Euroweek Australia report: financial institutions

Euroweek, August 2013

Standfirst: Australia has one of the world’s strongest banking systems. Its major banks are in good shape, fattened by retail deposits, and so haven’t needed as much wholesale funding as in previous years. But will this change as falling interest rates cause retail to flee deposits? And where do new Basel III-compliant hybrids fit in? By Chris Wright

Bank issuance in Australia has been curtailed by one thing: the banks just don’t need the money. In stark contrast to other developed world nations, Australia’s banking sector is well capitalised, healthy and secure.

Moreover, the trend of recent years has been for banks to bolster their balance sheets through amassing retail deposits rather than by looking for funding. Indeed, there has been little less than a bidding war over retail deposits in recent years. “Banks are happy to pay over the money for retail deposits: they are paying a lot more than they would for wholesale deposits,” says John Chauvel, head of debt capital markets at Westpac.

“The wholesale funding requirement of the Australian major banks is driven by the interplay between deposit growth and asset growth,” explains Paul Neumann, associate director at UBS. “Over the past few years banks have experienced a slowdown in asset growth and have funded the assets with a greater share of deposits. As a result, Australian banks are less reliant on wholesale funding markets, and this has enabled them to become more opportunistic and price-focused when assessing their funding options.”

This is the main reason that Australian banks’ issuance of domestic covered bonds appeared to vanish between March 2012 and August 2013 until ANZ re-opened the market (see separate article for more on covered bonds). Why would banks pay up for funding they don’t need? There’s no point. “Credit growth remains pretty subdued overall, and what credit growth there is, is largely funded by deposits,” says Steve Black at Credit Suisse.

Still, Australian bank deals remain the most significant bond issues around: according to Dealogic, of the top 10 global Australian dollar denominated deals in 2013 up to early August, eight were from the banks either in senior debt or mortgage-backed issues, with the only two exceptions being the New South Wales Treasury Corp and the Commonwealth of Australia itself. Both Westpac and Commonwealth Bank of Australia have launched deals of A$2 billion or higher this year, and internationally, all four have been active across a range of currencies.

There has been a sense of banks pulling themselves out of torpor and looking more closely at the markets again in recent weeks. “Very recently, we have seen a small tick up in mortgage lending, and after a very quiet period, the banks have taken the opportunity of a stronger market backdrop to raise some term funding both domestically and offshore,” says Black. This has manifested itself in international issuance in particular. Since late July, Westpac and NAB (with a $2.6 billion three and five year deal) have issued in dollars, NAB in euros (Eu650 million three-year floater), and CBA and NAB in sterling (a £300 million and £500 million three year FRN respectively). “There has definitely been greater activity for the majors recently in offshore markets,” says Adam Gaydon, director, syndicate at ANZ.

Also, as the major banks report their results and move in to new fiscal years, they are likely to move to new issuance programmes. “Three of the Australian bank majors have their full year-end at the end of September,” says Duncan Beattie, managing director, debt capital markets at JP Morgan. “That means these banks are typically more active in the first half of their fiscal years, so we expect them to be quieter in August and September and then more active post-results in late October, early November.”

Choice of market will, naturally, depend on cost. “Australian banks consider a variety of factors when choosing which trades to do, and in senior funding right now, the clear standout remains the US dollar market,” says Beattie. “However, some trades make sense in other markets,” he says, pointing to the CBA sterling and NAB euro FRNs, “which both worked well. Elsewhere, yen is pricing at a level that makes less sense.”

Australian banks may also find their hands forced as it becomes harder for them to continue to offer high rates on retail deposits as the Reserve Bank of Australia reduces rates. If that in turn leads to retail money leaving deposits and going into other investments, banks will have to reconsider their funding mix. “It’s going to get harder [for banks], as yields come down and retail investors reallocate back into equities to maintain the returns they need to fund their retirement,” says Chauvel.

Meanwhile, issuance in Australian dollars by foreign banks has been robust. This is covered in greater detail in the kangaroo bond article, but recent examples have included successful deals from RBC, Goldman Sachs and OCBC, while standouts earlier in the year included Wells Fargo, BAML, Citi and – most striking of all – National Bank of Abu Dhabi. Gaydon says that by the end of July there had been 30 financial institution issues from 21 issuers year to date: eight domestic, 13 from overseas. Those 13 broke down as six from the US, two from Europe, four from Asia and one from the Middle East.

Perhaps the most interesting part of the domestic market for financial institutions comes in the retail space, which has shown ardent hunger for hybrid securities. Hybrids in general hit a record A$13 billion last year, and all but A$3.5 billion of it was financial. In particular, as Basel III rules have come into effect in Australia, retail has proven by far the most willing market to provide regulatory compliant bank capital.

