Financial institutions funding debate: Bank funding faces up to the credit crunch

Delegate biographies: Learn more about the panelists

Euromoney What are the challenges facing financial institutions right now? Nick?

NM, RBC Well, primarily people simply don’t know how long they are going to be operating in crisis mode. After last August, folks felt things might start to recover in the post-summer break; then there was renewed hope that the New Year would be the turning point; then it was the Bear Stearns bail-out. None of these has been a turning point, and the inter-bank finance and money markets are not functioning at levels remotely close to previous norms. So we’re adjusting to a completely new paradigm. There is liquidity but banks cannot fund in a way that creates the optimum liability structure and it is going to be this way for the foreseeable future.

HS, DnB NOR I agree with Nick, but I am breathing a little easier now. But to us it’s a very important distinction whether funds are available or not, and in some periods in November and around March funds were not available. That’s a very severe situation – will your customers draw on committed lines, which could create problems? Yes, you have the central banks guaranteeing back-up liquidity. But it’s not ideal depending on central banks, and you can be sure that they will not want to be seen to be funding loan growth.

CB, Westpac Internally, we’ve stopped trying to predict when it’s going to finish and we are now operating on the basis that the current conditions are with us for the medium term. It seems as though we’ve been through three separate periods of crisis: first, finding out who was holding sub-prime or related exposures at the outset; second, a period of fear of bank illiquidity; third, a period of recapitalization, which we are still in. And now overlaid on that we have macroeconomic fears. I think the most important thing from our point of view is that there is good liquidity in the market at a price. But that price is dramatically higher than it was, unfortunately.

FVG, Fortis I think the broader picture is that the banking industry has committed a serious breach of trust. Ten years ago it was bringing worthless dotcoms to market; today it is lending money to people who could not pay it back and being perceived to be at the root of serious economic problems. This will take a long time to fix. In my view, the real turning point will be when the banking industry comes back with ideas that capture the imagination and regain the trust of the investor audience.

In the meantime, the industry faces two threats: the first is the disappearance of the shadow banking system, which was procuring a lot of liquidity into the financial sector, and that is gone. And the second is that with credit spreads for financials wider than those for non-financials, the banks’ traditional intermediation role is extremely difficult.

RG, Shinsei Japanese banks experienced a severe version of the current scenario for the better part of a decade in the 1990s. Our predecessor bank, Long Term Credit Bank of Japan, was bailed out by the government of Japan in the late 1990s. So we have been through this cycle. It was a long and painful process. Now, looking at US and European banks, at least the pain is being taken much more quickly, so this should ultimately result in a healthier banking system much sooner.

Looking forward, there is a prospect for a prolonged period of low growth, as banks will no longer be intermediating financial flows to the same extent as previously. Banks will inevitably focus on repairing their balance sheets and tightening credit standards. What is happening with the Japanese banks is they are also looking to bolster their capital positions to some extent but clearly have not had to engage in balance sheet repair to the levels and urgency the US and European banks have had to embark upon.

The new market environment

Euromoney So what is the new market paradigm and how do you adapt to it?

LD, ANZ The first thing is that the new environment is much less predictable than the old and there’s not a lot of point trying to accurately predict when things are going to improve in some sort of attempt to ride it out. So volatility will remain high for the foreseeable future and you’ve got to adapt your strategies to account for it.

CB, Westpac Another way of putting it is that the market has become extremely cyclical: the crisis has been typified by six- to eight-week periods of better liquidity and better news, and then similar periods where things reverse, with each down cycle tending to be worse than the last.

RG, Shinsei The funding pendulum has certainly swung from being an issuers’ market a year ago to being an investors’ market today. I believe investors will continue to be in the driver’s seat through calendar 2008 and well into 2009. For issuers, this environment makes it much more difficult to find compelling entry points for new issuance as the cost of issuing at an inopportune time can be very expensive. Consequently, being opportunistic is a more risky strategy now. Issuers will have to increasingly take a hard look at the balance between selling assets and raising incremental new capital.

