THE STATE OF EUROPEAN BANK FUNDING - Oliver Wyman · 2020-03-07 · Other secured funding (structured covered bonds and loan funds) 28 4.6. ... senior unsecured funding has been hit

THE STATE OF EUROPEAN

BANK FUNDINGNOVEMBER 2011

AUTHORS

Timothy Colyer

Matthew Sebag-Montefiore

In collaboration with Mercer

Contents

1. Executive summary 1

2. Introduction 5

3. The current state of European bank funding 7

3.1. A brief recent history of European bank funding 7

3.1.1. Pre -1997 7

3.1.2. 1997- 2007 – the period of easy money 7

3.1.3. The financial crisis 11

3.2. The post-crisis world 12

3.2.1. Refinancing requirements 12

3.2.2. Central bank funding 13

3.2.3. Regulatory response 14

3.2.3.1. Liquidity regulations 14

3.2.3.2. Capital regulations 16

3.2.4. Country comparison 17

3.2.5. Funding costs 18

4. The investor landscape 21

4.1. Short-term funding markets 22

4.2. Senior unsecured long-term debt 23

4.3. Covered bonds 25

4.4. Securitisations 27

4.5. Other secured funding (structured covered bonds and loan funds) 28

4.6. CoCos and other capital instruments 30

5. The future of European bank funding – and banks’ responses 33

5.1. The battle for deposits 34

5.2. Increasing tranching of banks’ liability structures 35

5.2.1. Asset-liability linking 37

5.3. Deleveraging, repricing and strategic implications 38

5.3.1. Repricing and cross-sell 41

5.3.2. Secured funding 41

5.3.3. Disintermediation 42

6. Messages for policy makers 43

6.1. Liquidity regulations 43

6.2. The importance of encumbrance 45

6.3. Bail-in regulations 46

6.4. Policy approaches to encourage savings rates and support for new business models 47

1. EXECUTIVE SUMMARY

Securing sufficient funding is arguably the greatest

challenge facing European banks. A lasting effect of

the financial crisis has been the disruption to the flow

of cheap wholesale funding that banks previously

enjoyed. Securitisation markets are still nearly closed

and the cost of long-term senior unsecured funding,

while down from its crisis peak, is still well above

pre-crisis levels.

Many European banks have now largely repaid crisis

central bank funding. However, recent market turmoil

and sovereign fears have disrupted short-term funding

markets to such an extent that these banks are once

again forced to rely on liquidity from the European

Central Bank (ECB). The ability to raise long-term

senior unsecured funding has been hit even harder,

with figures for Q3 2011 likely to show record low

levels of debt issuance. New liquidity regulations –

in particular, the Net Stable Funding Ratio (NSFR)

requirement of Basel III – will require banks to raise

~€2.7 TN of additional long-term wholesale funding

between now and 2018 or else reduce the gap between

loans and deposits by a commensurate amount.

Achieving this through additional wholesale debt

would require issuance volumes 80-90% higher than

the average between 2007 and 2010.

Short of a retreat by global regulators from the NSFR,

meeting this refinancing challenge will require a

mixture of deposit raising, deleveraging and additional

wholesale fund-raising. Indeed, given current

market conditions, a combination of these actions

will probably be required even to meet refinancing

requirements without Basel III.

This will reshape the industry. The Europe-wide NSFR

shortfall varies across European banks; some have

more than adequate stable funding while others

have significant shortfalls. Indeed, the consolidated

NSFR shortfall of all European banks would be only

€1 TN. Deposit-rich and long-term funded banks will

be able to take lending business from poorly funded

institutions that are forced to deleverage.

At the same time, European banks are being required

to bolster capital. This will make equity and new hybrid

instruments, such as contingent convertible bonds

(CoCos) that have been created specifically to respond

to new capital regulations, more important elements

of bank funding. High capital ratios should, in theory,

improve banks’ ability to raise debt funding, but

empirical evidence for this relationship is inconclusive.

Finding investors to provide this equity capital is yet

another funding challenge banks must meet.

Funding is also becoming more expensive. Even

without the NSFR, we estimate that the average

funding costs of European banks is set to increase a

further 10-45bps by 2017 as European banks replace

cheap pre-crisis funding with more costly post-

crisis funding. Indeed, with banks forced to increase

the maturity of funding and faced with investors

worried about the value of sovereign support for

banks, the increase in average funding costs could be

considerably greater.

The extent to which investors can meet banks’ demand

for long-term funding and capital will shape the future

of the industry. To understand this better, we surveyed

fixed income investors to discover their current views,

prognoses and cost expectations for a range of bank

funding instruments. Our survey revealed a very

different picture for different funding instruments, but

with challenges to many of the traditional mainstay

funding instruments.

Copyright © 2011 Oliver Wyman 1

Short-term funding sees continued strong demand, at

least for those banks with perceived strong sovereign

support. However, regulatory changes may cause

a radical change in the structure of this market,

reflecting banks’ need to fund assets longer than 30

days. Senior unsecured funding – the most common

form of long-term funding – faces an especially

uncertain future due to its subordination by mooted

bail-in regulations and concerns over the value of

the implicit sovereign guarantee.

As a result, lower cost, secured funding is increasingly

popular, with an increased use of covered bonds

already evident. Securitisation is likely to be a part of

this trend. We anticipate that securitisations will again

provide 10-15% of banks’ long-term funding, but

not for some time yet. Recent Residential Mortgage-

Backed Security (RMBS) issuance in the UK and Spain

suggests the start of this recovery. This trend may

further damage the position of senior unsecured

funding and deposits because issuance of secured

funding will lead to an increased “tranching” of a bank’s

liabilities (a move from simple liability structures where

most debt holders are of equal seniority, to one of many

tranches of seniority) in which senior unsecured lenders

are subordinated.

Given this background, we expect to see the

following trends:

A battle for deposits

− Customer deposits are the cheapest and safest

source of funding and a significant source

of standalone profit for banks under normal

conditions. The scramble for deposit market

share has already begun. We also expect bank

deposits to increasingly compete with money

market funds for liquidity given the favourable

regulatory treatment of deposits vis-a-vis

Commercial Paper/Credit Default Swap (CP/CD).

Increased tranching of banks’ liabilities

− The increased issuance of covered bonds,

increased Core Tier 1 and sizeable portions of

CoCos and other hybrid instruments will make a

bank’s non-deposit liabilities more “tranched”

− Senior unsecured debt will become the new

mezzanine, a trend that will only be exacerbated

by the introduction of any bail- in legislation.

Deleveraging, repricing and strategic focus on

self-funding sectors

− On the asset side, we expect banks’ balance

sheet growth to remain muted in the near term as

banks that depend on wholesale funding reduce

lending to meet new regulatory requirements

− The gradual repricing of lending businesses

without a natural deposit base – notably

corporate lending – will either squeeze the

economics or reduce the size of lending to such

sectors. Much corporate lending is already

unprofitable on a risk-adjusted basis, and we

expect banks to move lending towards Debt

Capital Markets (DCM) and loan funds while

attempting to maintain corporate relationships

for less balance sheet intensive and more

profitable business

− Parts of investment banking that are highly

dependent on thin spreads from very short-term

funding will also be squeezed as investment

banks are forced to increase the term of their

funding above 30 days

− Strategically, we expect to see banks focus on

fee-generating businesses that require little

capital or funding.

Financial strength as a strategic differentiator

− There is already substantial differentiation in

funding costs between banks considered by

investors to be financially strong and those

considered weak, especially in countries with

sovereign debt difficulties

− Financially strong banks with spare liquidity

will pick up market share. This is likely to result

in a market-led demand for capital ratios

(particularly Core Tier 1) above minimum

regulatory requirements.

2 Copyright © 2011 Oliver Wyman

For policy makers, the key messages from these

funding trends should be:

Liquidity regulation – details, timing

and deleveraging

− While we support the need for new liquidity

regulations, the details of these regulations

need careful consideration (e.g. the treatment of

liquid assets outside the liquidity buffer and the

treatment of covered bonds)

− The timing of these regulations will be important

to avoid undesirable restriction of bank credit

at a time when this is required to support

economic recovery

− Nonetheless, policy makers should accept that a

degree of balance sheet shrinkage is inevitable,

with banks passing on increased funding costs to

borrowers – to date, too much political comment

has demanded contradictory goals of increased

lending to individuals and business at the same

time as reduced liquidity risk and deleveraging

− Clarity about additional regulations is important

for the stabilisation of funding spreads, especially

regarding any bail-in regulation. While many

of the mooted policy suggestions have merit,

lack of clarity around how and when these will

be implemented has a short-term cost in bank

funding spreads.

The importance of encumbrance

− Further issuance of covered bonds effectively

subordinates senior unsecured debt and

regulators should be mindful of this effect

and the need to protect depositors, either

by differentiating deposit insurance rates or

introducing bail-in regulations

− However, this needs to be considered in parallel

with new capital regulations, as the net effect

on depositors from increased encumbrance and

capitalisation is unclear.

Removing barriers to new business models

− Regulators should support market infrastructure

that would lower the cost of corporates issuing

debt directly to the market, and keep taxes on

debt issuance to a minimum

− Widening legal covered bond schemes should

be considered to improve the availability of

bank funding. However, this should be done

without threatening the “gold-plated” status

of these instruments

− UCITS and pension regulation should permit the

inclusion of loan funds and other instruments

(e.g. CoCos). These are important to the banking

industry and suitable for individual investors and

pension funds.


2. INTRODUCTION

Securing sufficient funding is a great challenge

for European banks.1 In several countries (notably

Portugal, Ireland, Italy, Greece and Spain – PIIGS),

banks can make payments on a day-to-day basis

only by the grace of the ECB. Many banks in healthier

countries are grappling with the problems of closing

loan-deposit gaps in a market where demand for

deposits exceeds their supply. Many are being forced to

increase the term of their wholesale funding to meet new

liquidity regulations and to repay central bank funding.

New contingent instruments and equity capital are also

needed to meet new capital requirements.

These challenges mean banks’ senior managers

must consider changes to their funding and business

strategies. They also require regulators and politicians

to consider the consequences of the proposed

regulatory and legislative changes relating to funding.

1 Throughout this report, when we refer to Europe, we include Austria, Belgium,

Cyprus, the Czech Republic, Denmark, Finland, France, Germany, Greece,

Ireland, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Spain,

Sweden, Switzerland and the United Kingdom.

This report seeks to map the state of European

bank funding and the challenges facing the

industry, providing explanation, commentary and

recommendations for banks and regulators. It seeks

to combine the views of banks and investors (who

have been separately surveyed to provide input to

this report) and provide a fact base to guide future

discussions. The report is arranged as follows:

Section 2 provides a brief recent history of the

funding of European banks, the impact of the

financial crisis and the outlook for funding of

the industry

Section 3 considers the potential providers of bank

funding and the views of fixed income investors on

the future of European bank funding

Section 4 identifies the major challenges facing the

industry and likely trends

Section 5 provides recommendations for regulators

and policy makers.


3. THE CURRENT

STATE OF EUROPEAN

BANK FUNDING

3.1. A BRIEF RECENT

HISTORY OF EUROPEAN

BANK FUNDING

The recent history of European bank funding

can be split into four periods: the period

pre-1997 of steady lending growth matched

by deposit growth, the period of easy money

between 1997 and 2007, the financial crisis

and the post-crisis period.

3.1.1. PRE – 1997

During the 1990s, loan-deposit gaps did

not grow while the balance sheets of banks

expanded at a manageable pace. From

1995 to 2003, total growth in lending by

European banks was €1,174 BN, almost

exactly matched by a corresponding

increase in deposits of €1,172.

