SOME signs are subtle. Foreign lenders operating in America are tightening loan standards more sharply than domestic rivals; Hong Kong property developers are scrambling to issue bonds for want of other funding. But others—the “for sale” signs hung on the overseas assets of many European lenders—are pretty blatant. The ability and willingness of banks to compete across borders is unravelling.
The years before the financial crisis saw rapid growth in the cross-border activities of banks. According to the Bank for International Settlements, the average year-on-year growth rate for cross-border bank credit to non-banks during the 2000-07 period was a sizzling 15.2%, compared with 6.7% for total bank credit. Since then cross-border credit has fizzled (see chart 1) and looks likely to fall further.
European lenders were in the vanguard during the era of internationalisation, and around a third of their assets are outside their home markets. They are now under pressure to slim down their balance-sheets quickly, partly to shore up capital and partly because of funding strains. The IMF this week projected that banks in the European Union would undergo a $2.6 trillion deleveraging over the next two years. Much of that will be achieved by running for home.
In March the Reserve Bank of Australia revealed that the departure of European lenders, in particular French banks, had left an A$34 billion ($35 billion) funding gap in the syndicated-loan market for local companies. The story is similar in the Middle East, where a rush this year to issue Islamic bonds, or sukuk, is attributed to a withdrawal of European lenders. Within Europe, too, national boundaries are being reinforced as lenders cut back their exposures to weaker markets (see chart 2). Non-European banks are also trimming their foreign portfolios as they rationalise their businesses: Citigroup agreed to sell its Belgian retail arm in December; HSBC is offloading businesses from Costa Rica to Pakistan.
Some of this is cyclical. After the first contraction of international activity in 2008-09, a rebound occurred, and something similar might be seen in response to the provision late last year of three-year liquidity by the European Central Bank (ECB), which has temporarily eased the strains on euro-area banks. But there is good reason to believe the retrenchment represents a structural change.
Retrenchment need not be disastrous. Much pre-crisis cross-border lending was foolish, after all; think of all the German money in subprime American mortgages. And foreign banks are not the only suppliers of cross-border capital: the importance of foreign direct investment and portfolio flows as a proportion of gross inflows has steadily risen over the past three decades.
But banks matter. There is evidence that cross-border banking relationships between pairs of countries encourage other types of capital flow; reduce them, and the other flows may dry up too. And the availability of bank financing is vital to smaller businesses or long-term asset-based activities such as infrastructure projects. “The alternatives to cross-border banking are autarkic financial systems, which means relying on domestic capital formation and thus higher costs, or international flows via bond markets, which are more volatile,” says Peter Sands, the boss of Standard Chartered, an emerging-markets bank.
Home is where the taxpayer is
Three powerful centripetal forces are at play: politics, regulation and deleveraging. Take politics first. The financial crisis, and the sovereign-debt crisis that followed it, have left no one in any doubt about the relationship between banks and the state. If big lenders get into trouble, taxpayers end up bailing them out.
Now it is payback time. Banks have come under pressure from their governments to prioritise the customers that rescued them. “Project Merlin” set Britain’s biggest banks targets for their lending to small and medium-sized enterprises; Commerzbank, a bailed-out German bank, is committed to concentrating its lending on Germany and Poland. In December Crédit Agricole, a French bank, outlined plans that included the closure of corporate- and investment-banking operations in 21 countries. “Crédit Agricole is mobilised on a day-to-day basis to support the plans of the French people,” ran the press release.
In the case of banks in the euro zone’s peripheral nations, the politics of patriotism also mean propping up the debt of their governments. Italian and Spanish banks have used the ECB’s three-year loans to boost their holdings of domestic government bonds. Spanish lenders increased their holdings by 26% in the two months to January; Italian banks upped theirs by 31% in the three months to February. This reflects, in part, a calculation that few banks can survive without a sovereign that looks solvent.
Regulations are also steering banks (and insurers) into holding domestic government debt. Rules on capital and liquidity label government debt as safe and render domestic government debt peculiarly so. The overall effect is to make balance-sheets look a lot more patriotic. Huw van Steenis of Morgan Stanley reckons that euro-zone banks have an average of 6% of their assets invested in domestic sovereign debt, and that their holdings are growing by the day.
