Funding: Collateralised Funding Changing to Unsecured and Additional Tier 1

By definition, focused analysis results always depend on the factors taken into account. In this article, we will focus on main drivers explaining funding at a bank-specific level. Current trends suggest that Banks prepare for a switch from collateralised funding, such as Covered Bonds, to more unsecured funding.

To start, let us explore the following question: What is the ratio behind changing funding patterns?

From 2008 on most investors were looking for safe bank funding, if at all. Bank funding was mainly buy-side driven. Let us consider the following figures: European Covered Bond issues reached their peak in 2011, with a total of 370 billion US-Dollars. In addition to the market expectations, we understand regulatory uncertainty as a further driver which pushed secured funding. Specifically, Covered Bonds were expected to play a crucial role in fulfilling the requirements defined by the Liquidity Coverage Ratio. With respect to the final rules, Covered Bonds are still important. Their dominant impact, however, is balanced by alternative factors allowing to calculate an adequate Liquidity Coverage Ratio.

Between 2011 and 2013 the factors defining bank funding patterns changed: In 2013 the issuance of Covered Bonds fell back to a 2002 level. This break in the above-mentioned trend towards the 2011 peak occured even though the investors have been showing a stable demand for secured funding. What are the new drivers shifting the funding patterns to (relatively) more unsecured funding? Karlo Fuchs, Senior Director of Covered Bonds at S&P points out the following: First, banks focus more on deleveraging their balance sheets leading to less covered bonds. Second, banks are heavily working on meeting new targets set by the regulators, such as the Leverage Ratio and the Asset Encumbrance Ratio. In addition, regulatory grandfathering rules have the potential to wipe out parts of existing Additional Tier 1, in case a step up is combined with a call date and if the instrument does not fully comply with the criteria of Article 52 CRR.

We understand that these factors further push the issuance of unsecured debt in 2014/2015. The question if those instruments will be structured as Contingent Convertible Bonds will depend on the bank-specific funding mix and the tax treatment of those bonds, among other factors. Gerald Podobnik, Head of Capital Solutions at Deutsche Bank, weighs in on this topic in an FT article, stating that an “avalanche” of Additional Tier 1 contingent convertible bonds from European banks is expected in 2014 amid efforts to build capital buffers and boost leverage ratios. According to Dealogic data EU banks have issued a record 9.6 billion US-Dollars in CoCos to date in 2013; Podobnik expects up to 30 billion US-Dollars for 2014. The decisive factor for the final design of unsecured funding instruments will depend on bank-specific key indicators such as capital, leverage and encumbrance ratio.

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