Since the end of September, European governments have made unprecedented interventions in the banking system.  At least €350 billion of capital has been made available to Eurozone and UK banks, and nearly €2 trillion of guarantees extended for bank funding.  These interventions have staved off systemic failure, and have stabilised bank funding, not least by providing reassurance to depositors.  But wholesale markets remain largely shut.  Government guaranteed issues have become virtually the only wholesale market funding that is being done by banks (in stark contrast to non-financial issuance which saw its most active month of 2008 in November).  Banks' funding bases remain fragile, therefore, and are still far from normal.  It is not clear that any European bank can have much confidence growing their balance sheet.  We expect this situation to persist well into 2009.   

Loan Officer Surveys show banks are retrenching

The most recent European Loan Officer Survey showed a record percentage of banks tightening credit for corporates.  The equivalent US survey showed a similar picture.  This is one of the clear symptoms of banks trying to reduce the size of their balance sheets.  This deleveraging process was triggered in August 2007, has gathered pace through the course of 2008, and looks irreversible.  Higher funding costs inevitably imply higher hurdle rates for bank lending which reduces the pool of potential creditworthy customers who can afford these rates, and the amounts creditworthy customers can afford to borrow.  Government guarantees certainly stabilise funding, but they are not a basis on which banks can grow balance sheets, as they are short tenor and relatively expensive.   

Covered bonds and securitisation were the sources of cheap funding on which banks expanded their balance sheets in the first place – if these same banks are to grow their balance sheets from their current positions, covered bonds and securitisation will have to return.  Further specific legislation, and possibly government guarantees, will be required before they do, and this will take time to put in place.  It is also conspicuous that longer dated senior unsecured funding markets remain shut.   

Governments conflicted

It is entirely understandable that politicians sound exasperated by banks’ reluctance to lend even after receiving the benefits of government largesse.  The fact is, however, that there was no choice other than direct government intervention in the banking system in order to avoid its collapse, the consequences of which would have been disastrous.  Banks still need to de-risk, and the government interventions should help them do so in an orderly manner.  Yet as deleverage reduces the amount of credit available to the real economy, politicians need the banks to increase lending to potentially riskier segments such as small and medium-sized enterprises (SMEs) and households in order to demonstrate that taxpayers’ money has been well spent.    

The politicians can of course try to encourage or coerce banks (particularly partly nationalised ones) to lend to SMEs or homebuyers, but banks will merely withdraw more credit from other segments to compensate.   In aggregate, bank lending will contract until two conditions are met:

• that banks have ready and regular access to multiple sources of funding; and
• that demand for credit increases from creditworthy customers who meet stricter underwriting criteria and can afford to borrow at prevailing rates. 

Lower central bank rates will help both of these issues, but government guarantees to support just part of the bank funding base are not the cure on their own.   

Remain cautious on the outlook for bank credit

As the bailout of the banking system enters uncharted waters, at Schroders we remain cautious on the credit outlook for banks, staying high up the capital structure with all but the strongest banks.  Further rounds of capital injections, and even full nationalisations, are becoming a central scenario for 2009 as the banking transmission mechanism remains in intensive care, and governments are now committed to supporting it.  The impact of this on junior securities is uncertain, and to date they have been favourably treated relative to shareholders.  This may change over time, however, and the ostensibly appealing yields on junior securities – in some cases over 20% despite government support – may prove illusory.