We do not currently expect there to be an extension to the Term Funding Scheme [“TFS”] nor a replacement scheme. Therefore, the ending of the scheme will require a significant change in the funding plans of many UK lenders, some of whom have become reliant on central bank funding to drive growth. As a result we expect securitisation markets to revive and deposit rates to increase in the near term, especially around peaks in the scheme’s maturity profile. The notional value of UK covered bond schemes is also likely to rise for smaller, less highly rated issuers seeking attractive spreads. To avoid sharp increases in their underlying cost of funds, Treasurers will have to move early and look to develop their funding infrastructure well in advance of their contractual maturity payments to the Bank in order to avoid costly funding issues and potential headwinds to future growth.
Since the financial crisis the Bank has used a range of tools to stimulate and drive lending in the real economy. Whilst the effectiveness of such policies has been widely debated, the long-term impact on both banks’ funding structures and securitisation markets is clear. The sheer scale of central bank quantitative easing has undoubtedly influenced behaviour as securitisation markets in both the UK and wider-EU remain depressed from their pre-crisis levels [Figures 1 and 21]. Furthermore, the introduction of the TFS drawdown window in September 2016 further depressed UK issuance until its close in February 2018 [Figure 2] with a notable 14% drop between 2016 and 2017.
The reduction in issuance is unsurprising as the Funding for Lending Scheme [“FLS”] and its successor, the TFS, have provided cheap funding to banks collateralised by a range of asset classes. The fact that the Bank accepts “raw” loan portfolios [i.e. there is no requirement to securitise or structure the assets before pledging] as collateral provides a large disincentive to tap securitisation markets as distribution costs are removed. Furthermore, with TFS advances made at base rate plus a minimal fee2, from a cost of funds perspective there is no comparison between the Bank’s scheme and the market as liquidity and risk premiums are largely ignored [albeit swallowed by the Bank through their haircut methodology]. Therefore, even with non-commercial haircuts, from a balance sheet and funding perspective the pledging of illiquid assets at low cost has provided a boon for lenders.
Total TFS drawings totalled £121bn at end-2018 [Table 1] representing 179% of cumulative lending provided by participants during the period3. However, there is a significant disconnect between the relative drawings of different sized firms. Comparing Tier 1 firms to Tiers 2 and 3, for large Tier 1 banks aggregate TFS drawings far outstrip cumulative net lending indicating that this cheap funding has been diverted for other purposes. For some who have had to build-out their capital bases and react to regulatory changes this was probably an efficient form of borrowing even though the low interest rate environment has made deposit gathering historically cheap, albeit that this may also be a reaction to increased competition for deposits considering the swell of new market participants seen over the last decade. For Tier 2 banks drawings are fairly closely aligned to lending; but, for smaller Tier 3 banks the ratio is 81% suggests that lending growth was able to outstrip drawing allowances as businesses grew4.
As the scheme comes to a close there is a significant question over how banks will replace this huge funding source. Some commentators have suggested that the Bank may launch a new scheme to replace the TFS; however, in our opinion this is unlikely now that the Bank has transitioned the scheme from the Asset Purchase Facility [“APF”] and brought the scheme onto its own balance sheet. Whilst this action removed the need for an indemnity from the Treasury, the result is that any losses incurred through defaults and a transfer of assets will impact the Bank directly. The political interest around the burgeoning size of the Bank’s balance sheet [c. £590bn at end-20186] compared to its capital base [£3.5bn at end-20187] is likely to limit the Governor’s room to manoeuvre in this regard and the fact that a £1.2bn capital injection was required in order to migrate the scheme means that further cash is unlikely to be forthcoming. Whilst the Governor was keen to stress that the move could allow the Bank to re-launch the scheme if required8; despite its conservative haircuts against pledged assets, we do not feel that an increase in leverage is possible without undermining confidence in the institution’s ability to react to future crises.
With TFS advances working on a 4 year cycle from the date of drawdown, the first drawings are set to mature in September 2020; as such, banks will have to find new sources of funding in order to continue lending. Whilst drawings will mature throughout the September 2020-February 2022 period we envisage two maturity peaks at the beginning and end of this window. This stems from the clamour of new participants to join the scheme [most notably Tier 2 participants] in 2016 as well as those seeking to maximise usage of their drawing allowances before the scheme ended at the aforementioned attractive rates. Therefore, those seeking to raise funding around these times could expect to incur greater borrowing costs.
