Banks in major economies face funding disadvantage-BIS

    Investors’ search for yield has continued unabated in recent months but banks in advanced economies are not benefitting as much as non-financial companies and this is “bad news” for small firms and Europe’s economic recovery, according to the Bank for International Settlements (BIS).
    Before the 2007-2009 global financial crises, banks had a funding advantage as they were able to borrow at a lower cost than non-financial corporations, partly because investors believed the public sector would always come to the rescue of banks that were in trouble.
    But banks can no longer rely on being “too big to fail” and although they have strengthened their capital and liquidity positions - especially U.S. banks - the impact of the hit that banks took during the financial cries still lingers.
    Prior to the financial crises, the spreads on bonds issued by banks were typically 20-30 percent lower than those of non-financial bonds but this reversed sharply in 2007.  While it has narrowed since then, and even disappeared for U.S. institutions, the spread in November was still 40 percent higher for UK banks and 10 percent for euro area banks in November, BIS said.
    “The financial crises of 2007-09 marked the end of an era in which banks had a funding advantage,” said the BIS in its December quarterly review.

    The erosion of banks’ funding advantage limits their effectiveness as financial intermediaries and the BIS said there were signs that euro area banks have passed on some of their high borrowing costs with the average interest rate on bank loans stalled at levels above 3.0 percent over the past three years in spite of the European Central Bank’s (ECB) low interest rates.
    The consequence is especially dramatic in Europe where firms traditionally relied on banks for funds in contrast to the U.S. where firms always tapped markets for funds.
    But since early 2011 more than 50 percent of the funds raised by euro area corporates has came from securities markets rather than through syndicated loans and the stock of corporate loans has fallen 15 percent during the same period, BIS said.
    “The funding disadvantage of banks is not only bad news for banks, it’s bad news for those customers of banks that are too small to access the bond market and it is bad news for the economy,” said Claudio Borio, the new head of the BIS monetary and economic department.
    “Fixing the banks is crucial if the recovery is to gain traction,” Borio said, adding that the ECB's review of banks' books is extremely important and banks need to fully recognize losses in their portfolios and raise new capital.
    Another consequence of investors’ search for yield - which resumed in September after the U.S. Federal Reserve postponed tapering its asset purchases – is a breakdown in some geographical regions of a previously stable relationship between credit markets and general economic conditions.
    “What’s happening in corporate markets is unusual, it’s as if the typical relationship with the macro economy has taken a holiday,” Borio told journalists in a conference call.
    In the 15 years up to 2011, low or negative economic growth went hand in hand with high default rates and credit spreads.
    But from 2012 default rates in the euro area declined just as the economy entered a recession and credit spreads in emerging markets also fell from late 2011 to mid-2013 when it became clear that economic growth was slowing.
   “So far investing in risky corporate debt has paid off, but we simply don’t know for how long those default rates will prevail,” cautioned Borio.
    While low default rates tend to drive down spreads, Borio said low spreads also drive down defaults because lenders become more tolerant and borrowers face a lower cost of debt service.
    “If this process is indeed at work, it’s sustainability will no doubt be tested by the eventual normalization of monetary policy,” Borio said.
    (Click to read the BIS Quarterly Review for December 2013.)

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