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European Banks Innovate With Bonds to Fill Funding Gap

Europe’s banks are seeking increasingly creative ways to finance themselves as they attempt to make up for a dearth of traditional debt funding amid market turmoil.

The eurozone crisis and the prospect of new regulation have driven many banks away from issuing ‘unsecured’ debt, which is not backed by specific pools of collateral. This has traditionally acted as the bread and butter of their funding.

Most bank funding issued in recent months has taken the form of secured debt—including covered bonds—but some financials are now looking even beyond these.

Covered bonds are a type of debt made up of relatively high-quality loans and mortgages. Banks have rushed to issue them in record numbers this year, with investors eager to buy since the bonds are backed by collateral and are also secured by the bank’s other assets in the event of the issuer’s bankruptcy.

However, banks are constrained in the number of covered bonds they can sell because of regulatory limits on balance sheet ‘encumbrance’ and a shortage of high-quality assets. Some banks are examining whether ‘quasi-’ or ‘structured’ covered bonds—sitting somewhere between covered bonds and a traditional securitization—can help fill the gap.

“It’s clear that banks in Europe have moved away from issuing unsecured debt and are issuing covered bonds instead,” said Anna Pinedo, a partner at law firm Morrison & Foerster. “But now there’s overreliance on covered bonds.”

German banks including Deutsche Pfandbriefbank, are examining the possibility of issuing structured covered bonds. In essence that would involve using non-traditional collateral such as portions of residential mortgages not eligible for regulated covered debt.

M&G Investments, one of Europe’s largest bond investors, said they have had an approach from a bank seeking to sell them a quasi-covered bond, backed by a revolving pool of collateral including stocks and exchange-traded funds .

Tamara Burnell, head of financial institutions and sovereign analysis at M&G, said banks were looking to increase secured issuance through any means possible, as it is one of the few funding channels now open to them. In addition to being sellable to investors, secured debt can also be loaned out in return for short-term liquidity.

“All these demands on assets have made unsecured creditors and all sorts of wholesale depositors much more wary of giving banks money on an unsecured basis,” she said.

M&G, plus other funds and banks also report approaches from financials for ‘collateral swaps.’ These involve banks agreeing to exchange their assets, usually with an insurer or pension fund, in return for more liquid government debt , which can then be exchanged or ‘repoed’ at a central bank.

Basic ‘repo’ financing has also been increasing, as banks seek short-term liquidity from their banking counterparts or central banks, using bonds or other assets as security.

The International Capital Markets Association said in a recent report there was evidence of more “longer-term repos being negotiated by banks seeking to lock in liquidity.” Repos with terms lasting for more than a year jumped from 1 per cent at the end of last year to 8.7 per cent as of June.

Because of their private nature, bilateral deals such as repos or collateral swaps remain secretive. Typically they are arranged under the umbrella of ‘alternative capital solutions’ by investment banks.

“Nobody knows with any certainty, for example, how big this market is,” Dan Awrey, a lecturer at Oxford University, wrote in a recent paper. “As a result, it is exceedingly difficult to ascertain the nature and extent of the attendant risks.”

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