HS, DnB NOR And this cyclicality creates uncertainty. If you look at long-term funding, first-half 2008 versus first-half 2007, the amounts are significantly lower, so many banks have reduced their long-term funding and increased the short-term. This is the result of uncertainty over timing – should you lock in expensive long-term funding now or wait? The longer everyone waits, the bigger the backlog of long-term funding needs becomes, with a consequent effect on price.

NM, RBC Broadly speaking, most institutions that we speak to don’t want to go any further than three years, although there have been some longer private placement deals done. So the question is: how long do you go on with that strategy? You can do that for a year without skewing your book, but unless you think senior debt is going to get cheaper next year, why not put some longer-dated liabilities on your balance sheet now?

HS, DnB NOR That was our thinking. We gradually figured that the market dislocation would be long-lasting and so we started to fund normally at the higher price relatively early. But to Nick’s observation, we started to fill the 2010/2011 maturities due to lower prices and investors’ preferences but, to maintain a prudent liquidity management strategy, we are increasingly focused on longer maturities – we did the five-year senior at €2 billion this June. But at these price levels, all banks will face serious margin pressure.

CB, Westpac All the major Australian banks have taken the same approach, which is to fund right the way through this. We’ve funded normally from the outset – normally from the point of view of duration as well as amount and frequency, although not normally from the point of view of spread – and have written close to A$30 billion ($26 billion) from the beginning of October, and with an average duration of just short of three years. We think this is going to be a long time in repairing itself, and if spreads do come in, we think it will be gradual.

NM, RBC I wouldn’t be overly concerned that there will be a big asset liability mismatch as a result of the weighting that people are putting on shorter-term funding at the moment because, by and large, there aren’t many assets that banks run on their balance sheets that are longer than five years. The desire for longer-dated liabilities, I think, is being driven by the aggregate amount of wholesale funding that banks have needed to do in order to support the size of the balance sheet relative to the growth of retail: balance sheets have been growing faster than retail deposits. There’s a big drive globally to reverse that but the big challenge has been that you don’t want to do too much funding in any one year. So putting on longer-dated liabilities is more about taking the pressure off refinancing in the wholesale market, and the latter is depressed right now.

LD, ANZ You asked about strategies to cope with the new market environment. I’d say that our core strategy remains largely as it was 12 months ago, which is very much focused on diversification, consistency and transparency. The key difference is that there is now more emphasis on extending the strategic approach we have taken in the Australian dollar and fixed-rate euro markets to a broader range of markets and currencies. You only have to look at the samurai market to see evidence of this strategy in practice – it doesn’t necessarily provide the cheapest cost of funds, however the diversification benefits are very important. The purely opportunistic approach isn’t appropriate in the current environment.

CB, Westpac The samurai market is a great example of that I think. We had samurai infrastructure in place for the better part of six or seven years before we actually tapped it in January. Previously we found it difficult to justify issuing in samurai given the higher funding and infrastructure costs versus other markets. However, suddenly through this period the samurai market has come into line and has become an invaluable source of liquidity for us.

Back to retail

Euromoney We will return to the theme of diversification at the end because the role of emerging markets as capital exporters is a story of the future, but one source of funding that has perhaps not been exploited recently is retail. What can you do there?

HS, DnB NOR Of course loan to deposit ratios have become very important to analysts and they have been falling for some time. But with rising interest rates, deposits rather than structured products become more attractive to retail clients and this has been a very important source of diversification for us.

NM, RBC The UK banks have learnt it from people like ING Direct and some of the Icelandics but in the past they have failed to properly service the retail client. If they couldn’t sell you insurance or a mortgage or manage money for you in one way or another, the actual money you might be prepared to leave in a bank account was never really a focus. However, that’s changing rapidly. The challenge is to go back to old-fashioned customer-focused banking and to grow sticky deposits.

HS, DnB NOR Remember too that not all deposits are retail. We want to make sure we get as much out of our corporate relationships as we can, too, and so we try to finance our international loan growth to as large a degree as possible from deposits from the same customer base that we lend money to. In volume terms that might be more important than the domestic retail deposit base.