3.1.2. 1997 – 2007 – THE

PERIOD OF EASY MONEY

1997 to 2007 was the period of easy money:

easy money provided to European banks

by investors and easy money provided by

those banks to end customers. During this

period, punctuated by the dot-com crash

and mini-downturn of 2001-2003, lending

grew significantly faster than deposit-

taking. Banks moved from an aggregate

deposit surplus to a loan surplus (or loan-

deposit gap) of €22 BN in 2007. This blew

up to €289 BN in 2008 as deposit volumes

dropped as a consequence of the financial

crisis (see Exhibit 1).

Lending grew faster

than deposits in the

period of easy money

until 2007, fuelled by

increased demand for

covered bonds and

securitisations being

issued cheaply. This

came to an abrupt end

with the financial crisis,

leading to increased

dependence on central

banks for refinancing.


These aggregate figures understate banks’ need

for funding over and above customer deposits. The

distribution of loans and deposits across the banking

sector is uneven. In particular, savings banks typically

have a significant excess of deposits over loans, while

universal, corporate and commercial banks often have

a significant excess of loans. Banks also require funding

for business other than lending: namely, securities

holdings and other trading activities. Asset growth in this

business also outpaced deposit growth during this period,

increasing the need for banks to fund their assets from

wholesale borrowing.

Banks were able to fund their increased lending

during the period of easy money by using new

funding instruments that opened up additional

investor channels, most notably “super senior” debt

instruments that appealed to risk-averse investors

such as central banks, insurance companies and

pension funds.

The first large expansion in loan-deposit gaps

between 1997 and 2003 was funded principally from

a substantial expansion in the issuance of covered

bonds, from €235 BN in 1997 to €396 BN in 2003.

Covered bonds and securitisations

Covered bonds are senior bonds issued by banks and backed by a specific pool of assets (usually high quality

mortgages) that over-collateralise the bond. The result is a high quality bond with a better credit rating than

the senior unsecured debt of the issuer.

The covered bond market has a long history dating back to 18th Century Prussia (1769), and Denmark (1795). In

both cases, the covered bond market was created to help fund substantial building programmes – in the Danish

case to help rebuild the city after a quarter of Copenhagen was burnt down in the fire of Copenhagen. However,

until the mid-1990s, covered bond issuance was largely restricted to Denmark and Germany. During the mid-late

1990s, however, the creation of covered bond markets in other European countries opened up funding channels,

first in France, Italy and the Benelux, and later in Spain, the UK and Ireland. Covered bonds are attractive to

investors because they offer very low-risk returns. To date, there are no recorded defaults for covered bonds and

many are rated AAA, thereby attracting much lower spreads than ordinary senior unsecured bonds.

EXHIBIT 1: LENDING AND DEPOSIT GROWTH 1995-2010

500 -400

1,500-200

1,000 -300

2,000-100

2,5000

3,500

200

3,000

100

4,000

3004,500

5,000 400

-5000

€BN €BN

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2010200920082007

Loans

Deposits

Loan- depositgap

Source: Bank for International Settlements data.


Securitisations package up particular loans and sell debt securities related to loss tranches in these portfolios.

Typically this involves a “first loss” or “equity” tranche which takes the first losses from the underlying pool of

assets, a “mezzanine” tranche which suffers the next losses in the underlying pool of assets, and finally senior

and super-senior tranches that are protected from losses by the loss-absorption capacity of the equity and

mezzanine tranches.

The tranching features of securitisations were attractive to investors in the same way as covered bonds

because the protection inherent in the structures allowed rating agencies to assign AAA ratings to many of

the senior and super-senior tranches – but with the added advantage to issuers of offering capital relief by

transferring some portion of the credit risk in the underlying loans to investors. This made these tranches

attractive to risk-averse investors, while the equity tranches were offered at generous prices, making them

attractive to hedge funds during a time when default rates and yields were low. The securitisation market

was dominated by securitisations of retail mortgages, with later developments introducing securitisations of

corporate loans and debt (CLOs and CDOs).

EXHIBIT 2: DEBT ISSUANCE BY EUROPEAN BANKS 1997-2009

1,000,000

800,000

600,000

400,000

200,000

1,600,000

1,400,000

1,200,000

0

1,800,000

€MM

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Senior unsecured

Covered bond

RMBS

Other ABS

Other

Source: Dealogic, European Covered Bond Council


The second phase was funded by the creation and

subsequent explosion of the securitisation market.

Securitisation achieved rating enhancement and

thereby lower funding costs, while simultaneously

providing capital relief, particularly under a pre-Basel II

capital regime. As shown in Exhibit 2, the securitisation

market grew from almost nothing in 1999 to 30% of all

long-term debt issuance in 2006 and 2007, with the

UK and Ireland, Benelux and Spain the biggest issuing

countries (see Exhibit 3).

Not only was funding readily available during this

time but banks enjoyed consistently low spreads on

issued debt, making wholesale funding a cheap way of

financing balance sheet growth (see Exhibit 4).

EXHIBIT 3: ISSUANCE OF SECURITISATIONS BY COUNTRY 2004-2010

Iberia17%

Germany & Austria 9%

Switzerland1%

UK & Ireland49%

Nordics2%

France3%

Other1%

Benelux11%

Italy7%

EXHIBIT 4: FUNDING SPREADS 1997-2007

0.0%

-0.2%

-0.4%

-0.6%

-0.8%

-1.0%

0.2%

0.4%

0.6%

0.8%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

-1.2%

1.0%

Senior unsecured

Covered bond

RMBS

Other ABS

Other

Source: Dealogic, Bloomberg, Oliver Wyman analysis.


3.1.3. THE FINANCIAL CRISIS

The story of the financial crisis is well known. Worried

about the credit quality of US mortgages, investors

retreated from the securitisation market. With banks

so reliant on securitisations as a source of funding, its

removal forced banks to look elsewhere for funding –

largely to the short-term wholesale funding markets. As

losses on securitisations began to hit, investors became

worried about banks’ solvency and withdrew long-term

funding and even unsecured short-term funding. Banks

themselves shared these worries, causing the inter-bank

lending market to dry up. At the worst point of the crisis

most European banks were operating hand-to-mouth,

with a daily scramble for liquidity.

The authorities responded by providing banks with

massive quantities of central bank liquidity, secured

against weaker and weaker collateral, while shoring up

their solvency with capital injections (in some cases

through nationalisation).

EXHIBIT 5: CENTRAL BANK FUNDING TO THE BANKING SECTOR 1998-2011

500,000

400,000

300,000

200,000

100,000

900,000

800,000

700,000

600,000

0

1,000,000

CENTRAL BANK FUNDING FOREUROPEAN BANKS (€MM)

19

98

H2

19

99

H1

19

99

H2

20

00

H1

20

00

H2

20

01

H1

20

01

H2

20

02

H1

20

02

H2

20

03

H1

20

03

H2

20

04

H1

20

04

H2

20

05

H1

20

05

H2

20

06

H1

20

06

H2

20

07

H1

20

07

H2

20

08

H1

20

08

H2

20

09

H1

20

09

H2

20

10

H1

20

10

H2

20

11

H1


3.2. THE POST-CRISIS WORLD

Following the 2008 financial crisis, European banks are seeking

to replace securitisations and increase the term structure of their

funding; many continue to rely on central bank funding (particularly

in the peripheral countries); new regulations are creating additional

demands on banks’ debt, equity and hybrid funding programmes;

and funding spreads, while lower than their crisis heights, are still

substantially above pre-crisis levels.

3.2.1. REFINANCING REQUIREMENTS

As shown in Exhibit 2, the securitisation markets are yet to return

in any significant volume, leaving a large hole in funding that must

be filled through alternative wholesale funding, increased deposits

or reduced lending. Without a substantial reduction in lending or

increase in deposits, refinancing requirements will remain high.

Indeed, refinancing requirements look set to increase slightly

by 2015, as shown in Exhibit 6, but not substantially exceed

recent levels.

Funding in a crisis

Worries over sovereign strength and bank liquidity during the summer have strained European bank funding.

European banks’ access to short-term funding – especially cheap USD CP/CD programmes – has been

restricted, and they have found it difficult to issue long-term debt. Some commentators fear a repeat of the

liquidity crisis that occurred following the failure of Lehman Brothers in 2008.

At this point, it is essential to ensure that liquidity reserves are adequate, to avoid sending negative market

signals that could cause a liquidity panic, and to have contingent funding plans in place. War-gaming

scenarios, developing communication plans in advance and agreeing the order in which liquid assets are sold

or repo’d are essential to this, as is agreeing the crisis response with regulators, governments and central

banks in advance.

In the longer term, a prolonged period of crisis, or the expectation of one, could damage banks’ ability to

refinance. The widespread front-loading of issuance that occurred in the first half of 2011 means that banks

should be able to withstand one or two quarters of reduced issuance capability. With Q3 2011 set to be the

lowest quarter of senior unsecured issuance on record, this is now being put to the test. However, should

this extend to two or three quarters, and include a worse liquidity stress event, market uncertainty could

cause longer-term damage to European bank refinancing requirements, with following quarters needing ever

greater issuance to make up for current market conditions. Banks will need to issue debt whenever possible,

either at higher prices or in the form of less constrained covered bonds, and further limit lending while this

stress continues.

Banks face a refinancing

challenge over the

coming years as they

deal with the need

to refinance existing

debt, repay central

bank funding and

meet new Basel NSFR

requirements. We

estimate that, without

substantially shrinking

their loan-deposit gap,

European banks need

to raise €2.7 TN to

meet this requirement.

As cheap pre-crisis

funding is replaced

with expensive post-

crisis funding, average

funding costs will rise.


The market for long-term wholesale funding is already

difficult throughout Europe, and near impossible

for banks in PIIGS countries. And it could be further

undermined by a worsening of the sovereign debt

crisis, such as an unmanaged default by one or

more of the PIIGS or a Eurozone break-up. However

assuming a timely resolution of the current crisis and

return to more normal funding conditions (perhaps

a heroic assumption!), refinancing requirements

look manageable.

3.2.2. CENTRAL BANK FUNDING

Banks continue to rely on central bank funding.

Although this is especially acute for banks in countries

with sovereign solvency concerns (e.g. Ireland, Greece

and Portugal), banks in most European countries have

borrowed heavily from their central bank. As of week

40 2011, the total outstanding central bank debt to the

ECB was €580 BN – only slightly above the level of 2007,

but more than €380 BN above the levels between 2002

and 2007. As the largest non-Euro market, UK banks

also have an outstanding debt of £37 BN to the Bank of

England’s special liquidity scheme. With terms now less

generous and central banks withdrawing these lines,

European banks must find private sector sources to

replace central bank funding.

Assuming that central bank funding is repaid to pre-

crisis levels by 2015 and loan-deposit gaps are not

closed, banks’ long-term funding programmes would

need to reach levels similar to 2006 during 2014 and

2015 (see Exhibit 7).

EXHIBIT 6: REFINANCING REQUIREMENTS FOR EUROPEAN BANKS (BASED ONLY ON REFINANCING CURRENT DEBT EXCL. CENTRAL BANK DEBT)

800,000

1,000,000

1,200,000

200,000

400,000

600,000

2005 2006 2007 2008 2009 2010 2017201520142013 202020192018201620122011

0

1,400,000

€MM

Issued

Refinancing requirement

Source: Dealogic, European Covered Bond Council Dealogic data, Oliver Wyman analysis. Refinancing requirements assume similar term structure to debt being replaced as

that which was issued over 2004-2010 on average, assumes no net change in outstanding long-term wholesale funding, and excludes short-term funding.


