Banks' funding needs

G20 calls for better capital buffers at banks
Move follows criticism that some banks have relied too heavily on complex securities that have proved poor defences against big losses

Tony Deutsch called our attention to this excellent piece from the Economist, saying “This is roughly the story I was trying to get through at Wednesday Night. What concerns me is whether the basic idea in this article was what people took home with them.”

Total liabilities – Getting banks to improve their funding profiles will not be easy

It is difficult to establish any archetype for failure from the past two years. Banks with high capital ratios, such as Lehman Brothers and Iceland’s lenders, imploded, while those with lower ratios survived. Plain-vanilla retail banks blew up while some black-box trading shops prospered. Both small and big firms collapsed. Spotting a doomed bank, it seems, may only be possible once it is going to hell.
Yet there was a common ingredient in most failures: an over-reliance on wholesale borrowing. As the Western banking system has expanded over the past two decades its assets have grown to about 2.5 times its deposits, forcing firms to seek other types of finance. Bear Stearns and Northern Rock, largely reliant on short-term borrowing, faced the modern version of a “run” when their counterparties refused to roll over debts. Most other banks suffered some loss of confidence, forcing them to turn to funding from the state.
Unsurprisingly, regulators think that forcing banks to find more secure funding, along with more capital, will make the system safer. The Basel club of bank supervisors is considering new liquidity rules, as are many national regulators. New Zealand has already drawn up concrete rules (see article). It is not clear how far this can go. There can be no return to an idealised past where only a dollar deposited in a bank would be loaned out. To force banks to rely only on deposits would require a big shrinkage of their balance-sheets, with devastating economic implications. Besides, not all deposits are sticky. The Bank of England reckons that $100 billion of Russian deposits were shipped out of Britain in the last quarter of 2008.
Far from improving, the funding profile of the Western banking system has been getting even sicker this year. Banks have been raising equity and long-term debt and gathering deposits, but in the grand scheme of things their efforts have made little difference. For America’s top eight commercial banks such higher-quality forms of funding have risen only slightly, from 78% to 80% of the total in the past six months. America’s two surviving investment banks, Goldman Sachs and Morgan Stanley, still depend on shorter-term borrowing, usually secured with collateral (see chart). This is fairly reliable but, as Bear Stearns showed, in a market meltdown it can dry up without central-bank support. In Britain, Lloyds Banking Group, a leading wholesale-funds junkie, still has half of its total funding maturing in under a year.
If the duration of funding has not changed much, its source has. In America, the euro zone and Britain, central-bank lending and public guarantees of bank bonds have reached about $2.7 trillion. That equates to about 9% of banks’ wholesale funding, using IMF estimates. Support is concentrated on the banks with the worst funding profiles. So Dexia in Belgium has €82 billion ($117 billion) of state funding, and Lloyds could have up to £100 billion ($162 billion).
The original idea was that state support could be withdrawn swiftly as the panic subsided. America’s main debt-guarantee scheme will close to new issuance next month (with those guarantees already issued expiring in 2012). Europe’s schemes are typically due to close by the end of the year, with guarantees expiring between 2012-14. The hope is that banks will not only be able to refinance debt on their own but also extend its maturity, cutting their dependence on fickle short-term funding.
Funding strains have eased. So far this year, Western banks have issued $645 billion of bonds without government guarantees, according to Dealogic, a research firm. But the idea that the banking system can improve its funding profile at the same time as it weans itself off explicit state guarantees looks wildly unrealistic. This partly reflects the sheer volumes of debt involved. As well as turning over existing short-term borrowings of some $18 trillion, Western banks have to refinance longer-term debts that are maturing at the rate of about $1.5 trillion a year. With securitisation markets damaged and confidence in banks battered, that will not be easy.
It is also unclear that the most needy banks can borrow freely yet. Lloyds issued an unguaranteed and unsecured ten-year bond on September 3rd at 193 basis points above government yields, about double what the safest British bank, HSBC, might pay. Not only is this rate “uneconomic”, according to one banker, but Lloyds only raised €1.5 billion, a drop in the ocean. In July Dexia sold a similar five-year bond at 160 basis points above government yields, but the issue size, at €1 billion, is also tiny relative to its needs.
Muddling through is the likely outcome for most banks. State support may be extended for longer. Banks with too few deposits will gradually shrink and be unable to participate in juicy new lending opportunities. Unable to transform funding structures, regulators may focus instead on making assets more liquid. European supervisors want banks to have enough cash to survive a month-long freeze of wholesale markets.
Such “war gaming” has a patchy record. Bear Stearns had about $18 billion of liquid funds prior to its collapse, compared with a funding need of $60 billion-100 billion. Still, the size of the buffers being built up is staggering. Goldman Sachs now has liquid funds of $171 billion, equivalent to one-fifth of its assets. Banks in the future will probably have loads more capital and cash, but will still ultimately rely on the state to backstop their funding.