U.K. Banks Prefer Bond Buybacks
09/21/2012| 06:06am US/Eastern
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LONDON--Flush with cash but wary of making any more bad loans, U.K. banks are buying back their own bonds, potentially reinforcing criticism that they aren't doing enough to help the economy out of recession.
Lloyds Banking Group PLC (>> Lloyds Banking Group PLC) this week offered to repurchase up to GBP10 billion in senior debt, adding to a GBP4.6 billion transaction in July. Barclays PLC (>> Barclays PLC) on Monday said it had agreed to pay around GBP1.8 billion to repurchase bonds, while Royal Bank of Scotland Group PLC (>> Royal Bank of Scotland Group plc) completed a GBP4.15 billion deal.
All three banks have cash to spare, after shoring up liquidity this year to withstand the euro-zone crisis and downgrades to their credit ratings. Politicians and the Bank of England want the country's banks to jumpstart the economy and make more loans to households and businesses, but lenders say they are doing what they can and that there aren't enough credit-worthy customers. New loans also mean setting aside capital to cover potential losses.
Bond buybacks have looked like a better option. Even after paying a premium to entice investors, banks can improve their profitability by getting rid of the relatively-expensive funding, and also cut the size of their future interest-rate bills. Analysts say the deals demonstrate how far the U.K. banking sector has come since 2008, when a dearth of capital pushed RBS and Lloyds into state hands and Barclays raised emergency funds.
"Banks are showing their rude health and the strength of their liquidity positions," said Michael Symonds, a credit analyst at Daiwa Securities. "They could make loans to the real economy but here banks see real risks if they look at the uncertain economic outlook and the capital expense with granting a new loan."
In addition to the pressures of a weak economy, U.K. banks are in a hard, long slog to adapt to an array of business and regulatory pressures. Lloyds and RBS in particular are unloading hundreds of billions of pounds in unwanted assets from their balance sheets to repair their businesses. Both banks took large state bail-outs in 2008 and 2009 that still haven't been repaid.
Those rescues had in part been necessary because the two banks had far more short-term wholesale funding, or borrowings from other banks, than liquid assets such as cash and government bonds. When markets seized up in 2008, they couldn't keep funding themselves. Now, liquidity far outstrips short-term debt at RBS and Lloyds, as well as Barclays.
The downside is it can actually cost money to keep so much cash on hand because of eroding inflation. The banks have to rationalize how much they actually need to hold, now that the euro zone's problems may have calmed down.
"Liquidity comes at a cost. Using some of it buy back some of your more expensive debt boosts your margin," said James Longsdon, a managing director of financial institutions at Fitch Ratings.
Getting rid of expensive funding helps to flatter banks' net interest margin, a measure of the difference between the interest banks make as lenders and the interest they pay as borrowers. Those margins are in decline in the U.K. because a lack of customer demand and ongoing low interest rates are constraining lending profits. Any improvement in borrowing costs helps, and banks regularly undertake such "liability management exercises' with their debt.
The recent bond purchases are unusual because they involve senior bonds that trade at face value or higher. The same banks and many others in Europe have bought back their riskier junior bonds at big discounts to face value, a practice that allows them to book gains and boost capital reserves.
Meanwhile, the government is continuing to take steps to try and get banks to lend more. RBS, Lloyds and Barclays have all tapped a "Funding for Lending" program started in August that effectively lets banks turn portfolios of business and mortgage loans into cash from the Bank of England. The more banks lend, the less they pay to borrow the money.
Analysts and people at the banks say what is really needed to stimulate growth is a relaxation in capital standards, though that would go against rules being put in place by international regulators. Every time a bank makes a loan, it has to hold capital against it.
According to the Bank of England's latest quarterly lending survey, net business lending by banks is in negative territory. RBS Chief Executive Stephen Hester in August said his bank is "trying to lend as much as it prudently can." Lloyds CEO Antonio Horta-Osorio told executives in Scotland earlier this month that its net lending to small and medium sized businesses rose 4% in the past year as the market shrank by the same amount.
Barclays said SMEs can borrow at the cheapest costs seen since 1987, and that the new Funding for Lending scheme is also pushing down rates.
The BoE and the Treasury declined to comment on banks' recent bond purchases. The pressure to lend also goes against a concurrent move by the government to make the country's financial system smaller and safer. A banking reform bill that among other things will aim to separate retail and investment banking activities is to be presented in parliament in January.
"There is a paradox that on one side U.K. banks are being encouraged to make their balance sheets smaller and to comply with all the new rules. At the same time the government wants lending and spending to go up," said Bill Michael, U.K. head of financial services at KPMG.
-Write to Margot Patrick at margot.patrick@dowjones.com
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