Bank Funding Costs May Soar as LTRO Binds Assets, Barclays Says
The European Central Bank’s unlimited three-year loans to the region’s lenders may raise their funding costs to unsustainable levels and force them to slash lending, analysts at Barclays Capital said.
More than 800 banks borrowed more than 1 trillion euros ($1.3 trillion) from the ECB’s Long-Term Refinancing Operation in December and February. Because banks posted collateral in exchange for the loans, the amount bondholders would get back if a bank defaults has shrunk, analysts led by Simon Samuels said in a note to clients. That will force lenders to offer higher interest rates to attract investors, the analysts said.
“Bondholders face increasing subordination from this balance sheet encumbrance,” the analysts said in the note. “If funding costs can’t come down to economic levels, banks will either have to look for other sources of funding, or shrink.”
The ECB is flooding the banking system with cheap money in a bid to avert a credit crunch after the market for unsecured bank debt seized up last year and funding from U.S. money markets disappeared. Since the central bank announced its long- term lending program, yields on European bank debt have tumbled and the market for senior unsecured debt has reopened, with banks including Banco Bilbao Vizcaya Argentaria SA (BBVA), Intesa Sanpaolo SpA (ISP) and Lloyds Banking Group Plc (LLOY) completing offerings.
Other lenders may struggle to follow because investors are being pushed further to the back of the queue for repayment if banks default, Samuels said.
Loss Given Default
While the LTRO has reduced the risk that banks in the euro area will default, it has also increased the so-called loss- given default, the amount investors could recoup if a bank fails, he said. That could push the yield investors require to buy the unsecured debt of some lenders to as much as 10 percent, the same level as subordinated debt, the analyst said.
“It would clearly not be economical for banks to issue senior unsecured debt at anything approaching this cost,” the Barclays (BARC) analysts wrote. “Net interest margins would collapse if banks tried to absorb this cost; credit quality would suffer if they passed this on to customers.”
The LTRO has also coincided with an increase in sales of covered bonds, which are secured on bank assets. Covered bonds accounted for 40 percent of debt offerings by banks last year, the Barclays analysts said. Spanish banks sold 367 billion euros of covered bonds in 2011, up from 160 billion euros in 2005.
Encumbrance -- the pledging of assets as collateral to one group of investors -- is particularly severe in southern Europe, Samuels said. The proportion of bank assets pledged as collateral has jumped to 37 percent in Greece, 24 percent in Spain, 18 percent in Ireland and 17 percent in Portugal.
Of Royal Bank of Scotland Group Plc (RBS)’s 1.2 trillion euros of assets, 27 percent is pledged as collateral to the ECB, existing investors or as part of repo transactions. BNP Paribas (BNP) SA’s balance sheet is 27 percent encumbered, UBS AG (UBSN) 25 percent, Societe Generale SA (GLE) 21 percent, and HSBC Holdings Plc 19 percent. By comparison, the figure for Standard Chartered Plc is 1 percent, according to the Barclays analysts.
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