Bond rout threatens to hit bank funding

June 26, 2013 6:00 pm

Bond rout threatens to hit bank funding

By Christopher Thompson in London and Jason Abbruzzese in New York

Will banks be among the biggest casualties of the global bond market sell off through rising funding costs?

Like Odysseus’s boat passing between Scylla and Charybdis, banks must navigate an increase in their funding costs from higher market interest rates on one side and regulators’ demands on the other.EU banks’ average bond spreads – the difference between what banks can borrow at compared with a benchmark government treasury such as the US or Germany – hit 95 basis points this month amid investor expectations that the US Federal Reserve would wrap up quantitative easing, according to figures from Dealogic.

US banks saw their spreads increase to 122 basis points in mid-June, from 12.5bp a week before, although that has since come down.

“There’s fear in the air so caution is the order of the day,” said a senior London-based banker.

“Market interest rates have gone up quickly so it’s not something you take in your stride but it’s the borrowing spreads going up which banks are most worried about.”

Highlighting investor nervousness, the cost of insuring against default on a basket of European financial institutions has risen by 19bp since the end of May, according to figures from the Markit iTraxx Senior Financials index.

But that masks differences. While the cost of a credit default swap for Deutsche Bank has risen by less than 5 basis points the same insurance for Royal Bank of Scotland has increased by 66bp.

“Clearly issuers are sensitive to their funding level,” said Jeff Tannenbaum, head of European financial institutions’ debt capital markets at Bank of America Merrill Lynch.

“What’s more important than rising interest rates is volatility in banks’ spreads which, for a number of European banks, are up to 40bp wider over the past three weeks.”

The rise could take the shine off banks’ share performance. In the US financials have been among the best performing sectors on the S&P 500 for much of 2013.

While rising interest rates should help increase margins on lending, banks are being squeezed on other fronts.

Not only have falling bond prices hit the value of their holdings of debt, US and European lenders are set to come under tighter capital restrictions, while the US government is limiting profits on mortgage loans.

All this means banks could face severe headwinds. Traditionally, banks “have performed very poorly during these Fed normalisations,” says Barry Knapp, head of US equity strategy at Barclays.

Compounding the impact of higher funding costs is low economic growth. Falling demand for borrowing limits banks’ ability to offset increased costs by passing on higher interest loans to customers.

“At the moment it’s difficult to quantify how much of a hit banks will take due to rising interest rates,” says Suki Mann, head of credit strategy at Société Générale.

“They are unlikely to compensate for their losses in the bond markets in the short term because the lack of economic growth limits the number of profitable lending opportunities – although steeper [yield] curves will help.”

Regulatory pressures threaten to buffet banks’ balance sheets and funding costs further.

So-called “asset encumbrance” – the percentage of loans and investments banks pledged in order to protect creditors – is set to soar if EU regulators decide to protect all retail deposits from being “bailed in” if a bank defaults.

That would leave banks with a dwindling amount of unsecured capital to deal with crises.

At present the median asset encumbrance for EU banks stands at 22.5 per cent, according to research by the Bank for International Settlements. But the BIS projects that would rise to nearly 70 per cent if all retail deposits had to be protected as well.

Depositor preference and rising interest rates add up to increased risks for bondholders – making lenders less likely to provide cheap unsecured credit.

“Rising interest rates may lead to a change in strategy by some investors, who were previously prepared to buy subordinated debt,” says Khalid Krim, head of European capital solutions at Morgan Stanley.

“What is making some people nervous is the volatility in banks’ credit spreads – banks used to be able to borrow at cheaper costs than companies and make a margin when they loaned that money on, but that dynamic has changed.”

One silver lining is that bank balance sheets are stronger than during the financial crisis, one consequence of higher capital requirements under the incoming Basel III regulations.

Also, while the average EU bank bond spread has reached 60bp over the benchmark so far this month that compares with a spread of 135bp in April, according to Dealogic.

“The road to recovery will take time,” says Mr Krim. “Capital market investors need to be patient to enable banks to implement their plans and demonstrate the benefits of the new regime.”