Early in the year Westpac and NAB issued close to A$3 billion of Basel III compliant tier one securities between them, but perhaps the most significant deal came in April when Suncorp launched a Basel III compliant tier two deal. “That was the first time we had a prudentially regulated Australian borrower issue compliant tier two,” says Allan O’Sullivan, director, syndicate at Westpac, who specialises in these securities. Since then, Macquarie and ANZ have followed with tier one deals, and Westpac with an A$850 million tier two.

While institutions are not excluded from these deals, the fact that they are listed has lent them towards retail. “What’s linked these issues is that investors have been very comfortable with the underlying credit and regulatory oversight; that’s what’s supported patronage of the issues, rather than investors understanding all the nuances of non-viability and conversion conditions under the Basel 3 landscape,” O’Sullivan says. That’s partly because Australian retail is quite used to hybrid bank capital issues; by 2008, every major bank, and several not-so-major banks, had issued regulatory capital. But it does lead to some concern about whether investors fully understand what they are buying. Do retail buyers fully understand what the conversion issues are under Basel III, and how they are priced? Almost certainly not: they just like the yield and trust the names. “There isn’t a consensus among investors that prescribes what a non-viability premium should be,” says O’Sullivan. “Investors assess the quality of the name and its balance sheet.”

With such willing buyers in retail, Australian institutions have not yet engaged with tier two.  “It’s fair to say that in Australia, institutional participation in tier two Basel 3-compliant securities is marginal,” says O’Sullivan. “For many that’s because their price expectation is wider than any borrower is prepared to pay.”

Consequently, it may be a while before we see tier two issues outside of the retail market. “I wouldn’t rule it out for the second half of this year, but it will more likely be 2014 before the banks raise tier 2 in the new style with equity conversion if banks have become non-viable,” says Beattie at JP Morgan. “My sense is that offshore investors have rationalised the new approach more than the domestic market. Here, the only new-style trades have gone to the retail market, avoiding having that conversation with institutions.”

In the long term, Beattie thinks that’s counterintuitive. “I think if you are going to sell sub debt to retail, you should focus on tier one. That’s the most expensive form of capital, so you should raise it in the cheapest market. There is a finite capacity to retail demand in Australia, so tier 2 might go offshore.”

Rupert Daly, head of hybrid capital at Deutsche, is thinking along the same lines as Beattie. “Do the majors attempt to issue all their capital instruments domestically or see them also as an offshore product?” he asks. “Clearly they are going to issue hybrid tier one here – and have been doing so – because it’s materially cheaper to do so versus offshore. Is there sufficient demand in the domestic market to absorb tier two capital requirements from all four majors as well? Time will tell.”

The differences Basel III brings will be digested in a different way to elsewhere in the world. “Capital instruments that have been issued in Australia have been different from most European transactions,” says Andrew Buchanan, head of hybrid capital at UBS, which was structuring advisor on the Suncorp tier two deal and an arranger on the Westpac one. “All Australian capital transactions that have included the non-viability triggers convert into equity rather than being written down if the non-viability trigger occurs.” Investors should receive ordinary equity in those circumstances, rather than being written off as they likely would be in Europe. It’s unlikely that any Australian major bank will hit a non-viability event, but if it did, “investors should get some value back,” he says.

Looking ahead, Gaydon says there were around $19 billion of Australian dollar redemptions coming up in August, many of them in the financial institution space, and there is clearly still a buoyant market to support issuance. He says there is a strong bid between three and five years for financials – typically floating in the threes, with good balance sheet support, and either floating or fixed on the fives, with more real money – and notes that international participation in A$ issues from the banks is robust too. “It’s a yield play for many private bank investors, as Australian interest rates are still comparatively high on a global basis,” he says.

And issuance ultimately will be dictated by the changing nature of the banks themselves and their balance sheets.

“One trend we are seeing here is the migration of investment grade borrowers in the capital markets,” says Chauvel. “Here, a lot of borrowers who used to rely on bank markets for their core funding are now looking to the capital markets for funding instead; they use the banks for liquidity, working capital, hedging and underwriting.”

“That will force bank balance sheets to go down the curve a little bit into more sub-investment grade, and to play more aggressively in acquisition financing and infrastructure financing. And while banks might tilt their balance sheets towards infrastructure, I also see a lot of brownfield infrastructure projects with a proven track record that can start shifting their funding into capital markets themselves.” When balance sheets change direction, so too will funding mixes.