Corporate High Yield Debt & BKX (Update) + European Banks

Original post here.

I read this article earlier when I went to update my post on High Yield Debt and the US Banking Sector and found it extremely interesting. We are extremely close to the predicted levels of a bearish market in $JNK. The author Jeff York (@Pivotal_Pivots on Twitter) shows the yearly pivot point in $JNK at just below $37 and from looking at volume and basic chart patterns, I would not be surprised if we do enter a bearish market between $37 and $39. What does this mean? Well, the $BKX is very likely to follow. Why? Well it means a change in EM fundamentals but more importantly, it could mean bank illiquidity. I can foresee a situation in European banking where we see Monte dei Paschi fail (they have negative equity of -2.44%), which then sends shocks through Europe and over to Germany and with Deutsche Bank net bond derivative exposure at greater than their market cap, a bailout would be inevitable.

What really irks me is that with Basel III (the new legislation brought in to keep banks solvent), the goalposts have been moved. The regulatory environment is actually causing major systematic issues to the banking system and corporate financing sector as a whole (explained in the conclusion):

‘The devil is in the details and here is where we find the problems caused to the corporate sector:

The definitions of the Regulatory Capital and the RWA (risk weighted assets) have changed:
- Calculated according to the Basel III definitions, the Core Tier One ratio would have been 5.7% instead of 11.1% according to the old definitions
- The 87 “large banks” who answered the impact study would have been short of €600bn of equity at the end of 2009. New stress tests are disclosed regularly and the shortcomings differ, but they are still there. This means that banks will either/or have to raise more capital or decrease its present lending, which will create a crowding out of capital in the financial markets either way
There are new definitions of core equity leading to that it is reduced with up to 40% for large banks increased the crowding out effects even further. Major changes in the definition:
- Some financial instruments are not any longer eligible as Regulatory Capital
- Intangibles and deferred tax assets shall be deducted from the Regulatory Capital
There are changes in how RWA is calculated in average increasing it with 23%. Major changes include:

- Sharp increase of RWA amounts from trading activities (stress tests on value at risk, securitisations…) leading to many banks decreasing the trading leading to fewer banks quoting prices. This has already led to reduced liquidity and increased costs and risks for corporates in managing its financial exposure from import and export etc
- - This encourages particularly banks to perform their swaps through clearing houses
  - This may weight on complex derivatives businesses
- Loan portfolios require being marked-to-market even though it is not required by accounting standards. This increases pro-cyclicality

Basel III introduces a “Leverage Ratio” such that the amounts of assets and commitments should not represent more than 33 times the Regulatory Capital, regardless of the level of their risk-weighting and of the credit commitments being drawn down or not
The Financial Stability Board recommended in July 2011 that the 29 identified systemically important financial institutions have a Core Tier 1 ratio increased between 1% and 2.5%. Of course these “SIFIs” are the main large corporates’ banking counterparts. This provision has been “enacted” by the G20 in November 2011.
The European Commission has added:
- Minimum solvency ratio shall be 9% for the EU banks (instead of 7%)
- The EU banks shall comply with this level in June 2012 (instead of 2019)

AREA 2: Assets and liabilities management

Banks will have to comply with two new ratios:

Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)

LCR: high-quality highly-liquid assets available must exceed the net cash outflows of the next 30 days:

High-quality highly-liquid assets:
- Level 1 assets: Recognized at 100%: cash, sovereign debt of countries weighted at 0% (which include the PIIGS as they are part of the Eurozone), deposit at central bank. Level 1 assets shall account for at least 60% of the “high-quality highly liquid assets”
- Level 2A assets: Recognized at 85% and must not represent more than 40% of the assets: sovereign debt weighted at 20% (countries rated below AA-), corporate bonds and covered bonds rated at least AA-
- Level 2B assets (introduced Jan, 2013): non-financial corporate bonds rated between BBB- and A+, with a hair cut of 50%; certain unembumbered equities, with a hair cut of 50%; and certain residential mortgage-backed securities (RMBS), with a hair cut of 25%.
- The Level 2B assets will not be eligible for more than 15% of the “high-quality highly liquid assets” and a total level 2 assets will not be eligible for more than 40% of the “high-quality highly liquid assets”

Changes from January 2013 provide:
- To some extent, lesser cost of carry for banks on “high-quality highly-liquid assets” but still limited because of the 50% hair cut and 15% limitation
- Improvement for the financing of investment graded companies (BBB and above) by banks through bonds, which will remain in competition with residential mortgage-backed securities (RBMS) with lesser hair cut and whose markets is restored with these new provisions
- Level 1 assets remain at least 60% of the “high-quality highly-liquid assets”, which means that concentration risks and cost of carry remain.