FVG, Fortis We deem the retail segment currently very complementary to institutional long-term funding pockets, and consider such segment part and parcel of adequate asset and liability management, though name recognition and saturation require more immediate attention. Additionally, this crisis has also shown the importance of the secured market – the triparty repo market has been a tremendous help in weathering the storm and has not even been used to its full extent. Since many of the counterparties have different liquidity profiles to the banks, I think there is further scope for liquifying positions here. In general, though, I think that secured lending will be the key to any recovery, whether it be the covered bond, securitization or the triparty repo market.

NM, RBC But the emphasis on retail is a big change. Banks have run their wholesale and retail businesses in a particular way for at least 10 years and I don’t think most banks have run their retail-targeted deposit businesses as businesses in the sense of the marginal cost of funds. That situation will reverse.

HS, DnB NOR I agree with that. Retail liability has always had better spread characteristics than the assets, but there’s a massive focus on maximizing your retail take but not from just any customers. Quality of retail is important as well, and we’re very focused on that.

RG, Shinsei Looking forward, balance sheet pressure will continue to be intense, and financial institutions with retail deposit franchises are well placed to weather the storm. The key for a financial institution is a balanced liability and asset base or, in other words, a stable credit-deposit ratio. In the Japanese market, the limited use of institutional funding for most banks should help alleviate some of the funding pressure being felt by US and European banks.

LD, ANZ In the Australian context, the competition for deposits has increased significantly in the last 12 months. For the big four, retail deposits make up just over half of the total funding profile, and that’s an important source of funding for the banks. Now the more lowly rated players in the Australian market that relied heavily on the wholesale market are being particularly aggressive on the retail front. So it definitely is a focus for all banks to be a little bit more creative and work out how they can maximize genuine retail deposits.

Euromoney And let’s not forget the more traditional retail capital markets investor base. Is that still solid?

FVG, Fortis If we’re talking about Benelux, there’s always been a substantial base in Holland and Belgium, and one of the dynamics has been the vast demand for structured products in a low interest rate environment. If you now combine the higher interest rate environment with subordination, it’s an easy case to make to your retail investor to shift preference and look at bank capital.

CB, Westpac One of the things that’s most striking – take the US retail tier-1 market as an example – is that the retail market has remained open right the way through the crisis. So I think it is important, in whatever location, to have the ability to access retail.

Public versus private

Euromoney Let’s move on to the choice between public and private markets. How has the present crisis changed the relative attractions of these two sources of capital?

RG, Shinsei Public markets remain a preferred medium for us. The markets are open but are constrained in terms of execution certainty and price of capital. Windows of opportunity open and close at a fast pace. In this environment, it is helpful to be prepared ahead of time so opportunities can be tapped as they arise. Asian and European private bank investors are increasingly participating in FIG transactions partly due to the attractive coupons currently on offer.

NM, RBC Private placements have often been as much as a quarter or even a half of all FIG wholesale funding, and I think it’s been an area that’s really paid off. In terms of previous investor relations work and core investors who really understand your business, it’s been a sensational success. By and large, when people have come to market over the course of the last six or nine months in the public markets, they have repriced their curve. That has meant that they have opted to issue in size, which has meant that euros and dollars have dominated as the deepest and biggest markets. But I think that the happy offset to that has been the success of private placements, whether they’re done in senior unsecured form or in lower tier-2 slightly structured form – I know Fortis has had success with its retail network in that regard – or whether in covered bond form. I think this has been a great success story and a big part of the functioning of the market.

HS, DnB NOR Yes, as Nick points out, we have followed the strategy of very large public deals so far in 2008. With regard to residential mortgage covered bonds, for example, I think there have been three, perhaps four deals so far in 2008, of €2 billion, out of which DnB NOR has issued two. However, we are very mindful not to overload the public market, so the timing and size of our third covered bond issue in 2008 will be very carefully planned. But on the back of this, we have issued €1 billion in the form of private placements in covered bonds. Some of these have been moderately structured into interest-rate-linked structures.

