Charlotte Moore finds that the anticipated flow of bank assets is more likely to be a trickle - thanks to the very regulation that was supposed to open the floodgates
It was the great banking bonanza that never was. Investors rubbed their hands together with glee in anticipation of the great sell-off. Funds were set up in anticipation of the time that European banks would be forced to dump non-distressed assets at bargain-basement prices.
“Banks make money by borrowing money at a low level and then lending at a higher rate to generate a net interest margin,” says William Nicoll, director of fixed income at M&G Investments. “But a number of banks are currently holding assets at a lending level significantly below their own cost of funding, thus generating a negative interest margin. In an ideal world they would like not to own these assets.”
Investors thought that banks would want to sell off these unprofitable non-distressed assets to improve their profitability and strengthen their balance sheet. But the flood never came. The ironic twist is that banks have decided not to sell these loss-making assets because of the negative impact such sales would have on both profitability and balance sheet strength.
To get to the bottom of why there has been such a volte-face, let’s take a closer look at a simplified model of a bank’s balance sheet. Even though the way that a bank makes money is very different from any other business, its balance sheet, at first glance, is structured the same way - its assets must equal its liabilities plus its equity. And, just like any other business, the equity portion is made up of shareholders’ capital plus any retained earnings. A traditional bank would ensure that equity makes up a significant proportion of the balance sheet to protect its depositors from a sharp devaluation of its assets.
The new Basel III regulations are designed to ensure that banks hold more capital on their balance sheet. But the capital requirements being proposed are not as simple as requiring that equity make up a certain proportion of a bank’s balance sheet, because Basel III regulations apply different risk weightings to banks’ assets. The industry is currently working on the assumption that the regulations will require banks to have a tier-1 capital ratio of 10% of the total risk-weighted assets.
European banks have been famously undercapitalised and now have little wriggle-room. It was a very different financial environment when the banks invested in the assets they now hold - assets such as commercial property. Those assets were booked onto their balance sheets at the price they were bought, which was much higher than it is now.
“There’s a very simple reason we haven’t seen banks selling non-distressed assets,” says Iain Burnett, head of distressed debt at BlueBay Asset Management. “These assets have a different price to the one at which they were booked to the balance sheet. In my mind, it only makes sense for banks to sell a non-distressed asset if it can do so at around 92-93% of the value at which they acquired them. Unfortunately, they are likely to only be able to sell them for around 70-80% of the value. When an asset defaults, banks have no choice but to take the impairment hit and book that charge to their profit-and-loss account. But there is no requirement to do this for non-defaulted assets.”
Mathew Craston, head of alternative investments at European Credit Management (ECM), agrees. He says that he has seen some assets sold when banks could get 99 cents for them, and that a few are now selling distressed. “There’s a Lloyds portfolio out in the UK now, for example,” he says. “But the market got a little bit ahead of itself on this.”
If a bank sells a non-impaired asset for only 70% of the price at which it was acquired, this 30% loss would have to be booked to its profit-and-loss account, and ultimately its balance sheet, eroding both the retained earnings portion of the bank’s equity and the value of the bank’s assets. As the current price is still so far below the value at which the assets were acquired and the banks are undercapitalised - even though the assets now carry a higher risk weighting - selling them would still significantly erode the bank’s tier-1 capital.
Bank managers understand better than most the old adage that there is no such thing as toxic assets - only toxic prices.
“Banks are between a rock and hard place,” says Burnett. “On one hand, they are being told to clean up their balance sheet and on the other hand, they are being told that they have to comply with Basel III. It’s simply impossible to do both of these things at the same time.”
Nicoll concurs: “The market is stuck. The banks can not afford to take the loss at the moment. They would rather just leave the assets on the balance sheet and wait for them to revalue over time.”
Nor can banks decide to get rid of these loss-making assets, take the capital charge and then recapitalise their balance sheet by issuing new shares.
“Almost all European banks’ share prices represent a steep discount to their book value to reflect the tougher trading environment,” says Vaibhav Piplapure, head of structured and illiquid credit at Avoca Capital. “That makes raising new equity capital almost impossible, because it would dilute the value of the company too steeply for existing shareholders. Banks face a capital shortage. They are doing what they can to ameliorate the situation by buying back debt at a discount, using their assets as collateral to reduce funding costs and re-pricing loan rollovers to improve net interest margins but it is limited in scope.”
So, should investors hoping to relieve banks of these non-distressed assets simply give up or is there any chance that the situation will turn around soon?
No-one expects the situation to change radically. Mark Northway, managing director of Brookfield Investment Management, says that the preferred route will always be to “avoid the sword of Damocles” and hold on and wait for these assets to mature, but that there could be a slight pick-up in sales as the implementation deadlines for the European Banking Authority (EBA) stress tests loom. “These give bank management less choice because they will have to raise capital,” he explains. “It’s just a question of how they raise their capital.”
Still, the EBA stress tests are unlikely to result in a flood of assets coming to market - investors are expected to continue getting access to them in dribs and drabs. And banks may, instead, prefer to take the option of raising capital by finding an investor that will be prepared to give them a guarantee for the capital and transfer it off balance sheet, effectively creating synthetic capital.
Investors should abandon any hopes of a great gold rush. Banks’ balance sheets will eventually unwind but it will be a long and slow process.