Raising deposits is part of any bank’s wider funding plan; however, whilst interest rates currently remain near historic lows, rates paid to depositors could rise sharply in the short to medium term as the TFS scheme begins to unwind. Firstly, the large increase in the number of lenders over the last decade has undoubtedly increased competition forcing lenders to compete in order to attract depositors from a finite pool. Furthermore this has been exacerbated by the increase in online banking making it easier for consumers to move funds and compare rates. Despite this, it can be argued for general vanilla lenders that it is relatively easy to attract term deposits that are ALM matched to fixed rate mortgages and loans if a slight premium is paid. However for lenders with more nuanced asset profiles, the need to “pay up” for deposits could put a strain on margins especially if base rates eventually recover to levels more familiar from an historic perspective. The timeframe for this however remains unclear with the deadline for Brexit rapidly approaching.
It is expected that more lenders will look to wholesale markets for funding, but, as ever, there are incentives and challenges to doing this. On the one hand the FLS/TFS has arguably improved lenders’ data reporting with all participants having to complete Bank data templates on a monthly basis. These templates are based on ECB data templates and provide a fairly holistic asset view, which will help lenders meet new simple, transparent, and standardised [“STS”] data requirements for securitisations that came into place this January. Alongside this, the transition to wholesale funding will be easier for smaller lenders who now have the reporting and governance infrastructure in place as a consequence of TFS usage whereas, historically, they may have taken some time to develop it.
This point is particularly poignant for Tier 2 [“challenger”] banks who have seen rapid balance sheet growth and are beginning to outgrow their deposit bases. Nonetheless, as with deposits noted above, the sheer number of participants coming to market may also drive up securitisation costs. It is likely that new issuer premiums will be steep if the market is suddenly flooded with paper that investors have to absorb, particularly if this is combined with TFS maturity peaks, although, a consequence of this may be a reduction in spreads for larger issuers that have continued to issue since the crisis as the relative attractiveness of their paper rises. Risk premiums deduced by the market will also take note of the wide range of asset classes the Bank accepts. In its operations the Bank has clearly moved down the risk curve over time, pledged asset quality varies significantly, and some non-conforming assets may be uneconomical to price in the open market. As such, some lenders may struggle with the rates they have to pay compared to the TFS; this could lead to market consolidations and a slowdown in balance sheet growth for some. Nonetheless the impact may be dampened somewhat through balance sheet optimisation. Treasurers will likely seek to retain illiquid assets pledged to the Bank for use in the Discount Window Facility and naturally look to place higher quality assets into marketable deals. Whilst appealing to the regulators, this strategy may also help to keep spreads down to more manageable levels.
Covered bond issuance has steadily risen over the last few years. Pre-crisis, UK lenders only tended to issue in the Euro market which, historically, has always been deeper. However, Sterling issuance begun to increase after 2010 and this trend could continue if lenders exiting the TFS seek to utilise this funding source alongside asset securitisation9. Specifically, for Tier 2 banks with weaker credit ratings, covered bond issuance could provide an easier route to lower spreads and attainment of AAA-rated deals when compared to outright asset securitisation10. Furthermore, with the Bank’s resolution regime moving more towards a “bail-in” structure, covered bonds which provide exemption from bail-in laws could become more attractive for investors which would provide additional pricing benefits.
Figure 3 - Regulated covered bond issuance
As a result, we see covered bond issuance continuing to rise; however, the fact that regulators tend to place a cap on the percentage of encumbered balance sheet assets means that covered bonds are likely to form a part of a balanced funding plan rather than forming the primary source.
Following the end of the TFS, we believe that securitisation markets will receive a new lease of life as lenders are forced to seek funding from alternative sources as the Bank’s ability to continue to lend in this regard is limited. If securitisation markets are able to recover to historic levels, then this can only be seen as positive for pension funds and other long term investors who have undoubtedly been squeezed out of the markets by the Bank itself.
The need for deep, well-functioning wholesale funding markets is key for diversity and efficient capital market operation. With new securitisation regulation in place and tighter regulatory scrutiny following the financial crash, there may be some delay in issuance as lenders seek to meet all the requirements, but, those who are positioned earliest will undoubtedly see the best cost benefits as competitive market forces once more come into play.
1Association for Financial Markets in Europe [AFME] data - https://www.afme.eu/
20bp per annum for those with positive net lending during the reference period, up to 25bp per annum for those with negative lending during this period [only 7 of 62 scheme participants].
3Slight date mismatch noting that the lending data is from 30/06/16 but the drawdown period ran from 19 September 2016 to 28 February 2018.
4Noting that the reference period for drawdown capacity ran from 30 June 2016 to 31 December 2017 and is a leading indicator for banks who have seen rapid balance sheet growth.
9FCA Regulated Covered Bond Register - https://www.fca.org.uk/firms/regulated-covered-bonds/register
10For covered bonds investor’s dual claim against pledged assets and the underlying issuer provides additional credit enhancement beyond securitisation [claims only against the SPV and its underlying assets]. Methodologies vary but this can usually amount to anything between a 1 and 6 notch uplift depending on the issuer.