Figuring out how EU lawmakers want bank capital structures to look has been like nailing jelly to a wall. Market participants have been in agreement on the principles for a long time — credit investors must be on the hook if a bank fails, not taxpayers. But the details of how that should happen have been subject to endless tinkering and fine-tuning by regulators in recent years.
Now, everything is coming together at the same time.
Europe’s largest banks will only have this year to make sure they have enough bail-inable bonds to comply with the Financial Stability Board’s first total loss-absorbing capacity (TLAC) deadline. Smaller banks will at long last have clarity on how to hit their minimum requirement for own funds and eligible liabilities (MREL) — Europe’s equivalent capital standard.
Many of them had to sit out of the market in 2017 as they waited for Europe to agree on how to make senior bonds available for bail-in.
And on top of all that, central banks are set from this year to wind down their liquidity support programmes, which have helped banks reduce their reliance on market-based sources of funding.
More than €1tr of the European Central Bank’s Targeted Longer-Term Refinancing Operations (TLTRO) are expected to mature over the next four years.
It might not come as a surprise, then, that the European Banking Authority (EBA) is feeling a little uneasy. The supervisor said last year that firms were being optimistic in thinking that they would be able to squeeze billions of euros of new loss-absorbing debt securities into the capital markets and yet still be able walk away with prices that flatter their net interest margins.
“An assumed increase in issuance volumes in 2018 and 2019, following their decline in the preceding year, might pose a challenge for banks in terms of their ability to place them successfully on the markets,” the EBA warned in August, having spoken with 155 banks about their funding plans.
TLAC’s world tour
But the bankers sitting on top of the next two years of bank bond supply are more confident.
Europe’s global systemically important banks (G-SIBs), the largest and most important institutions, have already laid a good deal of the groundwork in preparing investors for the shift from bail-outs to bail-ins. Research from ABN Amro shows that they pumped €42bn of index-eligible bail-inable debt into the capital markets in the first nine months of 2017 alone.
There was particular thirst among G-SIBs for non-preferred senior bonds — which were given the go-ahead in France, Spain and Belgium as a way of issuing cheaper debt for MREL — while UK and Swiss banks continued with their transition towards holding company funding models.
“One of the benefits of the Bank of England’s early action on MREL is that UK banks have now had two or three years of issuing eligible securities,” explains Tom Ranger, treasurer at Santander UK in London. “Looking at our UK peer group, I don’t think there will therefore be a dramatic increase in supply in 2018.
“Across continental Europe there is some element of catch-up because there has been a bit of a delay in implementing legislation. But if you look at the glide path that institutions have, I don’t think it will be unmanageable for the market.”
UniCredit will surely be in focus. Unlike Banco Santander and BNP Paribas — the other two G-SIBs with considerable TLAC shortfalls — UniCredit was hamstrung in 2017 because Italy did not move quickly to change its insolvency laws so that banks could start issuing non-preferred senior bonds.
As a result, the national champion is looking at having to issue close to €6bn of just senior non-preferred debt for TLAC this year, if it is going to comply with the FSB’s interim requirements by the start of 2019. Throw in a potentially volatile general election in Italy in the first quarter and UniCredit’s task starts to look challenging.
But the Italian issuer has been making the best of a tough situation. Last April it raised $2bn of preferred senior debt in its first global bond offering for several years, re-establishing a relationship with its dollar investors.
This was part of an important trend in 2017, when banks began to look far away from home for market access. Indeed, TLAC became a truly global product. Investors in Australian and Singapore dollars, Swiss francs and yen all familiarised themselves with the newly created asset classes on offer from European banks.
David Hague, managing director of Nomura’s EMEA debt capital markets desk in London, thinks this is likely to be only the beginning.
“A lot of issuers have already been active in exploring a range of markets to reduce their reliance on euros,” he says. “We should expect to see more supply from newer jurisdictions as they start issuing senior debt for MREL.”
The yen market is an obvious choice. BPCE introduced yen investors to non-preferred senior debt for the first time in January last year. BNP Paribas, Crédit Agricole, Société Générale and Santander have all followed with deals of their own — so that European banks had raised about $7bn-equivalent in yen by November.
“We know there is big depth in the yen market for the right names and we now know that there is also appetite for a broad range of products,” says Hague.
“The investor base has matured, broadened and adapted mandates to accept a far greater variety for TLAC and MREL paper.”
The haves and have nots
Ready recourse to a variety of markets may mean that larger European banks can avoid getting caught in busy and competitive markets in 2017, as the supply of MREL debt instruments increases.
However, Europe’s smaller financial institutions might struggle amid any surge in supply volumes. Those with the weakest capital levels have been trading at a deep discount to the rest of the market ever since Banco Popular was put into resolution last June.
The Spanish firm’s failure gave investors their first insight into how European authorities might apply the Bank Recovery and Resolution Directive (BRRD) in practice. All of Popular’s subordinated bonds were completely wiped out as a result of the resolution, suggesting that loss given default will be very severe for bank debt investors in the future.
Peter Mason, head of financial institutions and co-head of FIG EMEA banking at Barclays in London, says people will therefore be keeping a close eye on the second and third tier banks in southern Europe.
“Some may need to raise more equity; some may be consolidated and there may even be further action from resolution authorities,” he says. “But I don’t think that will affect market access for the national champion banks. We could be seeing a bifurcation of the market into ‘haves’ and ‘have nots’ in southern Europe.”
“A second tier European issuer with a modest MREL requirement will probably find it particularly difficult to influence spreads,” adds Hague. “There is plenty of capacity for MREL supply in the capital markets, but issuing new debt will become incrementally more expensive for smaller names as you get towards the margins.”
A sea change
Nonetheless, smaller and rarer financial institutions were able to flock to the primary market in 2017, seizing the opportunity to raise loss-absorbing debt at appealing pricing levels.
That’s partly because the market was almost eerily serene. At the start of the year, issuers had been worrying about a packed and potentially difficult calendar for political events. They were looking ahead to elections in France and the Netherlands, with the surprise result of the UK’s vote to leave the European Union still fresh in mind, as well as the election of Donald Trump as US president.
But market participants were able to shrug everything off. Even frequent threats of nuclear war from North Korea were not enough to derail a tremendous rally in market valuations for bank debt last year.
“News on North Korea in the second half of 2017 was pretty alarming, but there was little investor reaction,” says Mason.
“It was incredible. The technical features of the market are still so strong that it would take a significant geopolitical event to shut things down in 2018. There is an Italian election — which may present similar risks to the French one in 2017 — but if we can get through that unscathed then the market should be in great shape, underpinned by the technicals.”
There is no doubt, however, that European financial institutions are going to face a sea change in the way the capital markets function this year.
Not only are central banks cutting off their supply of cheap four year loans to banks, but the ECB is also preparing for the end of crisis-era monetary policy and president Mario Draghi’s “whatever it takes” approach to preserving the euro.
By the end of the year, the central bank may be looking to exit some €2tr of corporate and government bonds bought through its quantitative easing programme, and interest rates may be racing away from the record lows of recent years.
This will be a crucial test for whether or not there is true demand from investors for very large volumes of loss-absorbing debt instruments. JP Morgan expects €45bn of net supply from European banks across all currencies in 2018.
Having been given crutches to support themselves after the financial crisis, banks will have to make the last part of the journey towards MREL and TLAC on their own two feet.