Making banks investible again after this year’s turbulence

Following the failure of four US banks and the bail-in of Credit Suisse, panellists at Risk Live Europe discussed the market outlook and whether reform is needed

Conventional wisdom states that, when interest rates rise, the net investment income (NII) margins of traditional banks improve while their markets businesses benefit from the volatility caused by uncertainty. 

However, the failure of four regional banks in the US so far this year and the bail-in of Credit Suisse in Europe has called that into question. 

In the wake of this turbulence, a panel convened at Risk Live Europe 2023 to debate what is impacting banks’ investability. They discussed the impact of Switzerland’s decision not to use the resolution regime, whether the bail-in of Credit Suisse has inflicted long-lasting damage on debt markets, and what measures banks and regulators might take to improve things. 

The following six key themes emerged:

1. NII margins are beginning to improve for banks in Europe

Of the 25 largest European banks, 23 are now benefiting from increased NII margins, with banks in southern Europe benefiting the most, said Gavan Nolan, executive director of business development and research, fixed income pricing at S&P Global Market Intelligence. 

That will be welcome relief for banks that have been struggling for years with their return on equity (RoE) being less than their cost of capital. 

RoE at banks has dropped to around 7–10% from 12–15% around 20 years ago, estimated Nick Silitch, former chief risk officer at Prudential. 

In Europe the problem has been even more acute, noted Nolan. For some banks in Germany, RoE was 2–3% for several years, he said. 

Silitch attributed the problem of RoE being lower than cost of capital to an unevenly applied regulatory regime that imposes stringent capital and liquidity rules on banks and insurers, but not on the multitude of other financial intermediaries that make up the shadow banking system.

2. Default rates are expected to rise

The impact of rising interest rates, in terms of non‑performing loans and loss provisions, has not yet been fully felt, and default rates are likely to rise from here, said Nolan. 

S&P expects default rates to rise in the leveraged loan markets where there is a floating rate structure, predicting they will return to their long-term average by next year. In the speculative-grade bond markets, however, defaults could be higher. “I don’t think that’s been fully priced in at the moment,” Nolan said.

3. Asset values are changing foundationally

Silitch noted that the interest rate environment for the past 40 years has been one of rates falling, with asset values rising. He predicted that, for the next 10 years at least, interest rates will no longer be falling. What had been a tailwind for asset values will become, at best, neutral or possibly even a headwind. “As interest rates rise, asset values go down – it’s just maths,” he said. 

He gave the example of cap rates on commercial real estate going from 4.5% pre-Covid‑19 pandemic, to 8–10% today. This alone will substantially reduce the value of the property but, on top of that, there is now heightened uncertainty in cashflows. Leasing profiles now look less favourable as tenants re-evaluate their need for fixed real estate – especially in major cities, he said.

As a result, buyers’ and sellers’ expectations are now widely divergent and transaction volumes in real estate are extremely thin. Any trades taking place at present are distressed and deeply discounted, Silitch noted. 

He cited one extreme case of a building in New York where the anchor tenant had left and the property sold for under $200 per square foot after being purchased in 2017 for $750 per square foot. 

The story is the same in other asset classes, he noted. Transaction volumes in mergers and acquisitions were down around 60% in the first quarter of 2023 in Europe and 45% in the US as buyers’ and sellers’ expectations realign. 

In a world of high leverage and debt maturities, falling asset values will make refinancing very difficult, which will lead to increases in distressed sales and defaults across many asset classes, Silitch said.

4. Uneven regulatory scope is impacting banks’ profitability 

Silitch noted that being unable to pass on the regulatory cost of capital and liquidity rules is a major difficulty for banks. “Banks and insurers used to be the [only] financial intermediaries. If [that were still the case], there wouldn’t be a problem because they could price debt and all the asset markets to reflect the added cost of the capital and liquidity regulations and rules.”

However, there is now a “multitude of financial intermediaries” that are not regulated – or are only lightly regulated – and are funded by fiduciary investors (for example, pension funds), making it difficult for banks to compete when they alone are subject to onerous capital and liquidity rules. 