Many other rules that are designed to make finance safer also risk making it more parochial. A big lesson of the crisis is that banks which are global in life are national in death. The bankruptcies of Lehman Brothers and MF Global showed regulators how assets could easily get trapped in foreign jurisdictions, leaving a bigger bill for taxpayers back home. There are signs that, in response, regulators are treating foreign assets more harshly than domestic ones. Bankers say that stress tests carried out on American lenders by the Federal Reserve in March put their foreign loans under greater pressure than American ones. Recent guidance from Britain’s Financial Services Authority on lending in areas like commercial property jacked up risk charges on exposures where there is a lack of historical data; Bob Penn of Allen & Overy, a law firm, argues that this has the effect of privileging lending in home markets. With capital scarce, such tinkering matters.
As national regulators seek to stamp their authority on international finance, conflicts and inefficiencies arise in all sorts of areas. Britain has filed lawsuits against the ECB for its proposal to prohibit clearing-houses outside the euro area from being able to handle more than 5% of trading in euro-denominated instruments. Differences between proposed American and European rules on derivatives may mean that banks build separate infrastructures on either side of the Atlantic. Things that matter could fall into the cracks opening up; many worry that trade finance, the lifeblood of cross-border trade, will be heavily penalised under new liquidity rules.
Resolutions and reality
Planning for bank failures is the area where the interests of national regulators collide most forcefully with hopes of international co-ordination. The Financial Stability Board, a global watchdog, wants the big regulators of cross-border banks to work together in the event that banks need resolving, and many banks hope for such agreements. But the regulators’ focus is on their national interests, not those of the world, or of the banks.
As Simon Gleeson of Clifford Chance, a law firm, points out, no government will care as much about treating foreign creditors fairly as it cares about compensating its own people. Iceland, which screwed its banks’ foreign creditors in favour of domestic depositors, is a case in point. A typical regulator wants banks in its purview to have enough assets both to keep operating in times of crisis and to pay back domestic creditors in case of failure, whether the banks are domiciled there or not.
Home-market regulators thus prefer their lenders not to have too great an exposure elsewhere. Austria’s central bank has said that Austrian bank subsidiaries in central and eastern Europe should not exceed a loan-to-deposit ratio of 110%, a way of ensuring that their funding needs do not make too great a call on resources back at headquarters.
Emerging markets, now alive to the possibility that parent banks in the rich world can be a source of instability as well as support, have their own worries about the “portability” of capital, liquidity and assets. Guillermo Ortiz, a former Mexican finance minister who is now chairman of Banorte, a Mexican lender, wants subsidiaries of foreign banks in emerging markets to be ring-fenced so that money cannot be funnelled out of the country.
Particular problems attach to “living wills”, documents in which banks lay out for regulators their plans to survive periods of extreme stress and, if the worst happens, to provide supervisors with the information they need for resolution. The process of agreeing on living wills with regulators in the countries concerned creates pressure for banks to use subsidiaries abroad, which have to have their own capital, rather than branches, which don’t.
The decision to set up a subsidiary in a new market (as opposed to just opening a branch) may be a harder one for boards, since it involves legal incorporation and taking on personal liabilities. Some bankers worry, too, that subsidiary units may be nudged by supervisors into running separate IT and management systems in order to demonstrate that they can keep operating without the support of a parent, making them yet more inefficient. Rules that make it harder to move money around will make it harder to commit to distant opportunities. An executive at a big American bank says that such rules will force his firm to invest less abroad than would be ideal. For emerging markets that have shallow deposit bases and undeveloped domestic bond markets, it all adds up to slower credit growth.
Markets that erect firewalls around their banking systems may also be sacrificing resilience in the event of a future crisis. For all the worries about wobbly international banks, the support of Western parents has proved more helpful than not in eastern Europe so far. Other sources of finance can be flighty, too. When bond markets closed to Dubai in late 2009, international banks kept providing liquidity. “There is a trade-off here between probability of default and loss given default,” says Standard Chartered’s Mr Sands. “People are losing sight of the first and obsessing about the second.”
The LDR of the pack
Even if regulators and politicians were carefree onlookers, the need to deleverage would remain. Once again, Europe is home to the banks with the most work to do, less because of the need to raise more capital than because of the way they fund themselves. European banks are more reliant on wholesale markets than any other big banking system (see chart 3). According to Simon Samuels of Barclays Capital, lending by listed European banks exceeds their deposits by $1.3 trillion. American banks, by contrast, are awash in deposits, with a funding surplus of $1.3 trillion.