CB, Westpac Over the past 10 years, private placements have been up to 50% of our funding, largely because we have successfully tapped into surplus Asian liquidity and much of this has been accessed privately. Traditionally, we used to price private deals about 10 basis points inside our public levels. Over the past year it’s been anywhere between 30 back to 10 back. So we have had to reprice private placements as well as our benchmark offerings. But it has still allowed us to leverage down the cost of our funds and it’s just a fantastic way of increasing your investor base.

FVG, Fortis Our core strategy is to use public benchmarks to establish the curves. Once you have the curves it’s much easier, as one of the reference points, to trade the private placement area. It’s been a godsend this year and for the major part of last year to be able to fall back on this private investor segment.

LD, ANZ Private placements are a core part of our funding strategy. In addition to the pricing benefit that you get from issuing via private placements, we like the fact that you get additional diversification, particularly through a whole range of different currencies. For ANZ our private placements are something like a third of our total funding, and that volume allows you to focus public execution on issuing in larger sizes and less frequently.

Core bank capital raising

Euromoney One major difference in the FIG funding landscape right now is that the focus is not simply on ALM, it’s on raising core capital. What is the right balance between hybrid and non-innovative issuance right now and what are the regulatory constraints?

CB, Westpac For us, we have room under a non-innovative limit and have recently exercised it with an issue. I agree that capitalization levels are a key focus of the market. The Australian banks are all pretty well capitalized, the major banks in particular have done very well post-Basle II, in our case because we had a very high proportion of well-collateralized prime mortgages on our book, and generally the corporate assets are very clean, so we’ve seen windfall gains as our risk-weighted asset base is dropping and our organic generation of capital is good, given we’re still very profitable.

FVG, Fortis From a more general perspective there are still different levels of hybrid capital allowed by regulators, depending on region. But I think it’s very clear that many investors and regulators deem this part of the capital base to be over-leveraged and are looking back at core tier 1. And it’s clear that the capital has not been that easily forthcoming. To return to previous market conditions, people will have to be convinced the banks can once again add value.

RG, Shinsei Japanese banks have been active in hybrid securities markets in recent years. Under Japanese law, however, banks are restricted to issuing hybrid securities up to a certain limit (eg, step-up hybrid securities up to 15% of tier 1 capital). Consequently, an optimal capital ratio needs to be considered along market, regulatory and rating agency constraints. A question for Japanese banks is how to refinance the significant capital that is falling due this year.

HS, DnB NOR We do not need hybrid capital, because the effects of Basle II, along with retained profits, will finance our expected growth in risk-weighted assets until 2010. However, the Norwegian regulator is extremely conservative and sticks to the 15% level for innovative hybrid capital, and we have not approached him in order to discuss any increase to 25%. I think we are all also waiting for the outcome of the EU-level discussions with regard to definition of capital.

Euromoney The Commission of European Banking Supervision (CEBS) study?

HS, DnB NOR Yes. So that leaves some uncertainty as to when and on what terms you should issue hybrid capital right now even if you assume grandfathering.

NM, RBC I think the CEBS study, which is coming towards conclusion in terms of its final recommendations to the European Commission and ultimately towards CRD, recommends that there should be grandfathering. But what is interesting is how banks have universally determined to go out and raise fresh core tier 1 capital. The entire focus of analysts and investors in terms of looking at leverage and loss absorption capacity has gone straight to core tier 1. And I think the whole debate about lower tier 2 is one that we need to have, because it’s pretty clear that banks aren’t going to be allowed to fail, not the ones that we’re talking about, and therefore the subtle degrees of priority of payments in bankruptcy is a marginal thing.

HS, DnB NOR Certainly nobody pays attention to lower tier-2. The regulator is sceptical about it, the investors don’t care, the rating agencies don’t care. So from my perspective, lower tier-2 is pointlessly expensive funding. So one thing I would welcome from the discussions in the EU is that they would rather have a higher minimum requirement without lower tier-2.

