The Interim Report of the UK Independent Commission on Banking proposes a number of potentially material changes to the structure of the UK banking system. We review the proposals and discuss the implications, both positive and negative, for investors in UK bank bonds.

 

During the 2007/2008 financial crisis, the United Kingdom (UK) government was forced to take material ownership stakes in the Royal Bank of Scotland (approximately 80%) and Lloyds (approximately 40%), nationalize Northern Rock (following a bank run), facilitate the sales of Halifax – Bank of Scotland (HBOS), Alliance & Leicester and Bradford & Bingley, and establish both liquidity and credit back-stop programs for the broader banking sector.

Coming out of the crisis, the government established the UK Independent Commission on Banking (ICB) to explore structural reforms to the UK financial services sector that would prevent future downturns from endangering the financial stability of the UK and assure that future crises do not result in taxpayer funded bailouts to the financial sector. The ICB was officially launched in June 2010 and was tasked with providing recommendations to the UK government in an Interim Report in March 2011 and a Final Report by September 2011.

The Interim Report released in March 2011 described a number of possible structural changes that the Commission was contemplating including:

  • Additional Capital Buffers – The report discussed a 10% equity Tier 1 requirement for Systemically Important Financial Institutions (SIFIs) as well as an additional buffer of 3% to be met through the issuance of contingent capital (CoCos). This closely mirrors the subsequent recommendation of a 2.5% SIFI buffer by the Basel Committee and is therefore likely to be adopted.
  • Resolution Regime – In line with many other jurisdictions (US, Germany, Denmark), the clamor for “no more taxpayer funded bailouts” is the key driver. The likely upshot is legislation that explicitly prohibits government support for financial institutions and requires a “living will” that would provide for an orderly wind-down of the institution should it become distressed/insolvent.
  • Secured Bail-in – The idea of converting debt into equity or simply writing it down at the point of non-viability in order to prevent an institution’s collapse has been proposed. However, the practical implications of such a proposal, as well as details, are to be determined (i.e., triggers, mechanism, bankruptcy regime, seniority, grandfathering of existing debt instruments).
  • Ringfencing of Retail Business – The concept of “Ringfencing” denotes creation of a legally and operationally remote entity within a broader corporate structure in order to protect said entity. Driven by the view that maintaining the safety of retail and non-financial depositors is a key goal of reform, the ICB has tacitly endorsed some form of ringfencing  the retail banking operations of UK universal banks. However, the specific details of such a transformation are to be determined. This stands in contrast to an explicit separation of retail and wholesale businesses that had been entertained.
  • Reduced Industry Concentration – The Interim Report highlighted “too big to fail” risk that corresponds to a highly concentrated banking sector and commented on the desirability of a less concentrated domestic banking sector with additional strong competitors (We note most other national regulators have failed to address this issue, such a contemplation was notably absent from the Dodd-Frank process in the US). This applies primarily to Lloyds (with a 30% deposit share) and RBS to a lesser extent.

Subsequent to the release of the Interim report, UK Chancellor of the Exchequer George Osborne gave a major policy speech on June 15, 2011 strongly endorsing the (Interim) findings of the ICB and promising to take up the recommendations, particularly with regard to increased capital buffers and ring-fencing. During his speech, he was at pains to emphasize the “British dilemma” whereby the financial sector constitutes an important and outsized component of the UK economy, but at the same time puts it at risk, given the size of UK banks relative to the economy (roughly 4.0x GDP).

Implications of UK Bank Reforms for Credit Investors

It is currently difficult to opine on the credit implications of banking sector reform in the UK, given that the Final Report (with detailed recommendations) is not due until September 2011, and timing of adoption and implementation by the UK government is uncertain (the Chancellor’s comments notwithstanding). However, it makes sense to address the potential benefits and drawbacks of the proposed regulatory changes.

