Loan-to-Bond Shift in the Wake of EU Banking System Redefinition

Written by | Tuesday, September 17th, 2013

European companies are about to borrow less than 500bn euro from loan markets, as the shrinking amount of funding from EU banks makes firms shift towards public bonds. The current amount accounts for a 60-percent drop when compared to last year, and it is the smallest ever proportion of funding from syndicated loan markets. Amidst the struggle of European banks to come up with a single definition of a ‘bad loan’ – as newly required by the EU legislation – businesses are forced to seek other sources of funding.

Given the slumbering situation concerning loans and the banking system itself, Europe is increasingly turning to public bond markets – a prototype of a U.S.-like corporate funding model. In the U.S., companies draw about two-thirds of their funding from public bonds, whereas EU companies have until recently relied on bonds only in one-third. Yet, a loan-to-bond trend is slowly emerging due to the very low interest rates as well as a significant drop in turnover in the EU lending market.

The new situation is being redefined by the new Basel agreement as well. Basel III, signed in 2010-2011 and scheduled to be introduced between 2013 and 2015, was developed precisely to fight the inefficiencies of financial sector revealed by the 2008 crisis. In general, the agreement is meant to strengthen capital requirements by introducing ‘additional capital buffers’ (2.5 percent mandatory buffer plus additional 2.5 percent in times of high credit growth), thus forcing banks to hold more capital against loans in effect leading to less lending and higher rates.

Hence, EU banks have likely found themselves between two walls. From one side, new Basel regulations seek to sharpen capital requirements and leverage ratio, and from the other side, nascent EU regulations, that are loosely coined ‘stress-tests’, struggle to redefine risk and transparency. In the meantime, moreover, the European Central Bank (ECB) is believed to shortly begin the work on an asset quality review of major banks in 17 EU countries.

In addition to the ECB review, national supervisors in respective EU countries are going to conduct a similar survey for the countries outside the eurozone. Both reviews virtually focus mostly on problematic types of loans, which is likely to curb funding even more. The chief objective of the entire endeavor is to harmonize the way European banks define risk and come up with a uniform definition of a ‘bad loan’. For banks, however, the asset review is just the beginning. According to EU officials, ‘stress-tests’ are more forward-looking and are meant to cover more areas in the future, such as the riskiness of the overall bank portfolios, coverage ratios or coping with credit crunch or volatility in economic growth rates.

The shift from loans to bonds in response to tighter bank regulations and loan provision among European companies is further reinforced by lowering borrowing costs on corporate bonds. Compared to last year’s 2.8 percent according to the European investment grade, this summer the costs averaged at around 1.8 points although they rose again in recent weeks. As a result, total funding from bank loans was only 238bn euro in the first half of this year, suggesting a this-year total below €500bn for the first time in ten years, based on the figures of the rating agency ‘Fitch’.

On top of the falling proportion of corporate funding by private banks, the void in financing is newly being filled by fund managers and numerous insurers. Groups such as M&G, Legal & General or BlueBay have begun to increasingly step in by offering direct loans to companies. Schroders, BlackRock and Allianz are also offering a number of infrastructure and property loans as well, while Axa, the insurance company, announced a €10bn new direct lending initiative in June.

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