Net cash outflows = cash outflows – cash inflows
Cash outflows:
100% of any repayment in the next 30 days
- 3% (on Jan 6, 2013 decreased from 5%) of retail banking deposits
- 40% (on Jan 6, 2013 decreased from 75%) of deposits from non-financial corporates and public sector entities
- 100% of deposits from other financial institutions
- Between 0% and 15% of secured funding backed with “high quality highly-liquid” assets
- 10% of credit lines to corporates, sovereign and public sector
- 30% (on Jan 6, 2013 decreased from 100%) of liquidity lines (back-up, swing lines) to corporates, sovereign and public sector
- 100% of credit lines to other regulated financial institutions
- 0% of secured funding from central banks maturing within 30 days (prior to Jan 6, 2013 the figure was 25%)
Cash inflows:
- 50% of loan repayments by non-financial counterparties (it is considered that banks, even in difficult times, will have no choice than to renew at least 50% of the maturing loans)
- 100% of loan repayments by financial institutions
- 100% of bonds’ repayments (whoever the issuers)
Changes from Jan 2013 provide:
- The new computation of net cash outflows will free hundreds of billion euros of “high-quality highly-liquid assets” requirements
- Theoretically the changes from Jan 2013 are particularly good news for banks with large corporate activities

The LCR shall be fulfilled at any time, absent a period of stress. The purpose of this ratio is to offer a mattress of liquidity under such periods. The Basel Committee expressly mentions that, during a period of financial stress banks may use their “high-quality highly-liquid assets” as a mattress, thereby allowing it to fall under 100%. Initially the Committee planned the LCR should be in force from Jan 1, 2015 but the schedule has changed: The ration should be at least 60% on Jan 1, 2015, 70% on Jan 1, 2016, and exceed 100% from Jan 1, 2019. As of December 31 2010 more than 95% of the banks already had a LCR exceeding 65% and most banks with major activities in corporate banking was ranging between 60% to 80%.

NSFR: long-term financial resources must exceed long-term commitments (long term = and more than 1 year):

Stable funding:
- equity and any liability maturing after one year
- 90% of retail deposits
- 50% of deposits from non-financial corporates and public entities
Long-term uses:
- 5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach risk-weighting (see comment above for LCR) with a residual maturity above 1 year
- 20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity above 1 year
- 50% of non-financial corporate or covered bonds at least rated between A- and A+ with a residual maturity above 1 year
- 50% of loans to non-financial corporates or public sector
- 65% of residential mortgage with a residual maturity above 1 year
- 5% of undrawn credit and liquidity facilities

Essentially this means several things for the banks & corporates:

Hedging is penalised decreasing the liquidity in the markets leading to increase in costs to hedge the operational financial risks of corporations. This is further emphasised by the penalisation of the interbank markets through requirement of more capital, and additional constraints on liquidity on interbank transactions.

Corporate credit by banks is

More capital required in general
Back-up facilities for commercial paper programs require that banks will have to have 100% of liquid assets in front of 100% of undrawn facility. The cost of carry will obviously be invoiced to the client and the ability of the bank to borrow long term will determine the availability of back-up facilities
Restrictions in maturity mismatch (including for repayments) are introduced. This may mean that the risk of borrowing short term to finance long term investments will be transferred to the corporate sector.

Other businesses areas threatened:

Trade finance (introduction of the leverage ratio)
Consumer finance (leverage ratio)
Project finance (NSFR)
Public sector finance, except governments (leverage ratio + NSFR)

Overall, the main revolution for banks is in the liquidity ratios (LCR and NSFR), whose definitions are very severe for the corporate sector. For example, the average French banks’ LCR would have been around 58% at the end of 2009 if calculated to the Basel III definitions. Also consider:

Access to central bank liquidity is not considered by Basel III ratios
French banks used to push life insurance products vs deposits – life insurance, even invested into certificates of deposits, gives no credit at all to liquidity ratios

Overall, Basel III aims to sharply deleverage the economy threatening economic growth at the same time as the debt crisis puts a pressure on governments to spend less. There is also some level of naivety in the provisions of the definition of “high-quality highly liquid” assets, which banks shall hold abundantly in their balance sheets to face their short term liquidity commitments. In fact the banks are pushed to hold huge amounts of sovereign debt…

The need to deleverage the economy is obvious however the way Basel III is designed has led to that the corporate sector to a large extent must rely solely on funding and hedging from outside of the banking sector. The basic role of the banks to redistribute financial risk and fund trade has in fact seized up.’

Basel III will eventually lead to a liquidity crisis and with there being several banks with a huge amount of bond derivative exposure it will lead to issues for BKX. However, the fact that many corporates have had to now go and find funding external to banks has created a liquidity problem in the high yield market too. If you don’t have many buyers and a lot of sellers, I think we will know what will happen to price pretty quickly if we do see further issues in the high yield market arise.