Positive Implications

The focus on Capital Buffers well above and beyond the 7% minimum common equity Tier 1 ratios mandated by Basel III is an unequivocal positive. Additional capital, especially if it comes in the form of common equity, serves both as a direct layer of protection for fixed income investors, and as a deterrent to marginal activities that require high amounts of leverage (many of which got the UK banks into hot water in the first place). In light of the Basel Committee on Banking Supervision (BCBS) recommendation on capital buffers up to 2.5% above the 7% minimum that was recommended subsequent to the release of the Interim Report, we view the likelihood of implementation as highly likely.

Negative Implications

While the practical approach to Ringfencing are not yet detailed by the ICB, we view this as a potentially negative development, as the truly “universal” nature of UK banks has always been a source of credit strength for bondholders. The fact that bonds and deposits were pari passu (i.e., having equal rights of payment), and that both represented obligations of the “Bank PLC” entity served as a source of stability and funding strength for creditors. Further, the direct link between the bonds and the deposit taking entity raised the systemic importance of the issuers, and hence, the likelihood of support. However, the practical implication of the government being obligated to support the bondholders as a consequence of supporting the depository institution resonates both with the government and the broader (taxpaying) public. The Interim Report contemplated a separate subsidiary containing the retail banking businesses (which are not clearly defined; assumed to mean the deposit taking businesses at a minimum) with higher capital requirements and restrictions on the ability to upstream capital to the consolidated entity. Presumably such ringfencing would reduce external risks to the retail banking business and also make it easier for regulators to support just this portion of the bank while allowing other parts to fail “in an orderly manner” (see discussion on Resolution Regimes below). From a creditor’s perspective, the trapping of capital and stable liquidity within a subsidiary would represent an explicit structural subordination of senior unsecured bonds that would presumably remain at the “holding company” level. While the issue of depositor funding of non-consumer activities (i.e., Barclays Capital) were not discussed, we presume such application of deposits would run counter to the spirit of ringfencing. While such an arrangement is already de facto for most US bank bonds (the majority of which are issued out of the holding company and are explicitly subordinate to bank-level depositors), this would represent a negative development for existing UK bank bonds. Conversely, however, the ICB expressly ruled out the possibility of explicitly breaking up the universal banks into separate wholesale and retail banking entities. From a rating perspective, we would expect an explicit differentiation between bonds issued by an entity within the ringfence and those issued outside of that entity (although the magnitude of notching is uncertain).

Uncertain Implications

The concept of Resolution Regimes has been widely touted by regulators and politicians the world over as a way to end moral hazard associated with an implicit government guarantee of individual banks. Generically, a resolution regime would mandate that universal banks provide a “living will” to regulators that would provide for orderly wind-down of non-essential operations and transfer of deposit taking subsidiaries to other banks, thus absolving the government of needing to support the entire entity (as was the case in 2008). By legislatively prohibiting extraordinary assistance to banks, the theory holds that banks will no longer be incented to “swing for the fences” on risk-taking decisions and that a truer cost of capital would emerge as the presumption of government support fell away, and banks would be forced to become both more transparent and more conservative. In practice, however, it is difficult to see a removal of government support so long as the “too big to fail” issue remains unresolved. Theoretically, the concept of ringfencing could insulate those portions of troubled banks that are deemed critically important to the health of the broader UK financial system (the ICB has highlighted the deposit/retail business).

