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Emergency bypass

22 December 2011 By Peter Thal Larsen

Can the bond market take the place of banks? That question will be partially answered in 2012, as borrowers seek to bypass strained lenders in search of cheaper sources of credit. For big companies, tougher regulation of banks has accelerated a long-term shift to seeking funds directly from investors. But small companies and consumers won’t find it so easy to make the switch.

The notion that bonds can provide cheaper and wider access to credit is hardly new. In the United States, big companies have long relied on bond markets for the majority of their financing needs. The development of securities backed by mortgages and credit-card debt promised to democratise credit for consumers as well. Indeed, the credit boom was based largely on the belief that banks were mainly in the business of repackaging loans and selling them on – the so-called “originate-to-distribute” model. Regulators bought into the argument that spreading the risk around made the system safer.

The financial crisis that started in 2007 revealed this theory to be disastrously wrong. Far from shifting risk out of the banking system, it turned out that lenders had been shuffling risky loans between themselves, or had shunted them into unregulated off-balance sheet vehicles. Many of these “shadow banks” were guaranteed – implicitly or explicitly – by regulated institutions. Regulators have now responded by demanding that banks hold bigger buffers of capital and liquid assets, while closing loopholes that enabled lenders to pretend risks had been transferred.

While necessary, these reforms will make credit more expensive. Standard & Poor’s reckons that for companies with investment-grade credit ratings, the cost of borrowing will rise by 55-70 basis points as a result of new regulations. Junk-rated borrowers will pay an extra 110-165 basis points. Add in the funding strains caused by the euro zone financial crisis, and it’s clear that bank lending will become costlier and scarcer. This is particularly the case in Europe, where three-quarters of corporate funding is still channeled via the banking system, according to the European Central Bank.

For big companies, the bond market may offer better terms. After all, bond investors have plenty of spare cash looking for a healthy return. And a shift from bank to bond market financing is already underway. The amount that European companies borrowed from the bond markets in 2011 was 33 percent of what they borrowed from banks, says Oliver Wyman. At the peak of the credit bubble in 2007, the figure was just 20 percent. Until the recent market turmoil choked off demand, junk bonds were particularly popular. In the second half of 2009 and early 2010, more sub-investment grade bonds were sold in Europe than in the equivalent period of 2006/07.

For individuals and small companies, however, the shift is less straightforward. Small and medium-sized enterprises (SMEs) don’t have direct access to the bond market. Some fund managers have responded by setting up loan funds aimed directly at SMEs, but it’s still too early to say whether these can provide a cost-effective alternative to banks. For consumers, tapping the bond markets depends on reviving the discredited market for mortgage-backed securities. Even then, investors will probably still depend on banks to sort out good borrowers from bad ones.

The expansion of bond markets isn’t entirely bad news for banks. True, less borrowing by companies means that loan books will have to shrink, squeezing revenues and forcing banks to cut costs even further. However, even ignoring the cost of new regulation, the vast majority of corporate loans were probably unprofitable anyway. That’s because banks underpriced corporate credit in the hope of securing investment banking mandates that would justify the cross-subsidy. Such “relationship lending” is now unsustainable – especially as investment banking fees have dried up amid the market turmoil. So while corporate lending will shrink, the pricing of what remains should become more rational. What’s more, investment banks’ debt capital markets and trading businesses would be a beneficiary of any secular uptick in bond issuance.

The upshot is that post-crisis regulation should give a boost to the bond market, which in turn could prove a silver lining for investment banks’ debt businesses. The big losers could be consumers and small enterprises whose access to credit is an essential building block of economic recovery. Not what policymakers intended.

Predictions: Breakingviews is publishing a series of articles over the holiday that look ahead to 2012. The pieces will be collected together in the annual ’Predictions Book’, produced in print and electronic form early in the New Year.


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