FVG, Fortis Well, in terms of major duress, of course you always look at the strongest element of your capital base. However, I would still say that there should be room for subordination levels within the capital base, as it meets specific investor appetite.

Securitization’s future

Euromoney Obviously we don’t want a full Basle II debate, but you are saying that you think the more exotic flavours of capital will be less common, which is a direct effect. What about the impact upon securitization?

CB, Westpac We have traditionally securitized for diversification of funding source, not for balance sheet reasons. The bad debt experience on Australian mortgage collateral is historically around a basis point, and the 90-day delinquencies are somewhere in the mid-30s. So the collateral has always been very good and, because of that and because we use economic capital principles, the actual amount of capital release we got when we did securitize from an economic point of view was close to zero. So from that point of view, Basle II should not impact on our inclination to securitize at all. If the market comes back, I’m absolutely certain that we’ll continue to securitize.

FVG, Fortis Notwithstanding the closure of the market at the moment, we think securitization has a much broader and wider role to play going forward. Over and above the liquidity perspective, there’s the solvency relief perspective, there’s a funding perspective, as there is also very importantly the collateral perspective. I think in that regard we look forward to using securitized assets as collateral within our covered bond programme. We mentioned the importance of secured funding earlier and I think a lot will happen in that space, and this might be one of them.

NM, RBC One of the great tragedies of the US sub-prime meltdown is the contagion into the European, and indeed Australian, RMBS market. Securitization in Europe doesn’t deserve to have had anywhere near the trashing that it’s experienced. Yes, a lot of the paper was bought by SIVs and those balance sheets have been, I think quite rightly, challenged for their relevance and sustainability. And, yes, a lot of bank treasury and liquidity books probably bought a little bit more RMBS than perhaps was advisable. But if you look at fundamentals in terms of the underlying collateral, the transparency in RMBS master trusts or, better still, discrete trusts, is far higher than from any bank and certainly better than most covered bond programmes. You get a lot of advance warning of anything going wrong and you get a tremendous number of structural features that allow the deal to self-remedy from the point of view of maintaining the rating. And I think the rating agencies did a superb job in the 30 years or so they’ve been rating European RMBS, and it’s a tragedy for them that they’ve made such a mess of it in the US, because it’s totally undone all that credibility. And for me, in terms of asset classes that really deserve to come back, and come back strongly, it’s RMBS.

HS, DnB NOR Yes, I quite agree. We are a significant investor in RMBSs because we use them as collateral in our central bank operations. So we feel the risk/reward is tremendous. The drawback is the volatility and the potential mark-to-market losses. We use covered bonds as our major funding tool along with senior debt instruments. Securitization is somewhat problematic given Norwegian legislation and we look at it only for potential capital relief. So we wish the RMBS market well, because it will take some of the pressure off the covered bond market, allowing us to benefit indirectly in our funding.

NM, RBC Because some investors will use up no line to DnB NOR in buying your covered bond and others will use up some percentage?

HS, DnB NOR Yes.

NM, RBC Whereas if they buy your RMBS, were you to issue it, it would have zero credit line usage. So it genuinely is incremental to your overall debt strategy.

LD, ANZ I think the RMBS market will come back. Frankly, it’s staggering to me that Aussie RMBS has traded as wide as it did, when underlying collateral has very low losses by historical standards. But I do think that that market will come back and we’ll be users of that market. It’s just unfortunate a lot of these securities are in the wrong hands, having ended up in the hands of distressed owners.

RG, Shinsei The securitization market has been impacted in Japan as in other markets. Shinsei is at the leading edge of the covered bond market with our plans to pioneer the first covered bond in Japan. While it will take some time for covered bonds to gain traction in Japan and the US, covered bonds are likely to become an important new source of financing, provided the appropriate legal framework is in place.

The CDS market

Euromoney We’ve not talked about the credit default swap market and how that affects you as institutions and how that affects your investors. Has this market been helpful or got in the way of what you wanted to achieve?