3.2.3. REGULATORY RESPONSE

The regulatory response to the financial crisis is critical

to the outlook for funding markets, especially the Basel

III rules, outlined during 2010 and due to be introduced

from 2013 through to 2018. From a funding perspective,

the most significant of these rules has been the proposed

introduction of the Basel III Liquidity Coverage Ratio

(LCR) and NSFR requirements, the new capital adequacy

rules and the possibility of bail-in legislation that would

automatically convert senior debt into equity under

certain conditions.

3.2.3.1. LIQUIDITY REGULATIONS

Most significant from a refinancing perspective is the

NSFR requirement that banks fund long-term assets

from long-term funding. Without a reduction of asset

books or increases in customer deposits, this will require

banks to raise a substantial volume of long-term funding

to replace existing short-term funding.

The granularity of available data does not permit

a precise calculation of NSFR for European banks.

However, we estimate that, if each individual European

bank with NSFR<1 tried to meet the NSFR requirement

only by issuing long-term debt (i.e. without reducing its

BASEL III RATIOS

Liquidity Coverage Ratio (LCR)

The LCR is intended to address short-term liquidity risks. It requires banks to hold a buffer of liquid assets to

offset the risk from the loss of wholesale funding, partial deposit withdrawal and other contingent liquidity

risks. The long-term funding implication of the LCR is limited, but the impact on short-term markets is

pronounced. Although additional liquid asset purchases are required (and therefore additional funding for

these purchases) the one month term of the LCR allows this to be funded out of short-term debt rather than

the scarcer and more expensive long-term debt. However, it requires that short-term debt is to be funded with

a term of at least one month, regardless of its liquidity. At present, much investment banking activity is funded

shorter than one month, something the LCR threatens to change.

EXHIBIT 7: REFINANCING REQUIREMENTS INCLUDING REPAYMENT OF EXCEPTIONAL CENTRAL BANK FUNDING

800,000

1,000,000

1,200,000

200,000

400,000

600,000

2005 2006 2007 2008 2009 2010 2017201520142013 202020192018201620122011

0

1,400,000

€MM

Issued


Central bank funding replacement

Source: Dealogic, ECB, Bank of England data.


loan-deposit gap), the total required additional long-

term funding would be ~€2.7 TN3.

As Exhibit 8 shows, raising these additional funds by

2018 (when the NSFR is due to be implemented) would

require long-term debt issuance at levels well above the

record highs seen pre-crisis.

Analysis of NSFR at a bank level is illuminating. Although

the shortfall of all banks with NSFR<1 is €2.7 TN, the

aggregate excess of required stable funding over

available stable funding for European banks is only

~€1 TN. This is because some banks – notably savings

banks, private banks and other retail organisations

that are deposit heavy – have NSFRs greater than 1,

while others – principally banks with large corporate

banking divisions which are lending heavy and deposit

light – have NSFRs well below 1. Exhibit 9 shows

the distribution of NSFR for European banks from

this analysis.

Net Stable Funding Ratio

More significant for long-term funding requirements is the introduction of the requirement for banks to

achieve a NSFR greater than one. This regulation dictates that assets that will remain on the balance sheet for

more than the next year (“Required Stable Funding”) be funded from debt longer than one year in remaining

maturity. This NSFR rule is intended to address structural liquidity risk created in banks’ balance sheets2.

Because most of a bank’s lending portfolios will count as “Required Stable Funding” under these regulations,

the rule demands a substantial lengthening of the term of bank liabilities.

2 This is a simplification of the Basel III rules. For details see BCBS188.

EXHIBIT 8: EUROPEAN BANK REFINANCING REQUIREMENTS INCLUDING REPAYMENT OF CENTRAL BANK DEBT AND NSFR COMPLIANCE

800,000

1,000,000

1,400,000

1,200,000

200,000

400,000

600,000

2005 2006 2007 2008 2009 2010 2017201520142013 202020192018201620122011

0

1,800,000

1,600,000

€MM

Issued


Impact of repaying central bank funding

Impact of compliance with the NSFR regulations

Source: Dealogic, ECB, Bank of England, Bankscope data.

3 Source: Bankscope data


3.2.3.2. CAPITAL REGULATIONS

A central component of the regulatory response to the

financial crisis has been new capital adequacy rules that

aim to increase both the quantity and quality of capital

held by banks. Capital requirements affect funding in

three ways.

First, the pure scale of required capital (with Switzerland

and the UK requiring close to 20% of Risk Weighted

Assets (RWA) to be funded with capital) makes capital

an important source of funding, partly substituting for

debt funding.

Secondly, the regulations have spawned new convertible

debt instruments in the form of CoCo bonds. Under

certain pre-defined conditions, these bonds convert

from debt into equity, thereby bolstering loss-aborbing

capital when it is needed. These new instruments come

with funding challenges of their own, such as specifying

the trigger points for conversion from debt to equity or

write-down features, deciding on an appropriate price

and identifying the right investor base (see section 4.6).

Thirdly, in the theory of Modigliani-Miller, increasing

capital ratios should be reflected in lower prices on

unsecured debt. Because creditors are better protected

from losses by larger capital buffers, the risk premium

demanded on debt instruments should be lower and

the required return on equity should also diminish. The

Miles Report from the Bank of England has combined

this with empirical evidence about required returns on

equity and the social cost of banking crises to argue for

a capital ratio at least double that required by new Basel

III rules4.

However, empirical observation does little to support the

theory that debt costs fall when capital ratios increase5.

Exhibit 9 plots a sample of spreads on 5-year senior

unsecured bonds issued in 2010-2011 against the Tier

1 ratio of the issuer as a simple test of this suggestion.

It does not support the theory that such a relationship

exists (no attempt is made here to control for other

factors, such as size, encumbrance or sovereign

strength). Analysing the effect of capital injections on

wholesale funding spreads for individual issuers in

recent years is complicated by non-stationary market

conditions. Again, however, it suggests at best a weak

relationship. The average correlation between Tier 1

ratio and 5-year senior unsecured spread for individual

issuers is 7% across all banks, and 38% when restricted

to banks that had experienced more than a 2% change

in Tier 1 ratio.

EXHIBIT 9: DISTRIBUTION OF NSFR

500

1,000

1,500

-500

-1,000

120%+<60% 60–80% 80–100% 100–120%

-1,500

0

2,000

€BN, NUMBEROF BANKS

Number of banks

Sum of excess/shortfall (€BN, to the nearest €100 BN)

Source: Bankscope data, Oliver Wyman analysis.

4 Miles, Yang and Marcheggiano: “Optimal bank capital”, External MPC Unit

Discussion Paper No. 31

5 NB: It is not within the scope of this report to comment on the supposition that

the required return on equity should fall when leverage is lower.


While this should not be taken as definitive proof

that there is no relationship between capital ratios

and funding costs – all other things being equal, we

would expect this relationship to hold – it is at least

evidence that there are a host of other factors at play in

determining funding costs (sovereign strength, timing

of issuance, etc.). All other things are not equal, and in

the volatile post-crisis world, banks and policy makers

cannot rely on increased capital ratios automatically

translating into lower funding costs.

3.2.4. COUNTRY COMPARISON

We can assess the funding position of a country’s banks

by considering their average Tier 1 ratios and their

average long-term debt issuance requirements 2011-

2018 compared to issuance over 2008-2010. This shows

how much equity and other debt they need to raise (see

Exhibit 11).

This shows that:

On average, European banks’ refinancing

requirements 2011-18 are 58% higher than their

average issuance in 2008-10 (excluding any

reductions in lending or increases in deposits)

While there is no clear consensus among regulators

about required capital ratios, if a Europe-wide

requirement to achieve an 11% Tier 1 ratio were

introduced, European banks would need to raise

~€100 BN in additional capital. Even a 10% minimum

Tier 1 ratio would require banks to raise an additional

~€45 BN in capital. In reality, with sovereign haircuts

yet to be fully incorporated into banks’ capital

EXHIBIT 10: RELATIONSHIP BETWEEN TIER 1 RATIO AND SPREADS ON 5-YEAR UNSECURED EUR BONDS (2010-2011 ISSUANCE ONLY)

SPREAD ON ISSUED 5-YEAR EUR SENIOR UNSECURED (BPS)

TIER 1 RATIO

13%

11%

9%

17%

15%

7%

19%

0 300250200150100 50

Source: Dealogic data, Bankscope.

EXHIBIT 11: COUNTRY ANALYSIS OF REFINANCING REQUIREMENTS AND CAPITAL RATIOS

11%

9%

17%

15%

13%

7%

19%

300%250%200%150%100%50%0%

Germany

Austria

Ireland

France

Sweden

Norway

Spain

Greece

ItalyPortugalLuxembourg

Finland

Netherlands

Switzerland

Iceland (refi % unknown)

BelgiumDenmark

United Kingdom

REFINANCING MULTIPLE (2011-18 AVERAGE REQUIREMENT/2008-10 ISSUED)

AVERAGETIER 1 RATIO

Source: Dealogic, Bankscope. Excludes any repayment of Central bank debt


calculations, the required capital injection is probably

a multiple of this number, and core Tier 1 capital

requirements could also be substantially higher

Across Europe, required wholesale funding issuance

is double that achieved over the last three years or

more. Refinancing requirements look most difficult

to achieve for banks in Spain and Ireland, which are

also among the least capitalised. Banks in these

countries will need to deleverage, most probably

through moderate deposit growth (restricted by

sluggish economic growth and low interest rates),

year-on-year reductions in lending and domestic

capital raising

The combination of low capital ratios and high

refinancing requirements suggest substantial

challenges for banks in Italy, Austria and France

High capital ratios and manageable refinancing

requirements mean banks in the Netherlands, Finland

and Switzerland are the best positioned in Europe.

3.2.5. FUNDING COSTS

With the securitisation markets still largely closed and

banks keen to issue long-term debt, spreads remain

high. Exhibit 12 shows the spreads on all 5-year senior

unsecured debt issued between 2004 and 2010. It

shows that covered bond spreads have recovered to

their pre-crisis levels on average, but senior unsecured

bond spreads have remained close to crisis levels.

Covered bond prices vary significantly across countries.

While German 5-year covered bonds were issued below

the swap rate in 2010, the average for the rest of Europe

was swap rate + 33bps, still down significantly from

105bps in 2008 and well below senior unsecured levels.

Given banks’ demand for long-term credit, it is unlikely

that the marginal cost of wholesale funding will fall

substantially in the coming years. This implies a

substantial increase in average funding costs as banks

replace legacy wholesale funding issued at cheaper

pre-crisis spreads with more expensive wholesale

funding issued post-crisis. Combined with the increase

in maturity required by the NSFR rule, this suggests a

continuing rise in average funding costs, even without

any further increase in marginal funding costs, until a

peak around 2015 (see Exhibit 13).

EXHIBIT 12: SPREADS ON 5-YEAR SENIOR UNSECURED AND COVERED BONDS

0.60%

0.40%

0.20%

0.00%

-0.20%

0.80%

1.00%

1.20%

2004 2005 2006 2007 2008 2009

-0.40%

1.40%

SPREADS OVER

SWAP RATE

2010

Senior

unsecured

Covered

bond

Source: Dealogic, Bankscope, Bloomberg data, Oliver Wyman analysis.


