What is in the price of AT1s after the sell off?
Volatility in the global banking sector has dominated headlines and continues to gyrate through debt and equity markets. But this isn’t limited to bank bonds or stocks. We think there will be broader implications for the financial ecosystem, particularly relating to funding and capital which will present opportunities for credit investors, public and private.
Funding – deposit flight in the internet banking age is a terrifying prospect for bank treasurers. Schemes such as government deposit guarantees clearly give treasurers significant protection against a liquidity squeeze, but when hysteria in the media (both traditional and social) is high, retail depositors don’t necessarily behave rationally and so those guarantees may not prevent a run on a bank. This is why the ‘major’ banks reportedly benefitted from large deposit inflows recently and consequently generally pay materially lower deposit rates when compared to smaller peers. Take for example, Lloyds Bank in the UK who pay just 0.85% for a standard instant access account compared to ~3% from the smaller ‘challenger’ banks on equivalent insured amounts.
It is also why treasurers strive for diverse funding mixes. Avoiding excessive depositor concentrations, maturity walls and using a balance of retail and wholesale funding tools such as money-market instruments, senior unsecured, covered bonds and asset backed securities (ABS) all providing mitigants.
We are often asked why issuers use ABS when cheaper alternative funding tools are available. One of the benefits that issuers are paying for is ‘matched’ (asset and liability) funding. ABS backed by consumer lending funds a specific pool of loans for full term. Revolving transactions can also fund future originations. Residential Mortgage Backed Securities (RMBS) transactions for example tend to have options to refinance the deals early (typically between 3 or 5 years) and investors would normally expect the call option to be exercised, but a treasurer with acute funding issues has the option to not call and thereby fund those loans for full term. For Commercial Mortgage Backed Securities (CMBS) or Collateralised Loan Obligations (CLOs), the matched funding principle also holds.
This is perhaps one of those benefits of ABS that is underappreciated in benign markets, but one that should be abundantly clear to treasurers who are currently in the process of weaning themselves off years of central bank liquidity, as well as to regulators who are almost certainly looking to find ways to bolster the future stability of the banking sector.
Capital – With equity expensive and Additional Tier 1 (AT1) issuance both expensive and at something of an impasse following recent events in Switzerland , banks seeking fresh capital have more limited options. This is not desirable politically or the ECB/BoE’s objective of ensuring a sound, functioning financial system.
Banks faced with scarce capital can of course slow lending, sell assets outright or find funding partners who are able to purchase newly originated assets. This in essence is why private markets have grown so much and continue to disintermediate the banking sector with such effective results.
One alternative solution is an area of the ABS market we talk less about, but one that has grown markedly in recent years; a segment called ‘significant risk transfer’ (SRT). Such transactions often securitise pools of assets which are more burdensome for banks from a capital perspective. SRT ABS allows external investors to take exposure to a material proportion of the credit risk on such assets for a commensurate yield, whilst banks in return are able to reduce risk weighted assets (RWAs), therefore improving capital ratios and allowing the banks to maintain lending. Such transactions can be public or private and are a scalable alternative capital management tool.
From the investors’ perspective, this product can be particularly flexible, as it allows them to target their risk appetite directly at the specific pool of assets being securitised, whilst at the same time taking no direct exposure to the originating bank where other issues may lie.
In the current environment, where banking risk aversion is high and where banks have restricted or expensive access to capital, we think SRT securitisations present a compelling case and a major opportunity for the expansion of public and private market investment in the securitised space; giving investors exposure to the asset classes of their choice at attractive yield opportunities, whilst providing banks with locked in and flexible capital relief. The likelihood of deeper regulatory scrutiny at the banking level will only serve to amplify this opportunity in our view.
A functioning and well-regulated ABS market is a key channel through which financial stability policy goals and economic growth objectives can be better achieved.