“To fix this issue, there needs to be a foundational reassessment of regulation that doesn’t just focus on banks, [but] on all financial institutions and transactions where fiduciary investors are at risk,” Silitch said.

5. Securitisations need to be reined in by fairer application of regulatory capital charges 

US and Bermudian insurers are the biggest investors in subordinated tranches of structured credit for collateralised loan obligations (CLOs), said Silitch. “The reason they invest in it is the arbitrage that’s sitting within the regulatory rules today,” he said. 

“If I’m a US insurer, I hold somewhere between 9.5 and 10% capital against a pool of single B loans. If I instead take that pool of single B loans, put it into a CLO structure and own a vertical slice, the risk is exactly the same, but I’ll hold under 3% capital.”

This creates a huge incentive for securitisations as a way to hold assets instead of direct lending on the balance sheet. The issue needs to be addressed through consistent regulatory charges across asset classes, Silitch suggested. “If you get the capital charges on the regulatory side right, it will eliminate the arbitrage,” he said. “It won’t stop securitisations from happening, but it will drive the cost of that securitisation up so that banks can more reasonably compete for assets.”

While the National Association of Insurance Commissioners is working to address this, there remains a big gap in the regulatory framework, Silitch said.

6. Market confidence remains shaken by the bail-in of Credit Suisse and failure to use the resolution regime 

The decision by the Swiss Financial Market Supervisory Authority (Finma) to force a merger of ailing Credit Suisse with its largest competitor, UBS, may have had a structural impact on the market rather than being just an idiosyncratic event, Nolan said. 

He warned that the decision to write down 16 billion Swiss francs of Credit Suisse’s Additional Tier 1 (AT1) bonds has had long-term consequences in the market for total loss-absorbing capital (TLAC) instruments, which can be bailed-in as part of a resolution or recovery process.

Although the writedown was allowed in the AT1 bond documentation, some investors in the bonds were angered because equity holders will receive a sum from UBS for the acquisition of Credit Suisse. If the bank had instead been placed into resolution, Finma would have been required to wipe out shareholders before bailing-in the AT1s. 

“There’s somewhat still a lack of confidence in that market,” said Nolan. “I think it has also fed down into the capital structure.” 

He said some confidence was restored to the AT1 market after the Bank of England and European Central Bank issued statements on March 20 distancing themselves from what the Swiss regulator did in terms of disrupting the creditor hierarchy. 

However, he pointed out that the iBoxx AT1 index had given away “several years of return in just the space of a few weeks” immediately after the bail-in. “It has since recovered somewhat, but there’s still risk premium being priced in, more so in Switzerland than other jurisdictions,” he said.

He added that forms of TLAC that are more senior in the capital structure have been less heavily affected, giving the example of credit default swap spreads at a “large German bank”, which were trading on June 7, 2023 at 1.9 times the spread on senior non-preferred debt compared with senior lower Tier 2, up from long‑term averages of 1.6. 

“I think investors don’t really believe that the senior non-preferred debt will get bailed‑in – or they think it’s less likely to get bailed‑in – whereas a subordinated lower-tier debt is more likely,” he said. “But, in terms of the regulation, they all should be in the mix for being bailed‑in – in theory.”

The Swiss regulator’s decision not to use the resolution regime undermined confidence in this key piece of post-financial crisis regulation, the panellists noted, but it wasn’t necessarily a surprise, said Silitch. 

“Having a regulatory regime with resolution plans is a good idea, and having a playbook is a good start,” he said. However, large systemic banks are likely to find resolution plans harder to adhere to than smaller banks.

“Whenever one of these really large systemic events is taking place, many of the influential people in the room driving the ultimate outcome had nothing to do with the formulation of the original resolution plan [and will have broader priorities than just protecting depositors],” he said. “The chance there’s political input from the Treasury and all sorts of other places is almost 100%, so I wouldn’t say the resolution plans will always get implemented.”

Nolan noted that many banks in Europe are now going through the resolution process – creating single resolution boards, for example – but there are gaps in the process, such as valuation of assets on the balance sheets. 

While the UK’s Prudential Regulation Authority has done a lot of work on this, there is more to be done.