Fixed income
03 Apr 2020

Coronavirus: investing in UK banks

Rob James, manager of the Merian Financials Contingent Capital Fund and financials analyst at Merian Global Investors considers how lessons from the global financial crisis apply today, why a coronavirus credit crunch can be avoided, and how cocos can provide a harbour in the storm as dividends are cut.

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COVID- 19 is hitting us all hard. So hard, that regulators and governments are shifting the goalposts with regard to the financial system, in particular in relation to the banks.

 

Banking sector risks

Following the global financial crisis (GFC), the authorities vowed that it would never happen again, so rules were changed to strengthen bank balance sheets.

The first area addressed was capital. Before the GFC, banks had little capital, and of that relatively small amount, the only element that was used up when they fell into loss-making territory was their equity (the part of the capital structure owned by shareholders). After the crisis, the level of equity was immediately raised several fold, and other forms of capital were explicitly put at risk – AT1 coco bonds, tier 2 bonds and even some senior bonds. This has put a very meaningful firebreak around each bank to prevent systemic contagion should it get into trouble.

Secondly, liquidity was addressed. Liquidity is the cash, or other low-risk assets, such as UK government gilts, that are readily available to settle any claims made against the bank, such as deposit withdrawals or repayment of debt. Today, the UK banks have hundreds of billions of pounds on deposit at the Bank of England to cover this scenario.

With those two systemic risks covered, the other major hazard banks face is of course credit risk – the risk that their borrowers don’t pay back what they owe. This is the risk that the banks succumbed to in the GFC – a lot of sub-prime (less than pristine quality) borrowers defaulted in the US,  and the aftermath rippled across the global banking system, leading to multiple failures here in the UK. That was understandable: the problem lay at the feet of the banks that had behaved recklessly, lending to customers that never really stood a chance of paying back their loans. As a result, banks and their shareholders paid a heavy price.

This time, however, it really is different. The cause of the current economic crash (and I deliberately avoid the term “recession,” because this is different) is a virus. Nobody is to blame, and most certainly, it is not a question of something that the banks have done wrong. Therefore, this isn’t a problem that the banks and their shareholders should have to pay for. That is why governments around the world are pledging trillions of dollars to support their economies, and the companies and individuals that make up those economies. They are doing this by issuing huge volumes of debt, the cost of which will be borne by society as a whole, rather than any one section of it.

This government action, and the simultaneous central bank response, is profoundly important as it means that the huge wave of redundancies and company failures that might have been expected will hopefully, at least to some degree, be avoided.

Together, the regulatory overhaul after the GFC and the quick response by governments to today’s crisis should alleviate the three major risks a banking system faces.

 

Avoiding a coronavirus credit crunch

As part of the disaster-avoidance package put forward to deal with the coronavirus outbreak, regulators have identified that some of the measures put in place since the GFC aren’t fit for purpose in a stressed environment, because they are highly pro-cyclical. By that, I mean that they progressively reduce a bank’s ability to increase lending as conditions deteriorate. That is exactly what regulators and authorities want to avoid – it’s called a credit crunch.

Thankfully this has been identified as a real potential problem before matters have deteriorated too far. A number of rules have changed, in accounting and also in the calculation of risk. This will help the banking system to continue to provide loans to the economy.

So, together, these packages and changes have made the banks far more resilient to a shock and as a long-term equity holder, this provides comfort that the investment case remains valid.

 

What about income?

While the banks are certainly more resilient today, what we are experiencing is still seismic, and purely as a precaution, a number of regulators around the world have asked (instructed) their banks to stop paying dividends to shareholders. The PRA in the UK was the latest to do this on the evening of 31 March – three days before Barclays was due to pay its final dividend of 6p per share for 2019.

The PRA stresses in its letter that this is not in order to shore up capital levels, but to increase the capacity to lend even further.

The UK banking industry is traditionally a large sector with high dividends, accounting for a significant proportion of investor income. This is now missing. But there is an alternative. As part of the regulatory response to the GFC, banks were allowed to issue a new form of capital, the Alternative Tier 1 bond, sometimes known as a coco (contingent convertible). These bonds pay coupons that are fixed, typically for five years from issue. After that, they are either called (repaid) by the bank, or their coupon is reset to the same spread above risk-free rates as when they were issued.

These bonds form a relatively small part of the capital of the bank, and the regulator has not asked banks to stop paying the coupons. Indeed, it is only dividends on ordinary shares that have been stopped.

The saving to a bank, and therefore the impact on its capital, of turning these coupons off is small. For example, for Lloyds, the ordinary dividends that would have been paid for 2019 were more than five times the total cost of all its coco bonds.

From our perspective, the coco offers a harbour in the storm. It pays a high yield in a time of dividend cuts across the market, with the relative security of investment grade issuers standing behind them, and huge government and regulatory support on all fronts.

 

Important information

 

Past performance is not a guide to future performance and may not be repeated.  Investment involves risk. The performance data does not take account of the commissions and costs incurred on the issue and redemption of shares. The value of investments and the income from them may go down as well as up and investors may not get back any of the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rate changes may cause the value of overseas investments to rise or fall. This communication is issued by Merian Global Investors (UK) Limited (“Merian Global Investors”), Millennium Bridge House, 2 Lambeth Hill, London, United Kingdom, EC4P 4WR. Merian Global Investors is registered in England and Wales (number: 02949554) and is authorised and regulated by the Financial Conduct Authority (FRN: 171847). This communication is for information purposes only. Nothing in this communication constitutes financial, professional or investment advice or a personal recommendation. This communication should not be construed as a solicitation or an offer to buy or sell any securities or related financial instruments in any jurisdiction. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the document. Any opinions expressed in this document are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or companies within the same group as Merian Global Investors as a result of using different assumptions and criteria. In Hong Kong this communication is issued by Merian Global Investors (Asia Pacific) Limited. Merian Global Investors (Asia Pacific) Limited is licensed to carry out Type 1 and Type 4 regulated activities in Hong Kong. This communication has not been reviewed by the Securities and Futures Commission in Hong Kong. In Singapore this document is issued by Merian Global Investors (Singapore) Pte Limited, which is not licensed or regulated by the Monetary Authority of Singapore (“MAS”) in Singapore. Merian Global Investors (Singapore) Pte Limited is affiliated with Merian Global Investors. Merian Global Investors is not licensed or regulated by the MAS. This document has not been reviewed by the MAS.  In Switzerland this communication is issued by Merian Global Investors (Schweiz) GmbH, Schützengasse 4, 8001 Zürich, Switzerland. MGI 04/20/0001

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