LD, ANZIt’s been helpful at times and it’s been harmful at times. It’s obviously been a great indicator of the direction of sentiment in the market. However, credit default swaps levels can at times be heavily influenced by technical factors at the expense of pure fundamentals, resulting in significant spreads between the cash market and CDS spreads – this can be harmful when pricing new issues. The fact that CDS spreads are extremely visible means that you can spend a lot of time explaining that that’s not necessarily where you can get deals done in the cash market.

Euromoney And when you decide where to print deals, have you changed your decision-making process since the crunch, ignoring CDS more and using the cash?

LD, ANZ The difficulty with the cash markets is that secondary spreads have been almost entirely useless because there’s been very little secondary market trading. So we’ve been forced to look at CDS spreads as a reference, but to try to take into account the fact that that too is a somewhat artificial number. It’s now much more about what investors demand, rather than simply plugging in inputs to get a price.

CB, Westpac I think funding has always been an art, not a science, but now more so than ever. Looking at how recent deals have printed you would sometimes be forgiven for thinking that you get extra points for artistic impression. There are so many inputs into what is the right price, but at the end of the day there’s probably still nothing better than actually asking investors the question themselves and having a good level of engagement with them. Having to take so many variables into account has certainly made finding that right price a lot more exciting than it used to be in the old days.

FVG, Fortis For us, CDS was definitely a pricing input at times when cash was almost totally absent as a price indicator. But there is clearly a problem with these instruments when the reference underlying is illiquid or the interest in the CDS far outweighs the trading in that underlying. At that point, CDS cannot really claim to add too much value.

HS, DnB NOR CDS were more important for pricing in the first part of 2008. There was some movement in the secondary cash market and CDS became less important. We use it more or less to brag, because our CDS is among the lowest in Europe! But frankly speaking, the CDS is often as illiquid as the cash, and so whatever you are looking at, pricing is extremely uncertain, at least for the Nordic names.

RG, Shinsei Given the recent lack of liquidity in the secondary market for cash bonds, investors are increasingly using the credit default swap market as a reference for new issue pricing. In the Japanese environment, however, hedging requirements from investors have been rather limited and hence the CDS market liquidity continues to be quite limited compared with the US market.

NM, RBC It’s a great thing that we’ve got the CDS market – I don’t think any of us want to go back to not having it – but it’s just one data point and, as Chris has said, pricing a new issue deal has always been about looking at various comps, whether cash or derivatives, and then assessing sentiment and momentum. I don’t think issuers are hung up on it but I agree that investors are perhaps paying more attention to CDS now than before in the absence of other data, and that creates a challenge for some borrowers.

The future

Euromoney Just to wrap up, is there anything issuers should look at that perhaps wasn’t important before?

FVG, Fortis Well, generally speaking, if you’re looking in terms of cycle, I think the banks are in the fourth stage of a cycle: the first stage was profit growth higher than in debt; the second is the debt accumulation taking over the profit momentum; the third is the bubble bursting; and the fourth one is the deleveraging that’s taking place now. Banks are scaling down their balance sheets and recapitalizing. However, the corporates are still at stage two and that is the next set of risks for the banks, since the commercial lending sector is much bigger than, say, the sub-prime market. Now you can hedge some of that risk in the CDS market and single-name market, but with the securitization market completely absent, it’s difficult to anticipate these risks. What does that mean from a FIG funding perspective? It means being proactive in bolstering capital bases further since we have seen losses in the region of two to three basis points where, again, the mean is 20 to 25. So I think you have to adjust for that.

HS, DnB NOR On the more encouraging side, I do think that one positive in future will be the emerging markets outside developed Asia as a source of capital. We have already seen some interest in our paper from China and the Bric (Brazil, Russia, India and China) countries, but as they deregulate and as the demographics shift further, we may be able to tap huge new pools of liquidity outside our traditional markets.

FVG, Fortis I totally agree. In Europe, and to a lesser extent the US, with populations growing older, de-saving is starting to take place: you’re not saving any more for the rainy day, you’re starting to consume your rainy day. And again, that’s why you’ll have to shift to emerging markets, there’s no two ways about it.