FIG ROUND TABLE/ THE PARTICIPANTS
- Brian Caplen, editor, The Banker
- Anthony Fane, head of European DCM FIG, BNP Paribas
- Jonathan Fine, head of European FIG syndicate, Goldman Sachs
- Nick Hill, director, Western European financial institutions ratings, Standard & Poor’s
- Simon Hills, director, prudential regulation and risk, BBA
- Charles Ilako, global financial services regulatory partner, PricewaterhouseCoopers
- Eden Riche, MD, financial institutions, Royal Bank of Scotland
- David Williams, head of European banks research, Morgan Stanley
Brian Caplen: Probably one of the most contentious issues at the moment is that of consolidation. Is the proposed ABN AMRO and Barclays deal more significant than the other cross-border mergers we have seen?
Nick Hill: Potentially, yes. It is pretty rare for a bank to effectively put itself up for sale in the way ABN seems to have. So I think it could potentially change the dynamic of the market if it goes ahead, and I’m sure other banks will look at ways of following suit and maintaining their own scale relative to the new entity.
Eden Riche: One of the major issues that has to be resolved is the issue of which regulator you use and the idea of the national champion. The Dutch want the headquarters to be in Amsterdam and to be regulated by the Dutch regulator. It will be an interesting test case.
Charles Ilako: The Financial Services Authority (FSA) is likely to be reluctant to let go of Barclays from a lead supervision perspective, and it could prove one of the sticking points.
The Barclays-ABN AMRO deal, should it go through, could trigger an increase in the level of cross-border activity, which hitherto has been limited.
BC: When you say the FSA would be reluctant to let them go, why?
CI: There are some sound regulatory reasons, given the size of Barclays and its relative importance within the UK financial system. The FSA has a stronger regulatory capability than the Dutch Central Bank and would, under any scenario, play a significant role in supervising the merged group.
Simon Hills: I think this throws into the debate the whole issue of home host regulation. Banks are looking for a strong home state regulator to take a holistic view of the consolidated group. They do not want to have multiple regulatory relationships around the world, but neither do they want a monolithic single regulator, say, for Europe.
BC: In terms of Barclays and ABN AMRO then, could the issue of regulation be a deal breaker?
Jonathan Fine: Regulation is important and will become more harmonised in the coming years but I don’t see that as being a deal breaker in this case. Size is becoming ever more critical in the international banking sector because how do banks hope to compete with the likes of Citi, Bank of America or HSBC? It is not going to be through organic growth but rather through acquisition.
David Williams: In terms of size, people will look at Citigroup and clearly see the problems that they are having. But from a management perspective, certainly in Europe, there is a great deal of confidence from the management teams that believe they can go in and acquire another bank and actually deliver a better performance. I suggest that we are going to see a lot more activity. Bolt-on acquisitions are increasingly seen as an attractive route to accelerate growth and are increasingly being tolerated by the markets.
SH: We have had that signal, too, from the European Commission, which has worked hard with industry trade associations and politicians to change article 19 of the capital requirement structure, which looks at cross-border mergers and acquisitions (M&A).
The situation created now is a lot more helpful.
BC: Increasingly, we are seeing private equity firms recruit FIG bankers specifically to look at deals in the financial institutions space. What will be the role of private equity?
CI: Private equity firms have started to re-shape the market place. Take Cheuvreux’s acquisition of BAWAG in Austria. I certainly see private equity firms playing an increasing role in the coming years
JF: Is private equity going to get involved in a sector that is stable, well-thought-out and well managed so it can tweak things around the edges to add a couple of percentage points here and there? Financial sponsors and the private equity market have, however, become very important in certain slices of risks that financial institutions originate. For example, the insurance industry has sought to transform parts of their risk on their balance sheets and private equity has had an important role to play.
CI: Private equity firms will have to convince regulators that they can be fit and proper controllers of banks.
DW: Once a bank is in play, because it has been put in play by private equity, I think you will then find that private equity will help to flush out interest from the established banking groups much more quickly than if they are left to their own devices.
SH: I think that bank-on-bank merger that you are talking about – functioning bank-on-functioning bank merger – is going to be increasingly driven in the future by portfolio management concepts and the opportunity to re-organise. I’d hope that regulators will at some point in the next two or three years – and rating agencies too – allow banks to benefit from those diversification effects that you get by putting two portfolios together. We are still very overbanked in Europe and the systems costs of being Basel II compliant are significant. Further consolidation would suit the single financial market we are looking to create.
