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Bank Finance: Rules of the Game

Sep 1, 2013

Regulatory and economic uncertainty has forced Latin banks to innovate to raise funding and capital. Yet despite today’s expanding balance sheets, simplicity still reigns over most market activity. By Katie Llanos-Small

In 1988, then state-owned lender Banamex needed capital. Sourcing it cheaply was not easy. So the Mexican bank structured a new type of bond that swapped $200 million of interbank deposits into a 20-year subordinated liability. The depositors were already somewhat resigned to leaving their cash in the bank, having had it already rolled over at three-year intervals since the sovereign defaulted in 1982. Banamex paid just 75 basis points over Libor, sweetening the deal for creditors by backing the notes with zero-coupon US Treasury bonds.

The transaction was an early example of a Latin bank looking creatively at a problem. While the financing squeezes for the region’s largest banks have, by and large, improved over the last quarter century, they are still finding reason to think laterally about their liabilities.

A covered bond sold by Panama’s Global Bank in 2012 is a more recent example of innovation, if driven less by a problem than a desire to tighten funding costs. The lender adopted the dual recourse structure used frequently by European banks to finance a pool of mortgages at tight spreads.

Yet for the bulk of Latin banks, for most of the past quarter century, the funding model has been simple. Bank lending in Latin America grew from 31% of GDP in 2004, to 38.5% seven years later, according to IMF statistics. Much of that stemmed from increasing consumer and household lending, although construction loans also grew rapidly.

Deposit Growth

The expansion in lending came in tandem with a rise in deposits. Across Latin America, bank deposits stood at 38.1% of GDP at the end of 2011, up from 32.3% in 2004. That means deposits still account for a large portion of banks’ funding – slightly over three quarters, according to IMF statistics. Nevertheless, banks are turning in greater numbers to capital markets to finance their growing lending. Some of that new access is a function of stronger economies and banking systems.

"Latin American banks in general are very well funded," says Marcelo Delmar, head of Latin American DCM at BNP Paribas. "They have a growing deposit base. And the growth in the size and frequency of issuance is linked to the growth of these countries."

Banco do Brasil, for example, tapped the euro market in mid-July.

"We accessed the markets with a euro transaction that was a great, €700 million ($930 million) deal and with the lowest coupon in our history," says Ivan Monteiro, the bank’s chief financial officer. "We were able to do that because we’re now a triple-B bank, and we are able to access the European market and the US market. We use that as an alternative to diversify funding sources for Banco do Brasil."

A growing number of banks are also said to be looking at issuing bonds for the first time to finance their lending.

"Five to eight years ago, banks weren’t the easiest sector to sell," says Stanley Louie, head of the new products group at Citi. "The top, largest banks, the state-owned banks, were a good proxy for sovereign credit. But generally in EM the investors are more of a corporate buyer base – there’s not the dedicated financial institution buyer base like there is for investment grade banks."

As the number of issuers and senior unsecured paper in circulation increases, investors will devote more resources to the asset class.

"In EM the roots of the market are more heavily skewed towards corporate and sovereign activity," adds Louie. "That is taking time to come into its own, and it is happening as there is more bank paper to look at. If we had an index that tracked banks that came to market, it would be rising. Initially it was just the biggest and second biggest banks in each country. Now we’re seeing the fifth, sixth and seventh largest coming."

Stabilizing the system

When it comes to regulatory capital, the picture is similarly evolving as the banks themselves adapt to changing conditions. Latin America’s banks have largely straightforward capital structures, with common equity making up the bulk of their capital.

A layer of subordinated, tier two capital is common among the larger institutions. Just a few make use of hybrid capital securities – deeply subordinated instruments that count towards tier one capital but which are much cheaper than equity as they are accounted for as tax-deductible debt securities.

Mexico’s Banorte proved the point in July. Needing to raise capital to fill a gap depleted by acquisitions, the lender turned to the equity market. Conditions were not great, and it trimmed the size of the deal slightly. But still the bank raised nearly 32 billion pesos ($2.55 billion).

But, in recent years, banks have increasingly looked at capital instruments used abroad to strengthen their balance sheets while keeping costs down. Banco do Brasil grabbed attention in January 2012 with its radical hybrid tier one instrument, structured before the country cemented its rules under the incoming, global bank standards known as Basel III.

To increase the chances of the security counting as tier one capital under the new rules, the bank incorporated clauses allowing it to change the structure of the note, depending on the final shake-out of how Brazil implemented Basel III.

It was not the first time a Latin bank had looked creatively at the instruments it could use in its capital structure. Brazil’s Bradesco stands out. In 2002, it sold a ¥17.5 billion ($145 million) 10-year subordinated bond, picking yen because of a favorable swap. Wrapped with political risk insurance, covering the possibility that Bradesco would not be able to transfer funds or convert reais into yen to meet interest payments, the deal was priced 200 basis points inside the government curve.

Three years later, the bank was the first sub-investment grade borrower in LatAm to sell a perpetual note, a $300 million non-call five-year tier two.

Meanwhile, in 2007 BBVA Bancomer tapped euro investors for capital in a dual tranche deal that was another Latin first. The Mexican lender raised €600 million of tier two capital and $500 million of tier one paper.

The pace of subordinated debt issuance has picked up in recent years as Basel III rules on regulatory capital have developed. That bought lenders them some time to come to terms with new rules for bank capital – and now means there is likely to be a lull in the market.

"You saw quite a lot of Latin American banks, especially in Brazil, selling a lot of tier two bonds in the international markets," says Vikram Gandhi, senior capital structurer at BNP Paribas. "In Brazil there was a lot of tier two loading done as the provisional Basel rules came out. At the time when growth was strong, an efficient way to build up the capital structure was to issue tier two." LF

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