and has room for consolidation,” says Dombret. “Against this background, all ideas need to be considered. Mergers must not be off-limits, either – provided these are between strong partners and preserve sustainable business models.”
It seems an extraordinary call given that the country’s Sparkassen can claim that they were able to stand and keep lending to local businesses through the financial crisis when publicly listed banks, that had been driven to take on bad assets by public investors incessant demand for high returns, had to be bailed out.
“I’m afraid I don’t think domestic banking consolidation is top of anyone else’s mind in Germany,” one FIG banker tells Euromoney.
M&A
It probably requires a stronger economic recovery first. Nevertheless analysts and equity investors are beginning to think about positioning for an M&A round.
Paola Sabbione, analyst at Deutsche Bank, has been analysing Italian savings banks as possible targets and consolidators in a country where banks’ return on tangible equity is 35% below the already modest benchmark of European peers. “For example, UBI Banca/Carige is a logical combination in our view,” Sabbione notes. “Assuming cost synergies of around 30% of Carige costs, we calculate a maximum EPS accretion of around 20% in a cash deal.”
Sabbione accepts that mergers of equals among the Popolari banks look more tricky given the weight of employees’ and local stakeholders’ influence, but says: “In fact, these Popolari could buy other small (not listed) banks before or instead of merging together; regulators may welcome this anyway, partially solving the issue of a too fragmented and over-branched banking sector in Italy.”
While consolidation could make the European banking system more efficient and better fit for purpose, strong banks aren’t exactly rushing to hoover up their undervalued and more vulnerable competitors.
“In a way the comprehensive assessment was a missed opportunity if European regulators really harboured an agenda to restore the effectiveness of banks as lenders to the real economy by driving consolidation,” one banker tells Euromoney. “It would have been better, for that, if more banks had failed.”
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There has been discussion of whether losses to restore a bank to viability might be applied to just a specified portion of their senior unsecured debt Demetrio Salorio |
Maged Latif, managing director, global co-head of financial institutions advisory at HSBC, says financial services is an industry like any other, “in which ultimately consolidation needs to happen for the stronger, better managed banks to take out over-capacity, save costs and protect margins”.
However, regulation is making this increasingly difficult. We are, for example, unlikely to see any large-scale merger activity between G-Sibs on the basis that any new entity may be by definition ‘too big to fail’ and too complex to manage.
“There could eventually be more in-market consolidation or market extension among medium-size and smaller banks, but the current regulatory uncertainties makes this more difficult to occur at great pace,” Latif says.
The key to any M&A deal is how much capital it will consume, as goodwill gets written off against equity. If a bank management team announces a material M&A deal and the very next day has to say that, because of some regulatory change, the merged entity will require more capital than used as the basis for calculating the deal’s economics, then that is not going to go down well.
“It is banks’ total capital ratio that is becoming evermore important,” says Podobnik. “But the needle is constantly moving on that. We were at a point where 17% of total capital looked like a good ratio. Now 20% looks good.”
A model?
There are banks that are obvious candidates to be taken over and obvious candidates to be consolidators. For almost a year Spanish banking has been benefiting from inflows of investment capital following a consolidation programme that took out the Cajas sector. Could this be a model for the rest of Europe?
There are banks in Europe that are very well capitalized and banks that are less well capitalized and trading on low multiples of low earnings.
“We spoke to one German bank that was always going to pass the [EBA] stress test,” says one analyst. “It came out a little worse than we had expected and it seems that they were so unconcerned that when the ECB asked for details of every loan on which the bank had amended payment terms, while other banks argued the toss on every line item, this bank even included all those loans where terms were adjusted because borrowers had pre-paid in full.”
Yet if even such strong banks are unwilling to throw their capital into M&A to cut costs, bolster margins and increase returns because of lingering uncertainty on capital requirements, how confident should portfolio investors be in allocating more money to the banking sector?