CI: There has been a lot of talk over the years about the potential impact that Basel II will have on M&A activity but it has proven to be overestimated. Several other factors including tax usually come into play in a bigger way than regulatory capital.
BC: Acquisitions have been a major impetus for capital raising but what do you think will be the trends in capital issuance in 2007?
Anthony Fane: Issuance is dominated by the need for new capital which is almost entirely acquisition-related. That has been the pattern for the past two or three years, particularly in the hybrid area. The same will happen in 2007.
JF: I think the vast majority of hybrid issuance that you see will be M&A-driven but that growth-driven hybrid financing is being constrained by the regulatory bodies in the various different European jurisdictions that will permit hybrid finance growth. The unknown factor is the pace of innovation.
SH: I sense there is a tremendous amount of liquidity in the market. Will we have to structure new innovative deals to meet investor objectives more tightly in the future than we do now?
ER: Most of the innovation that has taken place recently has been driven by the desire to minimise costs and maximise the rating agency and regulatory benefits from those instruments. I think the innovation curve will remain relatively flat for the time being.
CI: Basel II, particularly in its treatment of securitisations, is actually going to limit considerably the scope for regulatory arbitrage. Basel II is a far more risk sensitive regime than Basel I, imposing more stringent conditions on the originator to such an extent that the potential benefits behind the many types of securitisation transactions are considerably more difficult to realise.
NH: We have seen a lot of innovation over the past few years. The next big thing is the definition of own funds and the review of that could potentially trigger some further innovation.
DW: Banks are generating huge amounts of capital and one of the problems the banks are having right now is actually what to do with all the capital generation they are throwing off. The innovation is going to be coming from making the M&A work for both the buyer and the seller.
JF: The most critical thing – and Basel II is going to have a huge impact here – is optimising capital and how that capital gets allocated in the various different business units, how it gets treated, how it gets released, how it gets raised and so on.
ER:The big question is how much regulators claw back through operational risks and there are other aspects of it. My understanding of the way Basel II will work and the underlying assumption around it was that there was not going to be much of a net release of capital from the system; that was not the desired outcome of the regulators.
SH: I agree. Regulators are focusing senior managements’ attention on their ability to raise capital, not when things are going swimmingly as they are now, but in stress situations; we are moving senior management on to a different level of enquiry about capital raising abilities and capital raising when things are not so good.
That is a laudable objective but I wouldn’t want levels of capital in the banking system now to be based on historic (and perhaps no longer relevant) perceptions of how bad things could get built, for instance, on experiences of the early 1990s.
CI: I would also add that rating agencies will play an important role in (i) ensuring that banks maintain an adequate capital buffer and (ii) limiting the amount of capital banks release.
SH: That is a big concern of banks at the moment. Does the buffer increase between the regulatory capital and the capital required for rating agency purposes, and to what extent does that get released by the rating agencies?
I think that would be an interesting discussion going forward, particularly as we start talking about Pillar 3 and what that tells us about risk management. To what extent will rating agencies move along that path as well?
DW: One of the other aspects is also the securitisation markets and whether Basel II actually drives a lot more securitisation. Banks are discovering that you can use capital markets and securitisation. Mortgage-backed securities are just the start; with small and medium-sized enterprise loans, credit card loans, banks are looking at the whole balance sheet and taking a whole new approach to capital management.
Banks are going to have to go to their shareholders and explain why, if other banks are making incremental returns because of the use of securitisation in capital markets, they are not willing to participate in those markets to improve shareholder returns.
JF: It is a real sea-change from the banking attitude of 10 or 20 years ago. I think that the way the banking system will move is to focus on origination and distribution – the key objectives of the bank, while the asset management function will be syndicated out to the market. The future is really all about recycling risks into the capital markets and recycling capital against different, new originated products. The most profitable and best banks in the world will be those that maximise what can be called the velocity of capital – how quickly they can originate a new product, securitise it, recycle it or transfer the risk of that product out into the market, release the capital and deploy it again in a new field.
CI: One interesting development is going to be the interaction between Basel II and Solvency II, with banks and insurance companies interacting more and more across sectors. The issue is whether Solvency II is going to measure in regulatory capital terms a risk transferring from one sector to another in a manner that is broadly consistent with, or at least comparable to, Basel II. If not, this will open up risk arbitrage opportunities that could undermine financial stability.
DW: The world has moved on and we are now in an age where the best place for risk is in the traded markets, not on a bank’s balance sheet.
NH: We are very positive on the risk-management aspects of Basel II. Its emphasis on risk management and banks’ ability to shift risks around are hugely benefici
BC: I would be interested to hear this idea about the interaction between Basel II and Solvency II. Have the regulators actually sat down together?