EXHIBIT 13: REFINANCING REQUIREMENTS AND AVERAGE FUNDING SPREADS

2,000

1,800

800

1,000

1,400

1,200

200

400

600

2005 2006 2007 2008 2009 2010 2017201520142013 202020192018201620122011

0

1,600

.20%

.25%

.35%

.30%

.50%

.10%

.15%

.00%

.50%

.45%

.40%

Issued

Cost

Projected cost


Impact of repaying central bank funding

Impact of compliance with the NSFR regulations

Source: Dealogic, ECB, Bank of England, Bankscope, Bloomberg data; Oliver Wyman analysis


4. THE INVESTOR LANDSCAPE

An important factor in the future funding of European

banks is investors’ appetite for the debt and equity

instruments issued. The universe of end investors in

banks is potentially very wide. Every household and

corporate has a portion of their savings lent to banks in

the form of deposits. The professional market for debt

and equity instruments extends across pension funds,

insurance companies, mutual funds, sovereign wealth

funds and family offices. Moreover, because European

bank debt and equity is available globally, the investor

universe is not restricted to Europe. Altogether, this

professional investor group has €45 TN of outstanding

investments, as shown in Exhibit 14 below.

Although this suggests ample spare capacity for bank

funding, investors are subject to many restrictions and

the total universe for investment in bank debt and equity

is significantly lower than this total:

Much of the investment made by pension funds,

insurance companies and retail mutual funds is

“passive”, meaning that the fund automatically

invests proportionally in a pre-defined universe of

shares or bonds across the index

Of the actively managed funds, most are judged

in relative terms against the performance of

a benchmark index. This will tend to result in

investment strategies that are close to tracking the

index, with active positions taken relative to this

base index. Only so-called absolute return funds or

hedge fund strategies will be unconstrained by the

benchmark index

Fixed income funds are subject to asset quality

constraints, usually restricting the scope of their

investments to a particular band of credit ratings,

duration and instrument types. The most important

groups from the banks’ perspective are money

market managers (who are usually restricted to

investment in short-term, high-quality paper) and

investment grade fixed-income managers (restricted

largely to senior long-term debt with investment

grade ratings)

EXHIBIT 14: SPLIT OF INSTITUTIONAL INVESTORS BY ASSET CLASS

50%

Pension funds Insurance companies Sovereign wealth funds

Other institutions

Retail/HNWI

0%

100%

ACTUAL VALUES IN €BN

1,124

638

5,788

7,385

1,382

1,049

8,769

6,734

502

459

805

869

1,382

37

187

488

877

2,698

3,236

5,471

Equity

Fixed income

Money market

Other

Source: Oliver Wyman analysis.


Nearly all funds have restrictions on the

asset classes they can operate in. For

example, fixed income funds have low or

zero limits on the investment allowed in

equity (with implications for their ability

to buy CoCos)

Most funds have concentration limits that

restrict the maximum investment in a

single name or industry (often related to

the benchmark indices).

For these reasons, investors’ appetite for

bank liabilities will vary significantly with

the instruments concerned. The investor

universe for short-term debt, senior

unsecured debt, CoCos and straight equity

are all quite different.

To better to understand the views of the

investment community on bank funding,

Mercer and Oliver Wyman conducted a

survey of asset managers. 40 fund managers

responded to the survey, including many of

the world’s largest. Collectively our survey

respondents are responsible for managing

€6.7 TN in assets, and includes many of the

biggest names in the industry. The survey

asked investment managers to assess the

relative supply and demand dynamics for

different sources of bank funding (short-

term, senior unsecured, covered bonds,

other secured, securitisations and capital

instruments), the most important investor

groups for each type of funding, spread

expectations, and expectations to the form

and impact of capital raising.

Established market

with continued demand

from investors and

expectation that current

LIBOR-flat spreads

will remain

4.1. SHORT-TERM

FUNDING MARKETS

Short-term debt, including certificates of

deposit and commercial paper (CD and CP),

is a long-established source of funding for

banks. Well-rated, short-term debt of this

type gives investors a way of enhancing

the return on cash balances without taking

additional risk. Survey responses suggest an

excess of demand for this asset class, with

investor demand unlikely to change. In other

words, investors would take whatever supply

of short-term debt is offered to them at

present, and in fact see a shortage of short-

term debt being offered that is suppressing

spreads as a result. With liquidity regulations

reducing supply as banks are forced to

increase the term structure of their debt,

short-term spreads are expected to remain

similar to today (already close to pre-crisis

levels) or tighten further.

The short-term funding markets may also

face a challenge from Basel III rules. Under a

strict interpretation of the current Liquidity

Capital Ratio (LCR) regulations, the term

of much short-term funding would need to

increase to over 30 days. Liquid securities

held by investment banks outside of their

liquidity buffers and currently funded

short-term would need to be funded over

30 days to comply with the regulations.

For example, a 5-year bond held outside


the liquidity buffer that was funded shorter

than 30 days would create a <30 day cash

outflow with no commensurate cash inflow.

This, in turn, would require the bank to hold

a matching asset in the liquidity buffer – i.e.

another bond, this time funded longer than

30 days. The bank would have no choice

but to fund this bond longer than 30 days

under LCR. The exact interpretation of this

rule remains open for debate. Given its

consequences, it is possible that a change

will be made to the treatment of securities

outside the liquidity buffer. But the potential

impact is for a dramatically reduced supply

of CPs and CDs with <30 days’ maturity and

for new products to be created to take their

place. These could include CPs and CDs

with longer terms or call periods longer than

30 days, and would almost certainly incur

commensurately higher funding costs.

EXHIBIT 15: SUMMARY OF INVESTOR VIEWS ON SHORT-TERM FUNDING

100%80%60%40%20%0%100%80%60%40%20%0%

Similar to mid-90s

Similar to 03–08

Similar to today

At crisis levels

Above crisis levels

Significant excess supply

Supply slightly exceeds demand

Supply and demand in balance

Demand slightly exceeds supply

Significant excess demand

CP/CD

Othershort-term

CP/CD

Othershort-term

HOW DOES CURRENT INVESTOR DEMANDCOMPARE TO BANK SUPPLY?

WHAT ARE YOUR SPREAD EXPECTATIONSOVER THE NEXT 2 YEARS?

Stable demand expectations

Note For investor group suitability, survey respondents were asked to score the suitability of each investor group between 1 and 5. The results shown here show the weighted

average score assigned to the different groups (i.e. the sum of the scores assigned to each investor class for each instrument type)

4.2. SENIOR UNSECURED

LONG-TERM DEBT

Senior unsecured debt includes the

bonds, medium-term notes and other

securities issued by banks as long-term

debt instruments: that is, with maturity >1

year. As a fixed income instrument, senior

unsecured is typically held in fixed income

funds, with institutional investors such as

pension funds and insurers being the largest

investor groups.

Our survey reveals a general view that

spreads are likely to tighten as the sector

recovers, though not expected to return to

pre-crisis levels. Comments reveal a number

of risks to this asset class. As one respondent

summarised, “We expect tighter senior

spreads in future, but not at pre-crisis levels,

on a changed paradigm (less government

support, bail-ins, senior write down

language and resolution regimes, more

secured debt ahead of you)”. Asked about

spreads, another said “Big tail risks either

way, but the greatest chance of a blow-up is

Substantial risks to

senior unsecured debt as

continued encumbrance

of balance sheets and

bail-in regulations

threaten its seniority.

Investors are nervous,

especially in countries

with substantial

sovereign risk.


probably senior unsecured.” The key highlighted risks to

the senior unsecured debt issuance market include:

The enormous state support for financial institutions

during the crisis, both liquidity and solvency, helped

prevent bankruptcy amongst major banks. The most

notable beneficiaries of this support have been senior

creditors of the banks, as losses were incurred first

by equity holders and then by governments, with

senior creditors made whole. The bail-in legislation

currently proposed would give regulators the ability

to write down the value of senior debt where it was

necessary for the continued solvency of the bank

and before government support was extended. This

reduces the probability of a government bail-out by

reducing the value of senior unsecured debt. As the

quote above suggests, the term “senior” would be

something of a misnomer in this world. This debt

would become junior to deposits, junior to holders of

secured funding and potentially subject to regulators’

decisions as to when it would be written down.

As another respondent put it, “if bail-in language

becomes institutionalised, senior unsecured

becomes the new Lower Tier 2 asset class”. This would

reduce demand for the asset class and raise spreads.

Indeed some investment mandates may prevent

asset managers from investing in it

Respondents suggested that substantial

improvements in banks’ capital positions could

reduce the spreads on senior unsecured funding. The

size of this effect depends on the capital regulations

eventually implemented in each country

According to one respondent, expressing a

common view, “looking just at senior unsecured

debt, the market is likely to strongly differentiate

between peripheral banking systems (caught in the

uncertainties of their own sovereign’s challenges)

versus the core European banking groups that are

better diversified, have defensible franchises and are

well managed”

The continued growth of covered bond issuance is

widely viewed as a matter of structural significance in

the bank funding market. This is addressed in more

detail in the following section.

Senior unsecured is the “balancing item” in trends

towards greater tranching of the balance sheet. Given

pressures from either side – from deposits and from

covered bonds and other secured funding – the future of

this crucial source of bank funding is now uncertain. This

is keeping spreads higher than they might otherwise be.

EXHIBIT 16: SUMMARY OF SURVEY RESPONSES ON SENIOR UNSECURED LONG-TERM DEBT

100%80%60%40%20%0%100%80%60%40%20%0%

Seniorunsecured

Seniorunsecured



Stable demand expectations

Similar to mid-90s

Similar to 03–08

Similar to today

At crisis levels

Above crisis levels







4.3. COVERED BONDS

Investors expect a substantial rise in covered

bond issuance by banks seeking to bolster

liquidity and access this relatively cheap

funding source. We doubt this increased

supply will drive prices down in the short

term (i.e. drive up yield and hence the cost

of funds), because increased supply is being

matched by increased demand for low-risk

covered bonds from investors.

Due to their over-collateralisation, covered

bonds present extremely low risk. Losses

on these instruments require both the

default of the issuer and substantial losses

on the underlying asset pool. And most

covered bond programmes (such as the

German Pfandbrief) restrict the eligible

assets to better quality assets: e.g. high

LTV mortgages cannot be included. Given

concerns about subordination of senior

unsecured debt, covered bonds are also

seen as a safe-haven of seniority, being

exempt from the bail-in proposals. Rating

agencies continue to rate many covered

bonds AAA, making them an alternative to

sovereign debt.

However, two questions hang over the

future of covered bonds. The first concerns

their treatment under the Basel III liquidity

regulations. As high quality assets, bank

covered bonds could be considered liquid

assets, readily sold to raise cash during a

liquidity crisis. They could thus be held by

banks as part of the liquidity buffers required

under new Basel III regulations, thereby

reducing banks’ dependence on sovereign

bonds. Many banks in countries with long

covered bond traditions (notably Germany,

Denmark and the other Nordic countries)

already hold significant volumes of covered

bonds on their balance sheets, and in many

cases, treat these assets as part of internal

liquid assets buffers.

Although early statements from the Basel

Committee indicated that no financial

institution debt could be included in the

liquidity buffer, extensive lobbying has

softened their position to allow covered

bonds with a 20% haircut, provided they

were not issued by the bank that holds them.

This will still involve some sales at banks that

have large holdings of their own bonds but

it should not prevent banks from being big

holders of covered bonds.

Expected to be the

growth story of

European funding as

banks seek lower spread

costs. Question mark

over impact of LCR

restrictions on ability

of banks to hold the

instruments, but looks

certain to play a big role

going forward.

