As we have noted on previous occasions, regulation has been a key driver for the fundamental improvements seen in the banking sector in recent years. However, it can be a double edged sword for bank credit investors, and hence understanding regulatory action remains a crucial factor for investing in bank bonds.
Positively, tougher regulation has driven substantial balance sheet strengthening in the European banking sector in recent years, with both the quality and quantity of capital improving, as well as an increase in absolute and structural liquidity on bank balance sheets. There is also more hands-on supervision and the recent ECB AQR and EBA stress test have further supported this process, and in our view enhanced transparency and confidence in European banks’ balance sheets. Business models and strategies are being changed to adjust to the new regulatory requirements. At the same time, given regulatory, structural and also still cyclical pressures, bank returns will likely remain low. This is the new normal for banks.
However, we think regulation could provide more of a headwind for investors in bank bonds in 2015. Plans for TLAC (total loss absorbing capacity) for globally systemically important banks (G-SIBs) and MREL (Minimum Requirement for own funds and Eligible Liabilities) the equivalent provision in the Bank Recovery and Resolution Directive (BRRD) have the potential to lead to a material increase in supply in the sector, and subordinated debt will of course become statutorily loss absorbing at the point of non-viability from January 2015. Both TLAC and MREL aim to make sure that banks have sufficient loss absorbing capital in resolution. They are essentially increasing the subordination of bank bonds, and for G-SIBs early intervention/resolution and bail-in risks would likely increase in order to protect critical functions.
Regulatory agenda – a key near-term driver
TLAC proposals have also refocused attention on the question of ‘where does my debt sit in the group structure’ and how group structures may change as a result of TLAC requirements. Banks may use new issuing entities (hold co vs op co, resolution entities vs non-resolution entities) and potentially new debt instruments to meet evolving regulatory requirements. Take the recently issued UK holding company (hold co) bonds for instance, which have materially underperformed the banks’ operating company (op co) securities. Until there is clarity over ultimate group structures and funding arrangements, we expect ongoing uncertainty over valuations of bonds issued by different entities in complex groups. Moreover, in the UK, bank investors will over time have to deal with the added complexity of ring-fencing.
To be sure, there are still many moving parts in the TLAC and MREL discussions. We need further clarity on how the TLAC buffer can and will be filled by banks. We know senior hold co, contractual bail-in senior, T2, AT1 and CET1 can be used, and obviously banks will focus on the most cost effective solution. The big question for eurozone banks, however, is whether existing op co senior can be included (up to 2.5% of RWA), as this could reduce issuance requirements meaningfully. We think the latter is unlikely, and expect issuance of new contractual bail-in senior instead. The amount of TLAC required per bank is also not quite clear (and how this will feed through to requirements for domestic SIBs). Supply needs will clearly be quite different for TLAC requirements of 20% of RWA vs. 16% of RWA. However, no matter what the final outcome, we do see greater supply pressure as banks will likely try to get ahead of the game, and expect this to weigh on the LT2 sector in particular. We also expect further AT1 supply in 2015. Following around €eq40bn of AT1 issuance in 2014, we could see another €40bn of AT1 supply in 2015, both from existing as well as several new issuers. This compares to total issuance capacity of around €150bn for the major European banks. As there is no index driven buyer base for this asset class, investor demand will continue to be closely watched.
Finally, with the ECB now firmly in place as the single supervisor for European banks, we expect over time, to see more measures to increase harmonisation in risk-weighted assets (RWAs) for the banks, which could provide challenges for some. The ECB has stated its intention to reduce some of the 100 national discretions contained within CRD IV (the legislation enacting Basel 3 in the EU). More recently, there have been press comments on limiting the usage of DTAs, sovereign risk RWA harmonisation, as well as limiting the use of the so called Danish compromise (i.e. beneficial treatment of bancassurance business models). This is important for investors, as changes in RWA can have a meaningful impact on CET1 ratios, which are also triggers for AT1 securities.
Hence, while we remain constructive on ongoing fundamental improvements for European banks, we remain very selective in terms of which part of the capital structure to invest in for each issuer, taking into account regulatory driven name and sector supply risks, as well as idiosyncratic credit risks of issuers.