European Companies Move away from Bank Loans to Corporate Bonds: Implications for Investors
In contrast to shrinking bank lending to corporates, European corporate bond issuance has surged since 2009 — reaching US$75 billion so far in 2012, up 83 percent over the same period in 2011. Similarly, a 5 March Financial Times article by Chris Newlands, ‘Lending a hand as banks pull back’, describes the growing trend of money managers such as AXA entering into private-lending arrangements directly with companies.
This noted shift by corporates from bank to other forms of borrowing, including debt capital markets, has occurred against the backdrop of the funding crunch faced by both European banks and governments. It would seem justified for European corporates to diversify their funding given that they have traditionally relied on banks for financing. Nevertheless, this emerging situation begs for a closer examination by investors of the drivers of the trend away from bank lending. Investors should also be alert to the degree and implications of risk shifting away from banks and towards investment portfolios.
Impact of Regulatory Capital
In some quarters, there is a view that the anticipation of Basel 3 regulatory capital rules and rising capital adequacy thresholds might be motivating reduced bank lending. There is an implied expectation that increased equity held by banks due to Basel 3 could lead to increased average funding costs. Greater funding costs could in turn translate to increased cost of lending and, thereafter, to reduced lending depending on the price elasticity of loan products offered. These anticipated consequences are premised on the expectation of equity capital being costlier than debt. Debt is relatively cheap due to interest paid reducing taxes and also due to the implied state guarantee towards banks. The implied state guarantee effectively minimizes bankruptcy costs and makes overall high leverage less costly than it should be.
That said, it is probably overstating the case to primarily attribute shrinking bank lending to the Basel 3 requirements. The inappropriateness of simply attributing shrinking lending patterns to regulatory capital rules is backed by recent IMF evidence. A research paper, ‘Bank Behaviour in Response to Basel III: A Cross Country Analysis’, analyses the impact of new capital requirements introduced under the Basel 3 framework on bank lending rates and loan growth. The paper shows that Basel 3 is likely to result in large banks increasing their lending rates by 16 basis points and cause loan growth to decline by only 1.3 percent in the long run. Similarly, a recent Fitch ratings survey of senior fixed-income investors showed that only 28 percent of respondents considered ‘anticipation of Basel 3/regulatory overhaul’ a high risk to European credit markets over the next 12 months. In contrast, 91 percent of the Fitch survey respondents considered sovereign debt problems as highly risky for credit markets. Also, 67 percent considered a double-dip recession as a high risk factor.
Economic Risk and Refinancing Difficulties: a Better Explanation for Reduced Bank Lending
Rather than capital-related concerns, a more likely explanation for shrinking bank lending to European corporates is the anemic economic environment within Europe, plus the numerous difficulties banks face in their intermediation role. We can attribute the European bank lending aversion to the trend of de-leveraging and shrinking of bank balance sheets, where banks have reduced their overall risk profile in the aftermath of the 2007-2009 subprime mortgage-triggered credit crisis. These de-leveraging patterns have been exacerbated by funding constraints faced by European banks. For example, a December 2011 Fitch Ratings study shows the difficulties that banks have had tapping into money markets for short-term financing needs. Indeed, the study reports a significant shrinkage (i.e., 45 percent) of the U.S. money-market fund exposure to European banks since May 2011.
The above-mentioned refinancing difficulties have translated into lending aversion. The bank lending aversion manifests through both the reduced amounts and the shortened maturity of loans issued by banks to corporates. Consequently, the combination of shorter loan maturities and a reticence towards lending makes bank debt less appealing for corporate borrowers. From 2009 onwards, we’ve seen a paradigm shift and dawning realization by European corporate treasurers of the attractiveness of capital market debt. This has led to greater receptivity towards this less constrained form of borrowing, and a push for diversification of funding away from bank debt by corporates.
ECB Liquidity Intervention and Increased Investor Appetite for Corporate Bonds
To further understand why there is resurgence in corporate bonds issuance, one has to also focus on the demand side, with an emphasis on the factors underpinning the increased investor appetite for corporate bond paper. The increased investor appetite is evident from the migration of capital from money market funds towards bond markets. The Fitch survey of fixed-income investors also showed that 58 percent of respondents expect asset manager inflows into corporate credit funds during 2012, in search of higher investment returns. The appeal of corporate bonds reflects the current tendency by investors to view corporate bonds as safe havens relative to sovereign issues.
Another key immediate-term explanation for the increased investor appetite for bonds is the recent European Central Bank’s liquidity interventions via the Long Term Refinancing Operations (LTRO) funding injections made in December 2011 and in February 2012. The ECB intervention has had a positive impact on the ongoing European bank-sovereign nexus where there is an inextricable link between bank risk and sovereign risk. The ECB actions have buoyed investor sentiment and effectively increased the risk appetite across all asset classes, including debt.
However, one possible countervailing factor to the pattern of increasing corporate bonds is the potential for reduced issuance by banks themselves. This could happen if banks substitute corporate bond issuance with cheap funding from the ECB. The cheap funding may encourage banks to engage in carry trades where they borrow at 1 percent and invest in higher yielding assets. In a European context, any shift away from corporate bond issuance by banks would significantly impact on overall issuance volumes. Financial firms accounted for 68 percent of 2011 issuance. Nevertheless, an important counterpoint to make is that banks would have to, in their selection of funding choices, be wary of simply deferring the funding crunch. They would be rather unwise to neglect the current needs of money managers, pension funds, and insurance companies who have an appetite for banking bonds and are regular financiers for these banks. Ditching the money managers now may come back to bite the banks in three years’ time. Prudent risk management should mean that banks not rely solely on LTRO for their funding.
Shifting Risk: Implications for Investors
Notwithstanding both the rising demand and supply for corporate bonds and other forms of non-bank lending, a more fundamental question is whether this shift away by corporates from seeking bank financing may have an unforeseen impact on systemic risk. The potential unintended consequences were highlighted in Newlands’ Financial Times article, observing that money managers may be foraying into the lending space without necessarily having the equivalent risk management capacity of banks. Effectively, investors may have more investment choices, but possibly at a higher risk.
The liquidity risk of corporate bonds is another risk that investors may have to contend with in the future due to ongoing structural reforms within the banking sector. There is a distinct possibility of a reduced number of over-the-counter (OTC) liquidity providers due to banks downsizing their proprietary trading platforms. This potential shrinkage of liquidity providers could occur due to a raft of structural reforms under consideration that are aimed at either ring-fencing or minimizing proprietary trading activities within universal banks.
Overall, the trend of greater reliance on debt capital markets by corporates also calls for a critical examination of the adequacy of investor protection within European bond markets. Compared to capital market participants, banks typically enjoy information and contract negotiation advantages, and this allows them to better monitor and enforce the financial obligations of their borrowers. Thus, bond market investor protection measures, which include enhanced disclosure requirements and consistent cross-country bankruptcy protection laws, need to be commensurate with the extent to which debt capital market finance is growing.
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