EXHIBIT 17: SUMMARY OF SURVEY RESPONSES ON COVERED BONDS

100%80%60%40%20%0%100%80%60%40%20%0%

Traditionalcovered

bonds

Traditionalcovered

bonds



Increasing demand expected

Similar to mid-90s

Similar to 03–08

Similar to today

At crisis levels

Above crisis levels







The second big question raised by the increased

issuance of covered bonds is its effect on demand for

senior unsecured debt. In theory, incremental covered

bond issuance increases the risk on senior unsecured

debt by subordinating the claims on the bank. However,

to date, there is little evidence that further encumbrance

of assets does, in fact, result in higher spreads on

unsecured debt.

To test this possibility further, we asked our surveyed

managers how they expected further covered bond

issuance to affect spreads on senior unsecured bonds.

Managers overwhelmingly believe that further issuance

of covered bonds will be negative for senior unsecured

debt, reducing the value of senior unsecured and

widening spreads. However, this will depend on the size

of further covered bond issuance. As one manager put it,

“This will ultimately depend on how much of the bank’s

balance sheet is encumbered. Where it is significant, i.e.

>20%, then there could be a widening of senior spreads

but where it is more limited, i.e. <10%, then I do not

expect much impact on senior bonds.”

For banks, this suggests a need for caution when

extending covered bond programmes. The funding cost-

savings they directly deliver may be more than offset by

the increased cost of funds raised from senior unsecured

debt. This market effect is only likely to be increased

as governments reduce the extent to which they act

as guarantors on banks. At present, the encumbrance

impact is at least in part masked by a perception that

governments will stand behind senior debt holders in a

crisis, at least in larger banks.


4.4. SECURITISATIONS

Securitisations were a key funding

instrument for banks in the run up to the

crisis. At their peak, they amounted to

more than 30% of all long-term issuance

by European banks. The disappearance

of these instruments is one of the

biggest contributors to banks’ current

funding difficulties.

Recent issuance activity suggests a slight

thawing in the securitisation markets.

Nevertheless, investors remain suspicious

of these instruments, with demand for

anything other than the most senior

tranches of retail mortgage-backed

securitisations still virtually non-existent.

Investors also do not anticipate any

significant increase in demand or reduction

in spreads on these instruments over

the next two to three years. New capital

regulations that heavily penalise banks for

holding securitisation tranches on their

balance sheets further dampen the market

and widen spreads on these instruments.

In our view, securitisation remains a useful

instrument for banks and an attractive one

for investors. They allow banks to create low

risk and, hence, cheap funding instruments.

Most recent activity is of this form, with

structures designed to create super-safe

securities: e.g. through short-term notes

backed by trade receivables. RMBS and

similarly simple, low risk securitisations may

return to being a significant part of banks’

funding strategies, perhaps as much as 10-

15% of total wholesale funding.

However, this recovery will be a slow

process. Because investors remain

understandably wary of the credit quality of

banks’ back books, their securitisation will

remain difficult for many banks. For front

book mortgages and other simple, well

understood and low risk assets, however,

securitisation is likely to return slowly and

form an important part of banks’ short and

long term funding within the next 10 years.

After the problems of

the financial crisis, the

securitisation market

is unlikely to come

back with the same

scale or complexity as

pre-crisis. But we see a

role for securitisation –

specifically, high quality

RMBS – to cover 10-15%

of banks’ wholesale

funding issuance within

the next 10 years.

This will be prominent

amongst banks

constrained by the new

leverage ratio restriction

under Basel III.

EXHIBIT 18: SUMMARY OF SURVEY RESPONSES ON SECURITISATIONS

100%80%60%40%20%0%100%80%60%40%20%0%

CDOsother

CDOsother

CDOsSenior

CDOsSenior

RMBSother

RMBSother

RMBSSenior

RMBSSenior



Increasing demand expected

Little change except for senior RMBS

Similar to mid-90s

Similar to 03–08

Similar to today

At crisis levels

Above crisis levels







4.5. OTHER SECURED

FUNDING (STRUCTURED

COVERED BONDS AND

LOAN FUNDS)

Post-crisis, funding products have been

simplified. In contrast to the ever more

complex and opaque securitisation

structures created during the boom, the

predominant funding instruments post-

crisis have been better understood: notably,

CP, CD, senior unsecured and covered

bonds. However, two new funding methods

are gaining in popularity as banks seek a

cheaper alternative to senior unsecured

debt: namely, structured covered bonds and

loan funds.

A structured covered bond is similar to a

legal covered bond, except that it is not

subject to the same legal restrictions. Legal

covered bonds – that is, covered bonds

regulated under national covered bond

laws – are heavily regulated, with restrictions

on the asset types that can be included,

often only mortgages below a certain

loan-to-value threshold. This provides a

gold-standard for investors and a degree of

comparability at the cost of restricting the

potential size of the covered bond market.

Structured covered bonds extend the

attractive features of covered bonds – over-

collateralisation, recourse to the issuer, etc.

– to additional asset classes, but without

the established legal framework. The

most typical asset classes have been real

estate mortgages, public loans or publicly

guaranteed loans. Occasionally, ship,

aircraft, middle market loans and renewable

energy loans have been included.

Our investor survey suggests limited

demand for structured covered bonds.

Investors continue to prefer the legal

covered bonds due to the maturity of the

market. Nonetheless, with structured

covered bonds continuing to attract lower

spreads than senior unsecured, their

issuance is likely to keep increasing.

Structured medium-term repos allow banks

to raise medium-term funding backed by

both liquid and illiquid assets, with suitable

haircuts (as opposed to the more common

short-term repo). During the current crisis,

this funding instrument has been created

Structured covered

bonds and loan

funds will be crucial

instruments in the

corporate space

as banks look for

alternatives to

expensive senior

unsecured funding

EXHIBIT 19: SUMMARY OF INVESTOR RESPONSES ON NEW FUNDING INSTRUMENTS

100%80%60%40%20%0%100%80%60%40%20%0%

Similar to mid-90s

Similar to 03–08

Similar to today

At crisis levels

Above crisis levels






Structuredcovered

bonds

Loanfunds

Structuredcovered

bonds

Loanfunds



Increase in demand expected


by distressed banks as a way of achieving lower funding

costs for assets that are not eligible for central bank

repos. Because Basel III will require investment banks

to increase their longer term funding, and because all

banks will need sustainable ways of funding increasing

liquid assets buffers, structured medium-term repos are

likely to persist.

Through loan funds, asset managers compete with

banks in the lending markets. Loan funds now come in

three types:

Private equity firms replacing banks as the providers

of debt for leveraged finance deals. With high losses

experienced in leveraged lending, the availability of

bank lending has been scarce since the crisis. These

loan funds provide debt funding directly. An example

of this is HarbourVest, which created HarbourVest

Senior Loans Europe Ltd. to provide leveraged finance

while avoiding conflicts of interest

Funds acting as syndication partners in large ticket

deals, such as Hadrian’s Wall Capital and Aviva’s

partnership in infrastructure debt financing

Funds lending directly to corporate borrowers

that are not big enough to replace lost bank credit

by issuing bonds in debt capital markets. An

example is Metric Capital, a newly created fund

management company set up to target mid-market

corporate lending.

These funds lend to parts of the corporate sector that

have suffered a loss of supply from banks, due to either

liquidity or capital constraints. Because the funds are not

highly leveraged, they provide additional equity against

debt (in contrast to the leveraged funding structure of

the banks). Regulators should therefore welcome the

growth of loan funds. Banks may participate in these

structures by providing a management or origination

service, by making credit decisions or by taking a partial

balance sheet interest in the loans. So far, banks have

been most involved in syndication-type loan funds,

while competing more or less directly with the other

loan funds.

The lack of a significant track record, appropriate indices

and UCITS accreditation all hold back this asset class.

Nevertheless, investor appetite appears strong. Our

survey respondents indicated that investor demand for

loan funds exceeds supply from the existing small stock

of loan funds, and that investor appetite for these funds

is expected to grow further (albeit from a low base) over

the next two years as the market matures and a track

record is generated.


4.6. COCOS AND OTHER

CAPITAL INSTRUMENTS

New capital regulations in the Basel III

world require banks to deleverage. While

the details of these regulations are yet to be

finalised in many countries, the emerging

consensus is for a higher level of Core Tier

1 capital (broadly equity) supported by a

layer of loss-absorbing debt instruments.

The regulations have also had a substantial

impact on the issuance of different types

of capital instruments. For example,

traditional Tier 2 and some lower Tier 1

instruments will no longer be eligible for

regulatory ratios, and issuance of these

instruments has all but disappeared. New

instruments, notably CoCos have started

to replace the outgoing instruments, but

with no clear consensus to date on the form

these instruments should take.

CoCos were pioneered by Lloyds Banking

Group in November 2009 under regulatory

pressure to improve its capital ratios.

Rabobank followed in April 2010, seeking

to test the market for CoCos with write-

down features while improving its capital

ratio to protect its low wholesale funding

costs. And the Bank of Cyprus issued CoCos

with symmetrical conversion features (the

so-called CoCoCo) in Q1 2011.

The Swiss Financial Markets Supervisory

Authority (FINMA) has this year announced

that UBS and Credit Suisse will be required

to hold capital equivalent to 19% of RWA,

of which 9% may be held in CoCos. The

subsequent issuance of $8 BN of CoCos by

Credit Suisse ($6 BN private placement and

$2 BN public placement) was significantly

over-subscribed, with the bank attracting

$22 BN of orders for the bonds, allowing

it to issue at the relatively low rate of

7.875%6. This was a sign that investor

appetite for the instrument is strong, and

was followed by an announcement from

Barclays that it intended to make part of

its bonus payments in the form of CoCos.

Barclays Capital then estimated that the

total CoCo issuance could reach €700 BN

by 2018.7

Emerging capital

instrument to meet

local regulatory needs.

Early offers over-

subscribed but with a

shallow investor base

of mostly Asian retail

investors. CoCos split

the investor base with

little agreement as to

their role, merit, suitable

investor base or future.

EXHIBIT 20: SUMMARY OF INVESTOR RESPONSES ON COCOS AND TIER 1/ TIER 2

100%80%60%40%20%0%100%80%60%40%20%0%

Similar to mid-90s

Similar to 03–08

Similar to today

At crisis levels

Above crisis levels






Cocos

Other Tier 1/Tier 2

Cocos

Other Tier 1/Tier 2



Increase in demand expected

6 Source: Financial Times, February 10th 2011

7 Source: Barclays Capital: “European Banks: Are CoCos a Go

Go?” February 2011


Despite this seemingly strong momentum, our survey

suggests a lack of investor consensus and a number of

concerns around several key aspects of CoCos, notably:

The total size of the market

The suitable investor base for CoCos

The desired structure of new instruments.

With regulatory requirements expected to be the

main driver of CoCo issuance, the future shape of

regulation will be crucial to the popularity of CoCos as an

instrument. Yet, to date, only Switzerland has officially

endorsed CoCos as suitable capital instruments. Other

national regulators are still finalising capital regulations

that will apply to “systemically important financial

institutions” (SIFIs), and these are expected to differ

substantially across countries. As one investor put it the

“total potential CoCo supply remains unknown until

each region sets SIFI requirements but it appears that

supply could materially outstrip demand”.

Perhaps the most material concern about CoCos

expressed by survey respondents was the depth of the

investor base. Demand for the Credit Suisse CoCos

surprised the market, but it was concentrated in the

retail market with little institutional interest, especially

among traditional fixed income investors. One investor

commented that CoCos “have benefitted from strong

retail demand, particularly in Asia, which has to some

degree overshadowed institutional concerns”.

