PR OFILE
15% is still realistic in these investment strategies, ” summarizes Fery.
Why could these returns persist for a multi-year period? The structural imbalance between supply of and demand for capital is one reason, and the expertise required to do these types of deal constitutes a barrier to entry that may further constrain the supply of capital that can be deployed in these opportunities.
Basel III and one trillion Basel III rules are the main factor forcing banks to lower ratios of loans to capital, with European Banking Authority (EBA) stress tests and asset quality reviews, and EU rules on state aid, also imposing restrictions, according to Chenavari. The Swiss city of Basel straddles three countries – Switzerland, France and Germany – and the Basel III rules are homing in on a maximum loans/capital multiple of just over 12 times, with total capital set at a minimum of 8% of loan books, although regulators in some countries, such as Sweden and Switzerland, have already set lower multiples and higher capital requirements. Chenavari estimates that European banks will in fact converge towards average core tier 1 capital of 12.5%, which in effect limits their leverage to just eight times. To put this into perspective, before the crisis some banks were as much as 40 times leveraged on a “look-through” basis, including their off-balance-sheet leverage via SIVs (special investment vehicles). Fery, who left his investment banking days in mid-2007 before the bubble burst, admits that “less leverage in the banking system will contribute to financial stability”.
The deleveraging marathon has begun – with two trillion of assets shed by Europe’s banks between
Fig.1 Increase of European bank total assets
Eurozone MFI Balance Sheet - €Tr Eurozone MFI Balance Sheet as % of GDP (Rhs)
26.7 25.8 24.1 22.4 19.7 17.9 15.7 13.5 12.4 13.9 14.6 23.8 26.2 24.7
Source: Chenavari, ECB & Eurostat
50% 100% 150% 200% 250% 300% 350%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
2011 and 2013 (see Fig.1) but it has further to run. Longer-term lending for four or more years appears particularly vulnerable because Basel III D-Day is 2019. This deadline was last year pushed out by four years from the original aim of 2015, with respect to liquidity capital ratios, underscoring the magnitude of the challenge. The extension buys time, but ultimately banks must still meet the new criteria.
A lower ratio of loans to capital is only the most obvious Basel III change. Capital itself is more strictly defined, rendering parts of banks’ current capital bases ineligible. The risk weightings for assets, that once branded residential mortgages as low-risk, have been increased too, making consumer lending, for instance, a more capital-intensive activity.
Will the ECB fill the gap?
Private sector bank deleveraging would appear to be the mirror image of the ballooning central bank balance sheets, but the story is region-specific. Banks in the US are now growing loan books as the Fed begins tapering, while the ECB balance sheet has been shrinking since 2012, and it was only in September 2014 that Draghi stated an intention to get it back up to 2012 levels, although there are questions about whether this is attainable. That the ECB has finally embarked on QE may have captured the headlines. But the scale of QE proposed by the ECB has been dubbed “QE lite”, as it is expected to remain very small compared with asset purchases done in the US, Japan and UK. Forecasts are that the ECB might buy €100 billion of top-quality asset-backed securities over two years, whereas the Fed was buying more than that each month at the peak of QE – around 20 times as much per month. The forecast level of ECB purchases also look small versus the deleveraging mountain: €100 billion of asset-backed securities would be only 0.4% of the €25 trillion mountain of bank assets in Europe, and just 3% of Chenavari’s estimated €3 trillion amount of deleveraging. Part of the problem is that “securitization remains expensive for issuers in Europe, especially considering senior spread, which has room to tighten,” says Fery.
All in all, Chenavari estimates European banks still face a capital shortfall of approximately €1 trillion (one thousand billion), which will imply the need to rein in several trillion of loans currently on balance sheets. Banks are pursuing these goals from many angles. Some banks are conserving capital by retaining earnings, delaying the reinstatement of dividends, or not increasing dividends. Banks are raising capital through issues of equity and instruments such as contingent convertibles (CoCos), which the UK FCA recently said were off-limits for retail investors, and GLACs (gone concern loss absorption capacity bonds) could be the latest acronym to watch out for next year. Banks are letting some loans mature and not extending them. Finally, banks are selling off portfolios of loans, effectively sharing risk with third-party funds to buyers such as Chenavari – and possibly also now to the ECB.
While ECB policies might be infusing liquidity into wholesale markets, and improving the liquidity and cost of loans for some types of banks and borrowers, ECB policies are not removing the need for private banks to deleverage in Europe. That the EU economy has shrunk by 1% since the 2008 crisis, with plenty of depressing data seen in 2014, does not help banks to rebuild their balance sheets. Surprisingly, though, it is not only economically sclerotic Europe where banks need to deleverage. Even in wealthy Australia, which has escaped recession for 18 years and boasts vast pension fund assets, banks are capital- constrained – partly because overseas banks have been repatriating capital.
Partnerships with banks – and regulators? Regulatory capital and direct lending investment strategies are both useful in helping banks to climb
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