The European gap is filled by borrowing on wholesale markets. The capital markets have peeped open in the wake of the ECB’s three-year lending operations. But a peep is not enough. The ECB’s intervention was needed precisely because the euro-zone sovereign crisis and the increased need to factor in the losses that follow when a bank fails have left bond investors a lot less interested in holding bank debt than they were. So lenders have little choice but to bring down their wholesale-borrowing needs.
In practice, that often means pruning back activities abroad. Banks typically establish a presence in new markets by lending, and wait for deposits to catch up later. Foreign subsidiaries that have loan-to-deposit ratios (LDRs) in excess of 100% and that rely on cross-border funding from their parents are obvious deleveraging candidates. Eastern Europe is the region that looks most vulnerable on this score. It is the most reliant on foreign banks; and although those banks also raise local deposits, countries such as Hungary, Romania and the Baltic states are all big recipients of cross-border funding as well (see chart 4).
European banks are not about to shut down their foreign networks altogether, not least because the business they do abroad is often their best prospect of growth. Lenders are more likely to manage LDRs down by letting loans run off or by competing for more deposits than to pull out of countries altogether. But the effect will still be felt in the form of scarcer and dearer credit.
There is a faster route to funding salvation than reducing bread-and-butter commercial lending. One particularly striking feature of the pre-crisis expansion of Europe’s banks was that so much of their activity was in dollar-denominated areas such as commercial-property lending, leveraged buy-outs, syndicated loans and commodity financing.
Some of that dollar activity was funded by deposits gathered by banks’ American units; another wodge of dollar funding came from swapping local deposits into foreign currency. But lots was gathered on wholesale markets, often in the form of short-term debt that needed to be constantly rolled over (think of the money provided to French banks by American money-market funds, whose flight from Europe last year caused so much trouble). This type of funding—short-term, wholesale and with an added dollop of foreign-currency risk for good measure—could not be further removed from the liabilities lenders, or their regulators, now want. With French banks in the vanguard, they are offloading dollar-denominated assets.
Among the sectors most exposed to this retreat are project finance, asset-based lending in shipping and aviation, and infrastructure funding. These are areas where assets tend to remain on banks’ balance-sheets for 10-15 years or more. That makes them unattractive bets: long-term dollar funding is hard to come by; short-term funding presents rollover risk; and lenders are wary of locking up bits of their balance-sheets inflexibly when things are so uncertain. To make matters worse, risks are high, so these kinds of lending use up lots of capital.
Alternatives to bank finance are harder to come by in these areas than in areas like syndicated lending. The risks inherent in shipping, a notoriously cyclical industry, or infrastructure finance, where there is lots of construction risk, mean that credit ratings are low, making them a hard sell to bond investors. New regulations called Solvency 2 could make it harder for European insurers to hold long-dated assets. Bankers are now trying to cook up new ways of distributing such assets to investors. One option in infrastructure finance, says the boss of a big European bank, is for the bank to offer financing for the riskier construction phase and then hand over to bond markets when projects start to generate cash flows (although it is unclear what yield investors would demand in return).
The hidden harm
Such innovations are a reminder that the international financial system has many moving parts. New ways of securitising dollar-denominated assets could mean that banks end up slimming their balance-sheets more slowly. The homeward migration of European lenders opens the door to others: Japanese banks, which sit on a surplus of deposits and are willing to lend on a long-term basis, are now the first port of call for project-finance deals. Banks of no fixed abode, such as HSBC and Standard Chartered, may also be poised to benefit in some markets, and American banks could yet decide to become more expansionist. Corporate-bond markets provide another source of funding for larger firms.
But, for all this, a homeward bias in banking will raise costs for some countries, and some classes of client, a lot. Where the process of retrenchment is too swift, it will be hard to refinance some existing debts. Ring-fenced subsidiaries risk being more brittle in the event of a crisis. The costs of infrastructure finance will go up and its availability decline.
There may also be costs for markets that have previously exported deposits and are now seeing them return: some in Germany already worry that too much credit is sloshing around. Some of the forces pulling banks back home are reasonable ones. But once trillions of dollars are set in motion, getting them to settle back down in an optimal way is next to impossible.