Another suggested that, “While early CoCo issues were

supposedly heavily over-subscribed, another one or two

issues will over load that retail investor base”.

In the longer term, there appears to be a near

unanimous view that CoCos in their current form are

inappropriate for institutional fixed income investors.

“We do not see a natural fixed income base for CoCos”

is a representative quote of the opinion of our surveyed

managers. CoCos lack agency ratings, violate the

mandates of the many funds that are prohibited from

holding equities and lack a benchmark or index against

which managers can trade and measure performance.

Given the scale of potential issuance, this is a big

problem for European banks. The demand from Asian

retail and hedge fund investors will be insufficient to

take up the volumes of CoCo issuance needed to satisfy

banks’ regulatory capital requirements.


Types of CoCo

An issue for the nascent CoCo market is a lack of

market consensus on the optimal structure for

CoCos. Already several different structures have

been discussed and issued:

Equity conversion CoCos, where the bonds

convert into equity below a certain trigger level.

This was the type issued by Lloyds Banking

Group, with a trigger at a Core Tier 1 ratio of 5%

Write-down CoCos. As issued by Rabobank,

instead of converting into equity, these involve

a partial write down below a certain capital

ratio. They have the advantage for fixed

income investors of having no potential to

become equity (and thus remaining within

investment mandates)

Reversible CoCos, whereby equity can be

converted back into debt or debt holders made

whole in the event of the bank’s recovery

CoCoCos, whereby the debt can convert into

equity if either a capital ratio trigger level is

reached or the equity prices go above a certain

level (thus introducing a degree of upside). This

was the type of CoCo issued by Bank of Cyprus,

seeking to give additional incentive to investors.

Our investor survey showed no consensus

preference for any one of the common types of

CoCo (see Exhibit 21).

Although many surveyed investors believe that

CoCos will never be attractive to fixed income

investors, they suggested that CoCos are

improved by:

triggers

Many investors expressed concern about

the ability of regulators to unilaterally trigger

the equity conversion or write-down. Trigger

points need to be clear and objective, anything

reliant on regulatory discretion will be

unpopular with institutional investors

features

A number of investors expressed a preference

for CoCos with an option for being converted

back into debt beyond a certain point of

recovery: “Optionality to write back up would

be strongly preferred”

agencies

trade-off

Investors will demand yields closer to equity

returns on CoCos with higher capital ratio

conversion triggers, and closer to debt yields

on CoCos with low capital ratio conversion

triggers. “A common criticism of CoCos is

that they have all the upside of debt and all

the downside of equity. We believe this is a

very valid criticism of many proposed CoCo

structures… Second-tier issuers of CoCos may

have to pay yields of 10-12% in order to attract

investors in the current environment.”

EXHIBIT 21: WHICH TYPE OF COCOS DO YOU SEE AS BEING MOST ATTRACTIVE TO FIXED INCOME INVESTORS?

Contingent write-down CoCos 37%

Contingentequity

conversionCoCos

37%

Neither 26%


5. THE FUTURE OF EUROPEAN

BANK FUNDING – AND

BANKS’ RESPONSES

How European banks meet the current funding

challenges will reshape the industry. We expect to see

the following trends:

A battle for deposits In the post-crisis world,

customer deposits are the cheapest source of funding

and a significant source of profit for banks. The

scramble for deposit market share has already begun.

We expect bank deposits to compete increasingly

with money market funds for liquidity given their

favourable regulatory treatment

Increasing tranching of banks’ liabilities

Increased issuance of covered bonds, increasing

Core Tier 1 and sizeable portions of CoCos and other

hybrid instruments will increase the tranching of

bank’s non-deposit liabilities. Senior unsecured will

become the new mezzanine – a trend that will only

be exacerbated by the introduction of any bail-

in legislation

Loan funds are likely to emerge as an alternative

funding approach for the corporate sector – and for

corporate banks – as firms seek access to banks’

credit competence and banks look to protect

relationships with cross-sell potential

Deleveraging We expect banks’ asset growth to

continue to be muted as banks that depend on

wholesale funding reduce their lending to meet

new regulatory requirements

Strategic shift to self-funding sectors The poor

returns from lending to sectors that do not provide a

natural deposit base will lead to a radical change in

business models. Assuming corporates are unwilling

to pay much higher spreads, traditional corporate

banking will be replaced by a less balance-sheet

intensive business model, with the capital markets

playing a larger role in funding corporates. We expect

banks to focus on lines of business that provide them

with a plentiful source of funds and with fee income

while placing light burdens on their balance-sheets,

such as traditional retail banking, transaction banking

and fee-based investment banking

Solvency becomes a strategic differentiator

rather than a cost There is already substantial

differentiation in funding costs between banks that

investors consider weak (especially those in countries

with sovereign difficulties) and stronger institutions.

Banks with financial strength and spare liquidity will

pick up market share.


5.1. THE BATTLE

FOR DEPOSITS

The true value of customer deposits has

always been high. Most retail current

accounts are priced substantially sub-LIBOR,

providing near risk-free returns by investing

customer deposits into safe government

bonds. Pre-crisis, this was achieved via

the margin between customer deposits

and the base rate. This margin has been

squeezed by the low base rate environment

following the financial crisis. Nevertheless,

with wholesale funding costs increasing

dramatically and banks still able to price

sticky customer deposits well below LIBOR,

they are a more attractive source of funding

than ever before.

This new importance of deposits is likely to

persist, for two main reasons:

1. Basel III’s NSFR allows banks to use either

90% or 95% of deposits to fund stable

assets (most lending), whereas short-

term funding can only be used to fund

highly liquid securities or lending with

less than a year’s maturity remaining

2. When base rates rise from their

currently low levels, deposit margins

will probably increase, as the scope

for banks to price sub-LIBOR also

increases. Exhibit 22 shows the historical

relationship between LIBOR and deposit

spreads for UK deposits between 1995

and 2010. It reveals a strong relationship

between LIBOR and spreads. Of course,

competition for deposits is now stronger

than it was between 1995 and 2008,

which means that the correlation

between LIBOR and deposit margins

may be weaker than it has been in the

past. Nonetheless, increases in interest

rates will give banks scope for additional

deposit margins.

Competition for deposits will lead not only

to higher rates for customers but also to

operating models and strategies more

focused on deposit gathering. Even if this

did not increase the total amount of funding

available to banks, the industry’s funding

Deposit-gathering

has become a key

driver of strategic

success. Understanding

which deposits are

most valuable and

devising tactics for

gathering them will be

important sources of

competitive advantage.

EXHIBIT 22: RELATIONSHIP BETWEEN DEPOSIT SPREADS AND LIBOR (UK DEPOSITS 1995-2010)

SPREAD(RATE–3M LIBOR)

-1

-2

-3

-4

0

0 2 8 10

1

2

-5

3

4 6

Average instant access accounts

Competitive online players

As interest rates rise, spreads are likely to recover

2009 and YTD 2010

Market leading onlineprices, show similarpattern to average

3M LIBOR (%)

Source: Bank of England data, Oliver Wyman analysis


needs could be alleviated if increased

competition resulted in deposits moving

from banks with excess deposits to banks

that rely on wholesale funding. This is

not unlikely, given the relative economics

for deposit-rich and deposit-poor firms.

Because deposits are sticky, this rebalancing

of loan-deposit gaps between institutions

may occur through a movement of market

share in customer lending from bank to

bank; banks with larger customer deposit

bases will be better placed to compete for

lending than those with funding problems.

The competition for deposits is unlikely to be

limited to the banking sector. Banks are also

likely to compete more keenly with money

market funds. Given that deposits are more

attractive to banks than money market fund

wholesale money, banks will seek to attract

sophisticated investors directly into deposits

by competing with the money market funds.

Finally, it is possible that the efforts of

banks in raising deposits will increase the

aggregate saving rate in the economy. If

there is capacity within European economies

for increased saving or for substitution from

investment to deposits, then increased

competition from banks for deposits

could result in an aggregate increase in

the size of the market. A relatively modest

effect of this sort could alone be enough

to alleviate funding difficulties. To return

banks’ refinancing requirements to a more

manageable level equivalent to the average

of 2008-2010 would require only ~4.5% of

GDP to be saved into bank accounts (or a

commensurate reduction in lending volumes

by banks).

Increased encumbrance

and bail-in regulations

threaten to create a

more tranched liability

side to banks’ balance

sheets. Thus far, this

has had little effect

on spreads, but there

is a risk of a knock-

on impact on senior

unsecured. We expect

banks to start linking

funding strategies and

instruments to the asset

side of the balance sheet,

and using this to guide

funds’ transfer pricing.

5.2. INCREASING

TRANCHING OF BANKS’

LIABILITY STRUCTURES

The boom in securitisations prior to the crisis

is instructive about the segmentation of

investor demand and the potential future of

wholesale funding for banks. The tranching

of securitisation structures allowed banks to

create both super-safe AAA securities and

equity-like return tranches from underlying

portfolios of moderate risk loans, thus

meeting the two most common demands

for risk-return profile on assets from an

underlying pool.

Trends in today’s funding market suggest a

continued move towards this tranching, but

across the whole balance sheet rather than

just through securitisations:

Increased issuance of covered bonds

encumbers a greater proportion of the

assets and creates a larger super-senior

tranche of bank debt that is senior to

all others

Increased capital ratios, both in core

equity and CoCos and other hybrids,

creates a larger equity tranche to

bank debt

Proposed bail-in regulations would make

senior unsecured and short-term debt

subordinate to customer deposits.


It is, as yet, unclear how increased tranching

will affect pricing for senior unsecured.

While increased capital buffers reduce the

probability of default on these bonds, their

subordination to deposits and covered

bonds increases the loss-given default

(LGD), especially given that the encumbered

assets will come mostly from the better

quality part of the portfolio.

Bail-in regulations would increase the cost

of senior unsecured funding because they

would remove the implicit government

guarantee on this tranche of the bank’s

debt. Rating agencies have been outspoken

about the impact the removal of the implicit

government guarantee would have. In

October, Moody’s downgraded twelve UK

banks by between one and three notches

on the basis of the reduced likelihood of

UK state support in the event of default

(including for the SIFIs in the UK). This

followed its decision to downgrade 30

Spanish banks in March, half of which

were downgraded by two notches. These

ratings apply only to the squeezed senior

unsecured tranche, as covered bonds

have enhanced ratings and deposits are

protected by government-backed deposit

insurance schemes.

EXHIBIT 23: TRANCHING OF BANKS’ LIABILITIES

Liabilities today Potential futureliabilities structure

Increasing seniority

Increased capital tranches

Tranching of the senior unsecured component due to due to bail-in and other regulations

Increased covered bond issuanceCovered bonds and securitisations

Senior and desposits

Customer deposits

Senior unsecured and ST debt

Junior/hybrid debt

Equity capital


5.2.1. ASSET-LIABILITY LINKING

Regulatory changes and investor demand both point

towards a more hypothecated link between funding

instruments and the banks’ assets, with a better

match between the duration and credit quality of

banks’ liabilities and the assets. Given the funding

cost advantages of originating assets that can be used

for secured funding instruments, banks will look to

prioritise these assets through strategic planning, and

incentivise the origination of suitable assets through

funds’ transfer pricing.

For regulators, this hypothecation is motivated by a

desire to reduce liquidity risk and is the rationale behind

the NSFR of Basel III. For investors, it clarifies the risk of

the debt they are investing in. Considering both assets

and liabilities in terms of their credit quality, seniority

and duration suggests a potential matching approach

(see Exhibit 24).