CI: Insurance companies tend to be supervised on a standalone basis by their national supervisors with limited consolidated supervision carried out. Solvency II will change this. It will provide better ways to assess risk and the transfer of these across sectors.
It is also notable that both Solvency II and Basel II provide firms with a choice of approaches for determining how much capital they need to set aside. It is also of note that the entry point approach under Solvency II will be more similar to the intermediate method than the basic approach under Basel II – this suggests that compliance is likely to be a very big challenge for a larger proportion of insurers than banks. This may also mean that Solvency II will have a bigger impact on insurance companies than Basel has had on banks.
AF: It is a lot more change in a much shorter period of time. You are going from a long way behind to best of practice, in one jump. You have not had a CAD (capital adequacy directive) or anything as a precursor.
SH: I think it is difficult to argue against this concept of same risk, same capital, whether it is held by a bank or insurance company.
ER: I think that is going to be a very interesting point because they have got to try and align it. Otherwise there is going to be an arbitrage in the system.
CI: One interesting dynamic is the potential impact of the Markets in Financial Instruments Directive (MiFID) on capital. The directive’s central focus is on greater investor protection, more transparency and best execution to such an extent that there will inevitably be a value shift from firm to customer. The question is what can financial institutions do to make up for the ‘loss in value’? Part of the answer will be to better allocate and manage capital.
BC: What about the choice about whether to do securitisation or covered bonds? And would legislation in the UK in this area make a difference?
AF: In a post-Basel II world, we expect securitisation to be less important because it basically releases regulatory capital, not ‘economic capital’ and there is no point doing regulatory capital relief in a world after Basel II. Covered bonds are cheaper – which is why you are seeing all the growth in the covered programmes at the moment.
SH: I’m not sure the covered bond legislation will make much difference. The legislation we are hoping to get in the UK is going to be quite principles-based, which we very much support, and in that it might be helpful for some investors.
NH: Basically, I think that UK banks have found a way to structure deals without legislation so far.
JF: Nationwide was involved in an interesting trade – in that it was a tailored solution for a specific need – for a client who was likely to be able to cancel the need to have that capital outstanding in a relatively short period of time and get tremendous pricing as a result of it. It is clearly an important trade to highlight. One of the most important buzz phrases right now is active credit portfolio management and you can read for that capital management.
BC: When we were talking about capital raising we focused on acquisitions. In emerging markets, banks are doing hybrid deals that clearly have nothing to do with acquisition, but rather with building branch networks. Are we going to see more deals of that type?
ER: I think we are. As markets in South Africa, India and the South American countries become more mature, banks will start accessing the capital markets for their capital business. It will be like the more developed markets 10 years ago, so I don’t think the direct linkage with M&A activity will be there. That will be more about them getting involved in new markets and relying more on capital markets to provide part of their capital funding.
BC: In terms of the capital transfer process, how much do you see hedge funds being involved in that kind of process?
JF: Well, we are seeing insurance companies doing some pretty interesting structural innovations on what they can securitise and pass out to the market; and we are seeing similar things on the part of the banks. Clearly, covered bonds are an efficient method of risk transfer, but for a very limited number and type of assets. The other ways of recycling risks can be some securitisation and some synthetic method of transferring that risk to the market, where quite clearly the most yield-hungry investors or those who are most willing to look at the most complex instruments are going to be increasingly important. So hedge funds, and probably private equity, will have an important role in the recycling of those risks.
BC: Hedge funds appear quite active now even in the lending market, certainly the distressed loan market. Some concerns have been expressed about investment banks building up their distressed debt teams ready for the next time. Are these reports being alarmist?
NH: If we look at the sheer amount of debt that has been issued in Europe over the past few years, statistically, that is likely to lead to a material increase in the default rate and speculative-grade debt over the next five years.
DW: The amount of hiring that is taking place across investment banks currently is quite frankly enormous. I think most investment banks are building up in most areas and the credit portfolio management is an area that people are still massively interested in. Clearly, distressed debt is one area of opportunity.
One can levy a criticism that the global corporates are actually afraid to commit capital to investment because they are targeting the wrong rates of returns.
We live in a very low interest rate world, so one thing that we would expect over the coming years is for the corporate world to start to re-gear, because if they don’t re-gear, they are going to get taken out by a private equity firm.
But I think that the amount of hiring that is taking place – certainly across fixed income divisions – means that hiring in the area of distressed debt is still a relatively small proportion of the total, supporting the view that we are still in mid-cycle.