However, in institutions the size and complexity of the UK’s universal banks (HSBC Holdings PLC (HSBC), Barclays PLC (BACR), Royal Bank of Scotland Group PLC (RBS), Lloyds Banking Group PLC (LLOYD)), it is difficult to see: a) how such a complex institution could be wound down in an “orderly” manner and b) how the failure/wind-down of such an institution’s wholesale businesses would not have a disproportionately negative impact on the broader financial system (Lehman Brothers, after all, had almost no retail/depository business). As a result, it is not necessarily credible that the UK government would not provide support for a troubled universal bank, although the imposition of a resolution regime would likely restrict the government’s options for the same, and predicting the form and direction of such support is very difficult. The push for resolution regimes (even in a more regulated/presumably less risky financial sector) would not necessarily be an outright negative development for creditors, but would make bank bond investors more risk averse going forward. From a ratings perspective, the lower likelihood of government support would likely remove at least a portion of the ratings uplift that currently benefit the universal banks (although, all of the agencies have mentioned the still high likelihood of some form of support given the systemic importance of these institutions). Finally, from a spread perspective, bank bonds are unlikely to return to their historic trading levels inside the trading levels of comparably rated non-financial corporates. However, bank bonds should eventually trade at comparable levels to similarly rated non-financials as the uncertainty surrounding financial reform and credit recovery recedes.

Senior Unsecured Bail-in falls somewhere between the concepts of Resolutions Regime and Capital Buffers. Conceptually, the ability to either write-down or convert into equity a portion of senior unsecured bonds of a troubled bank would serve both to re-capitalize a troubled institution and would also satisfy the Resolution Regime purpose of avoiding a “taxpayer bail-out” of the bondholders similar to what occurred with RBS and Lloyds in 2008. Still to be determined are whether such a bail-in concept would apply retroactively to outstanding senior unsecured debt, whether all senior unsecured bonds going forward would have a bail-in feature, what the trigger for a bail-in would be, and whether such bonds would be appropriate (or even investable) for insurance accounts.

Reduced Industry Concentration at least begins to contemplate the “too big to fail” issue within the UK’s highly concentrated banking sector. Particularly with the failure/exit of numerous smaller institutions, the Interim Report was focused on the desirability of increased competition by well capitalized competitors. To that end, they recommend the sale of approximately 600 branches and associated deposits by the Lloyds Banking Group to reduce that institution’s 30% deposit market share. The growth of such second tier competitors as Santander UK and National Australia Bank, both of which had entered the UK bank market with previous acquisitions, and the possible entry of Virgin Money were explicitly encouraged. While the branch sale by Lloyds (as well as the commercial banking business sale by RBS to Santander UK) should both be credit neutral to those specific institutions, it is hard to see any of these actions materially reducing the concentration risk within the sector. As a practical matter, bank sectors within all of the G-7 markets have been consolidating for thirty years, and neither regulators nor politicians appear willing to reverse this trend. Even in countries where further consolidation is explicitly prohibited (Australia/Canada), the failure of any of the countries’ major banks would threaten the broader financial system. Furthermore, in the absence of a global consensus (which appears unlikely), no individual country is likely to break-up its largest banks, and thus put its domestic banks at a disadvantage to other countries. As a result, a move toward a higher level of regulation and higher capital levels appears the most likely path. To the extent that this results in a more utility-like banking sector, such an outcome should be positive for bondholders.

Final Credit Thoughts and Broader Implications

The process of the ICB in the UK mirrors a global attempt to better regulate and de-risk the financial sector (Dodd-Frank in the US, Bank Restructuring Act in Germany, Basel III). All of these efforts include elements of increased capital, reduced complexity and removal of moral hazard (taxpayer liability) through implicit/extraordinary support. To the extent that these varied efforts result in a better capitalized and simpler banking system, we would view the outcome as fundamentally positive for creditors. However, the failure to directly address “too big to fail” (even if higher capital requirements encourage reduced size) leaves considerable interdependence between the credit of the systemically important banks in each jurisdiction and the credit of the overall sovereign. As creditors, however, we would welcome a shift to a more utility-like banking sector with more capital and lower risk, even if it came at the cost of somewhat reduced profitability.

N. Sebastian Bacchus, CFA
Vice President, Corporate Credit

For more information, contact:

Joel B. Cramer, CFA
Director of Sales and Marketing
joel.cramer@aamcompany.com

Greg Curran, CFA
Vice President, Business Development
greg.curran@aamcompany.com

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Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.