Thinking about funding in this way suggests using

short-term funding for highly liquid securities only, with

covered bonds linked to mortgages and other covered-

pool eligible assets while customer deposits and senior

unsecured funding are used to fund the remainder of the

balance sheet. Should banks be forced by regulators to

separate or ”ring-fence” investment banking from retail

banking, this could lead to senior unsecured being used

to fund balance sheets only of illiquid structured credit

positions in the trading book and corporate lending.

Covered bond issuance explicitly links funding with the

prime mortgage book as collateral, while LCR and NSFR

regulation effectively prevent banks from funding long-

term assets with short-term debt. Given the advantages

of doing so, we expect banks to explore methods of

issuing an ever wider array of covered bonds against

high quality assets. This will expand the hypothecated

box and squeeze the pool of assets held against senior

unsecured and customer deposits.

This trend could be very significant for short-term debt

markets. Short-term debt is an important source of

funding for banks because it remains liquid (at least for

banks where the sovereign is still perceived to be strong)

and therefore allows banks to manage their fluctuating

cash flow needs on a daily basis. By contrast, senior

unsecured and covered bond issuance programmes are

often large and lumpy, and not suitable for daily cash-

flow smoothing. However, the subordination of short-

term debt holders through bail-in regulations and the

potential downgrading of banks’ senior unsecured debt

would threaten the liquidity of this vital market. This

suggests the following possibilities:

EXHIBIT 24: LINKING ASSET AND LIABILITY DURATION AND CREDIT QUALITY

Short-duration Long-duration

Higher-credit

quality

Lower-credit

quality

Assets

Liabilities

Highly liquid, highly rated securities – high liquidity and turnover makes suitable for short-term funding increasing use of these assets for repos

Short-term secured funding (repos)

Unstable portion of customer deposits

Low-rated securities

Short-term unsecured funding

Prime mortgages

High-quality corporate and specialised lending

Lending to governments/ PSEs

Covered bonds

Stable portion of customer deposits

Structured credit

Lower quality large corporate lending And most of SME lending

Unsecured retail lending

Senior unsecured debt


5.3. DELEVERAGING,

REPRICING AND

STRATEGIC IMPLICATIONS

The new funding environment affects asset

strategy in the following ways:

The increasing cost of wholesale funding

means banks will seek to close their

loan-deposit gaps. As our analysis in the

first chapter of this report suggests, this

is unlikely to be achievable without some

level of asset reduction or an increase

in aggregate savings rates (e.g. by

raising the retirement age or compulsory

retirement savings plans)

Rebalancing balance sheets to meet the

NSFR requirement will lead to deposit-rich

institutions with large balances of stable

funding gaining lending business from

wholesale-funding dependent institutions

The tranching and hypothecation of bank

funding mentioned in 5.2.1 will change

the profitability of different lending and

asset segments. Over time, we expect this

to lead to:

− Repricing of these segments to reflect

the true economics of lending to

each segment

− Strategic focus on higher profitability

segments, with asset reduction

focused on low-profitability segments

− A change in the way banks serve

different segments, with a move

towards a brokerage model linking

customers to investors directly

rather than balance sheet lending

in some cases.

Increased use of secured short-term

funding instruments (notably repos).

The scope for expanding this source of

funding is limited as the market capacity

is already largely exploited through repos.

Banks may try and extend the range of

assets that support repos to increase

this scope. Most repos today are written

against highly liquid short-term assets,

but a new class of repo that is backed by

illiquid banking book assets may emerge

Attempts by either banks or regulators

to make short-term senior unsecured

funding senior to long-term unsecured

funding. In our opinion, an important part

of the public policy debate around bail-in

regulations should focus on the seniority

of short-term debt and the extent to

which governments guarantee it

In the absence of either of the above,

meeting funding gaps with short-term

debt will become more expensive.

Banks are likely to hold larger liquid

asset and cash buffers to manage short-

term liquidity and extend the term of

short-term funding to fall outside the

LCR bucket (one month), allowing them

to fund lending with less than a year to

maturity. This is particularly relevant

for investment banking businesses that

depend on obtaining short-term funding

at very low margins. Already facing an

increase in funding costs due to the need

to increase maturity of short-term funding

to >30 days to comply with the LCR, this

further increase in funding costs would

be a substantial blow to profitability, and

force a strategic rethink and repricing of

products dependent on cheap short-term

wholesale funding.

Funding and capital

pressures will cause

banks to reduce their

lending. We expect

banks to focus on lines

of business that are

either self-funding or not

capital intensive and to

reprice balance sheet led

business. This will lead

to some radically new

business models.


EXHIBIT 25: IMPACT ON ASSET SEGMENTS

Liquidity

Risk adjusted margins

Mid-corporate lending SME lending

Fee-based business

(e.g., M&A advisory)

Other retail lending

Derivative sales

Debt capital markets

Retail mortgages

Liquid trading books

Specialised lending

Large-corporate lending Commercial real estate

?

?

The most attractive customer segments

will combine significant pools of deposits

or provide assets eligible for inclusion

in covered bond pools. Other segments

will see increased lending margins,

reduced volumes and increased pressure

on cross-selling fee-based products to

improve economics.

As Exhibit 25 shows, the least attractive

segments in a world of increased wholesale

funding and capital costs and constrained

funding availability are corporate and other

large asset-backed lending:

Retail banking is likely to be

relatively attractive

− Large deposit base means this

segment is largely self-funding

− The ability to use mortgages for

covered bond funding keeps

aggregate funding costs low

− High margins in non-mortgage

lending together with relatively low

price elasticity suggests that any

increase in funding costs can be

passed on to customers

Investment banking activities, especially

those that do not depend on short-

term funding to generate margins, also

look relatively attractive in the new

funding environment

− Fee-based businesses with little to no

balance sheet impact such as M&A

advisory are particularly attractive

− Liquid trading books can be funded

relatively cheaply through repos

− Illiquid trading strategies that rely on

long-term wholesale funding (e.g.

structured credit) are harder hit, both

by liquidity and capital requirements

− Trading strategies that rely on cheap

short-term unsecured funding will be

squeezed hard if bail-in regulations

translate into higher short-term

wholesale funding costs


Corporate banking segments will be the most

affected by the tougher funding environment

− Corporate deposits are far short of corporate

lending, meaning the sector relies on

wholesale funding

− Corporate lending assets are not eligible for

traditional covered bond vehicles

− The illiquid nature of corporate lending means it

needs to be funded primarily long-term

− Margins are relatively low because the customer

base is price sensitive

− The small to medium-sized enterprises (SMEs)

segment could deliver high risk-adjusted returns.

However the current political pressure to lend

to this sector at low rates, combined with the

high operational cost of lending means that

much SME lending is written at low levels of risk-

adjusted return.

Corporate banks have the following options:

1. Reprice lending and concentrate on higher

margin business

2. Cross-sell fee-based products to corporates more

aggressively to subsidise lending to corporates, using

the lending as a loss-leading relationship builder

3. Create a market for corporate lending-backed

secured funding to reduce funding costs

4. Disintermediate themselves, either by offering DCM

as an alternative to bank lending to corporates or by

partnering with loan funds. The switch from lending

to DCM has been marked since 2007 and is likely

to continue.

EXHIBIT 26: EVOLUTION OF DEBT CAPITAL MARKETS COMPARED TO LOANS

2006 2007 20132005 2009 2010 2011 20122008

0%0

30,000 45%

20,000

10,000 15%

30%

LOAN VOLUME (USD BN) DCM/LOANS

Bilateral loan volume

DCM over bilateral lending

23%

22%

20%21%

25%

32%33%

35%36%

Source: Economist Intelligence Unit, Dealogic, Oliver Wyman analysis, Scope: 20 biggest countries by GDP


5.3.1. REPRICING AND CROSS-SELL

Exhibit 28 shows a pro-forma calculation for the break-

even margin on a typical large corporate loan, assuming

a Core Tier 1 ratio of 10%, total capital ratio of 15% and

a permanent increase in liquidity premia on unsecured

wholesale funding of 90bps.

The regulatory measures introduced post-crisis combine

with higher spreads on wholesale funding to add more

than 170bps to the break-even spread on a typical

corporate loan.

Lending to corporates has often been priced below its

marginal cost. This is because lending has been seen

as the crucial relationship product with corporates,

allowing the bank to cross-sell investment banking

products (derivatives, DCM, Equity Capital Market,

M&A advisory, etc.) that improve the profitability of the

overall relationship. However, increased cross-sell alone

is unlikely to be able to make up the additional 170 bps

cost of lending. So lending spreads, which have already

widened, are likely to increase yet further.

The relationship model of corporate banking should also

come under pressure as banks reassess the true value

of lending as the anchor relationship product. Many

smaller banks that lack credibility in some of the more

profitable investment banking products may be forced

to exit by the further deterioration in economics.

5.3.2. SECURED FUNDING

Corporate lending is hard hit by the lack of a market

for funding secured against these assets. A likely

trend, therefore, is towards the creation of a market

for “structured covered bonds” – a structure exactly

like a normal legal covered bond but with a wider array

of assets behind it. Issuing CDOs would probably be

preferable for banks, because it would allow a greater

degree of capital relief through risk transfer. But investor

appetite for this asset class shows no signs of returning

in any volume.

Issuing structured covered bonds secured against

corporate loan pools would further tranche the balance

sheet, subordinating depositors and the residual senior

unsecured debtholders further. The success of this asset

class is likely to depend on:

Banks’ ability to identify a high-quality pool of

underlying assets that is well understood by

investors. This may restrict the bonds to larger, rated

companies in the short term

The extent of over-collateralisation offered

The willingness of rating agencies to award rating

enhancement to these instruments.

EXHIBIT 27: PRE- AND POST-CRISIS MINIMUM MARGIN ON CORPORATE LENDING

DEAL CHARACTERISTICS

PD 1%

LGD 40%

Maturity (years) 5

EL 0.40%

RWA% 117%

P

Funding

structure

Core Tier 1 4.68 12

Other capital 4.68 6

ST Wholesale funding 30

LT Wholesale funding 60.32 82

Cost of

funding

Cost of CT 1 12% 12%

Cost of other capital 10% 10%

Cost of ST W/S (over LIBOR) 0% 0%

Spread on LT wholesale funding 0.10% 1.00%

SPREAD 1.49% 3.21%


5.3.3. DISINTERMEDIATION

A more radical approach is for banks to disintermediate

themselves and remove corporate banking assets from

their balance sheet. For larger, rated corporates, the

increased cost of borrowing from banks makes direct

access to the capital markets more attractive. Banks

can disintermediate themselves here by providing this

access (i.e. DCM).

However, DCM requires reliable credit ratings. The cost

of analysing the credit quality of unrated corporates

will be too high for mainstream debt investors.

Bank intermediation here can be understood as the

outsourcing of credit pricing by investors who lack the

scale to invest in the skills required to assess unrated

mid-corporates. However, such intermediation can be

achieved in several ways:

Traditional intermediation In a traditional model,

the bank acts as intermediary by borrowing from

investors and lending to borrowers. The bank takes

on a liability and acquires an asset. Investors in the

banks have no direct control over where their funds

are placed by the bank; lending decisions are at the

discretion of the bank

Brokerage In the DCM approach, investors lend

directly to borrowers. The intermediation in this

model is no more than a brokerage service, with

banks linking investors to borrowers. Investors have

total control over who they lend to, and do not rely on

the bank’s credit decisioning capabilities

Originate to distribute Banks link investors to

particular pools of assets, allowing investors to invest

in particular assets and opening up asset classes

that are otherwise not available to investors given

distribution costs. But the banks do not hold those

assets on balance sheet. While securitisations did this

in a pure way, covered bonds provide a mechanism

by which investors are exposed to a particular asset

class as well as to the whole bank and move in this

direction. (Note that a bank that was 100% funded

with covered bonds would be equivalent to a bank

funded 100% with securitisations in terms of the

credit exposure of investors.)

Loan funds These are a variant on the originate to

distribute model. Banks or funds provide guided

micro credit decisioning and origination services but

the assets and risk are held off the banks’ balance

sheets, instead being owned by the investors in the

fund. As fund investors provide equity to invest in

loans, the balance sheet of loan funds is much less

leveraged than a traditional bank balance sheet.

This model allows non-bank financial institutions,

such as insurers, to enter the lending market

(Aviva, for example, has a direct lending offering to

commercial property.).

We expect the trend to be towards greater

disintermediation – from lending to DCM for larger

corporate exposures and towards loan funds for SMEs.


6. MESSAGES FOR

POLICY MAKERS

Following the financial crisis, policy

makers are faced with a menu of

conflicting objectives:

Protect against future liquidity crises

Increase confidence in financial

sector solvency

Protect taxpayers from needing to bail-

out banks in the event of future crises

Ease bank resolution in the event of

future crises

Encourage banks to lend to the business

and personal sectors to support

economic growth.

The responses to these objectives have been

far-reaching, and each has an important

impact on the funding landscape. The

emerging trends and analysis in the previous

chapters point to some important lessons

for regulators about the effects (intended

and unintended) of existing regulations and

about policy developments that are needed

but under-discussed to date. In particular,

we believe regulators should aim to deliver

the following:

Clear, proportionate and appropriately

timed approach to liquidity regulations

Clear bail-in proposals

An appropriate policy response to

increased encumbrance

Policies that increase savings rates and

encourage deposit growth

Policies that support alternative business

models for corporate lending.

6.1. LIQUIDITY

REGULATIONS

The financial crisis demonstrated a clear

need for banks to increase liquidity buffers

to cope with short-term stress and reduce

the extent of maturity mismatch. Regulators

responded to this with the LCR and NSFR.

Taken together, they require banks to hold

greater buffers of liquidity assets and either

increase the duration of their funding or

reduce lending dramatically. This is done by

applying formulae that estimate the stability

of different funding sources and stickiness

of assets. The scale of the liquidity failure

during the financial crisis clearly justified

regulations to improve banks’ management

of liquidity, and both the LCR and NSFR are

a move in the right direction in this respect.

However, the funding environment poses

difficult questions for regulators about the

timing and detail of these proposals:

The scale of the funding challenge in

meeting the proposals will keep the cost

of senior unsecured bank funding high

in the medium-term and force banks

to restrict the availability of credit to

businesses, thereby raising its price,

i.e. the cost of borrowing for corporates

and individuals. It is likely that the

corporate sector will be hardest hit by

the new funding regime. While in the

medium term, we think a reassessment

of the business model for corporate

banking is warranted, the speed at which

While we support

the LCR and NSFR

regulations, their timing

and details should be

carefully considered

to ensure they do not

create distortions or

excessively increase the

cost of borrowing.


this adjustment takes place needs to be carefully

considered given the fragility of European economies.

There is no easy answer to what the optimal

balance is, but policy makers should be honest with

themselves in recognising the irreconcilability of

new liquidity regulations with the stated desire for

banks to increase lending (such as the negotiated

deal on SME lending between the UK government

and the UK’s largest banks). The trade-off being

made between reduced vulnerability of national

economies to banking crises and reduced short-term

growth prospects is a value judgement which is a

political rather than an economic decision – but it is a

real trade-off.

Existing proposals suggest that covered bonds will

be permitted in the liquidity buffer with a 20% haircut

provided they are not issued by the bank itself. In

deciding how to treat covered bonds in the liquidity

coverage ratio, national regulators should consider:

− The impact on liquidity of greatly increased

issuance Covered bonds have been demonstrably

liquid during the recent crisis. However, they

remain assets issued by financial institutions and

vulnerable to general fears about bank solvency.

Should the extent of covered bond issuance

become material, thus reducing the effective

buffer on losses from senior unsecured debt in

the liability structure, the crisis-liquidity of these

instruments would also be affected

− Avoiding the “house of cards” There is, in

principle, no difference in systemic liquidity

risk between a banking industry that originates

mortgages and funds itself short-term and one

that originates mortgages, funds these with

long-term covered bonds which are all held

within the banking industry, and then funds its

purchases of covered bonds with short-term debt.

Yet under current Basel III rules, these would be

treated very differently. Given the trend towards

greater covered bond issuance, regulators should

monitor the extent to which covered bonds are

sold outside the banking sector, or retained within

it. The LCR should reflect the extent to which

these instruments are truly liquid outside the

banking industry.


6.2. THE IMPORTANCE

OF ENCUMBRANCE

As discussed in the previous section,

covered bonds effectively subordinate senior

unsecured debt holders and depositors. This

means that depositors in banks with higher

encumbrance are exposed to greater credit

risk from bank failure than depositors in

banks with lower encumbrance.

While the probability of such a failure can

be mitigated by requiring banks to hold

more capital, the severity of such an event

for depositors increases with encumbrance,

by reducing the value of the unencumbered

assets that can be used to make depositors

whole. Unlike professional debt holders,

depositors cannot reasonably be expected

to demand higher rates on deposits from

more encumbered banks. To protect

depositors, regulators should consider a

number of policy responses:

Bail-in regulations These increase

the seniority of deposits by placing

them above senior unsecured in the

tranching of the liability structure and

as such provide additional protection

for depositors. Of course, this would

encourage banks to encumber their

balance sheets further. However, banks

will not be able to dispense with senior

unsecured funding altogether, so

introducing bail-in will effectively protect

the seniority of deposits

Reflect encumbrance in capital

requirements Highly encumbered

banks could be required to hold

additional capital buffers to protect

depositors from the reduced asset

protection against their deposits (or else

banks’ encumbrance could be simply

capped). Any such approach should

carefully balance the risk mitigation of

capital against the increased severity of

default that encumbrance brings. Overall,

we consider this an inferior option to

bail-in regulations given the complexity

of the requirements it would place on

regulators in calibrating the additional

capital requirements

Vary deposit insurance rates to reflect

the risk taken by depositors

− Economically the purest solution

to the problem, particularly as it

also allows risk to be taken by the

largest bank depositors (generally

not covered under deposit

insurance schemes), removing

potential moral hazard for large

professional depositors

− In any case, deposit insurance premia

should reflect the risks taken by those

depositors. This means reflecting

the impact of increased capital

tranches, seniority through bail-in

regulations, and potentially the impact

of encumbrance – although this will

create additional requirements for

regulators in calibrating the cost of

deposit insurance at a bank level.

The issuance of

covered bonds means

banks’ balance sheets

will become more

encumbered. Regulators

should watch this trend,

together with any effect

of bail-in regulations

on liability tranching.

Deposit insurance and

capital requirements

should account for

the economic effect of

encumbrance on the

risks to depositors and

senior debt holders.


6.3. BAIL-IN REGULATIONS

The fixed-income investors we surveyed

expressed concern about whether and in

what form policy makers will introduce

bail-in regulations that subordinate senior

unsecured debt holders to depositors. As

mentioned above, the likely consequence of

the bail-in regulations is an increased cost

of senior unsecured debt and eventually

of borrowing for corporates. We highlight

three additional considerations for

policy-makers when designing any bail-

in legislation:

Clarity At present, debt investors have

priced-in to the cost of senior unsecured

debt the potential for bail-in regulations,

with an immediate negative impact on

the cost of bank funding. Uncertainty

around the shape of the final proposals

today adds to this risk premium. A

simple solution to this problem could be

to reduce the proposal only to making

deposits (at least retail deposits) senior to

wholesale funding by law, rather than pari

passu with senior unsecured funding,

thus removing the potential for arbitrary

bail-ins and clearly defining the trigger

for a bail-in (i.e. default by the bank)

Co-ordination with other regulatory

changes Regulators should co-ordinate

bail-in regulations with changes to capital

requirements, and reflect this in the price

of deposit insurance. Bail-in regulations

should be introduced only once higher

capital ratios have been achieved, as this

will offset the negative effect on senior

unsecured spreads.

Bail-in regulations can form an important

part of regulations and help to protect

depositors from the increasing tranching of

bank balance sheets. However, because it

will increase senior unsecured funding costs

and, thus, corporate lending rates, it should

be combined with policy moves to support

alternative business models for corporate

banking, such as reducing the cost of DCM,

increasing the liquidity of the market for

structured covered bonds and increasing

the overall savings rate.

Above all, clarity is

needed. Regulators

should be conscious of

the effects of the new

regulations on the cost

of senior unsecured

funding as well as the

impact on the riskiness

of deposits.


6.4. POLICY APPROACHES

TO ENCOURAGE SAVINGS

RATES AND SUPPORT FOR

NEW BUSINESS MODELS

As discussed in the previous sections,

increasing deposits will be important for

banks seeking to improve their liquidity

positions and reduce funding costs. Policy

makers have a difficult balancing act

between supporting credit supply to the

economy and increasing the aggregate

savings rate. At a more micro level, a

simpler and narrower set of policy actions

could focus on increasing the relative

attractiveness of bank deposits and other

funding instruments by removing artificial

regulatory barriers to these instruments.

Such policies could include:

Beneficial tax treatment of certain

bank deposits

− This could be restricted to accounts

that are sources of bank liquidity, e.g.

those with call periods longer than

one year

− Differentiating the tax treatment of

bank deposits and money market

funds would be one – albeit radical –

approach to encouraging risk-averse

savers to place their money with banks

rather than money market funds

Removal of the barrier to investing in

bank funding instruments through the

inclusion of a wider set of instruments in

UCITS and pensions frameworks

− This is particularly relevant for more

exotic instruments – such as CoCos,

structured covered bonds and loan

funds – rather than deposits, where

money market funds can cannibalise

bank deposits, increasing liquidity risk

without providing additional funding

for banks

− Loan funds should be attractive to

regulators, especially where leverage

is kept relatively low. In such a case,

this is essentially replacing the highly

leveraged capital structure of a bank

against these loans with one that is

largely equity (in the form of money

from investors). UCITS and other

regulatory recognition would help

encourage this investment vehicle

− All of these instruments are suitable

for UCITS investors and pension

funds, and it is important that these

regulations do not artificially reduce

investor demand

Policy makers must

balance the need to

increase savings rates

with the impact this may

have on the macro-

economy. Nonetheless,

an increase in the

savings rate would help

stabilise the funding of

banks and improve their

ability to allocate capital

to the economy.


Timothy Colyer is a Senior Consultant in Oliver Wyman’s London office.

email: [email protected]. Telephone +44 207 852 7675.

Matthew Sebag-Montefiore is a Partner in Oliver Wyman’s London office.

email: [email protected]. Telephone +44 207 852 7417.

Oliver Wyman is a leading global management consulting firm that combines deep industry knowledge with specialised expertise in strategy, operations, risk management, organisational transformation, and leadership development.

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THE STATE OF EUROPEAN BANK FUNDING - Oliver Wyman · 2020-03-07 · Other secured funding (structured covered bonds and loan funds) 28 4.6. ... senior unsecured funding has been hit