Funding diversity – exploring the options

Banks in Asia-Pacific should make sure they are fully aware of the diverse wholesale funding options available in the wider capital markets which can fortify their resilience, bring down their funding costs and allow them to be more efficient with their regulatory capital and other prudential metrics.

Banks traditionally fund their operations from retail deposits and wholesale funding. The availability and cost of that funding can have a significant effect on a bank’s resilience.

The cost of funding retail deposits is relatively stable – it is effectively the rate the bank pays on the savings made by retail customers. The cost of wholesale funding, on the other hand, can be more volatile. Wholesale funding comprises a variety of elements, such as borrowing in the interbank market, a bank’s debt issuance programme or funding from its central bank.

Wholesale funding can also include so-called “secured” funding – covered bonds, securitisation and asset-backed commercial paper (ABCP) programmes. Secured funding can provide banks with additional dimensions to their funding.

Diversity and funding costs

First, secured wholesale funding allows banks to engage the capital markets far more widely than other types of wholesale funding. This gives banks access to a far more diversified investor base, increasing the suppleness of their funding. More engagement with the capital markets also helps take risk out of the banking sector, enhancing an economy’s financial stability.

Second, secured wholesale funding can provide cheaper funding costs. For instance, in the case of securitisation and covered bonds, the cost of funding is less than bank senior unsecured bonds (particularly so in the case of covered bonds), giving a significant economic upside to drawing funding from these markets. In the case of ABCP, while the yield may be marginally higher than a bank’s own commercial paper costs, many banks (such as those in the EU) can deploy highly calibrated regulatory capital models when they use ABCP programmes, allowing them to be more conservative with the application of their capital base, thereby reducing the cost of that capital base.

Third, bringing these two aspects together, secured wholesale funding allows for the funding profile of the bank to become smoother. The different sources of wholesale funding, whether secured or unsecured, are generally not correlated and diversification can help reduce the volatility of the overall funding cost to an average of the different sources from time to time. The same goes with respect to the availability of funding, which will vary in different markets at different times. The greater the access to a variety of funding sources, from different investors in different parts of the world, the more robustly a bank will be able to react to shocks.

Secured wholesale funding in Asia-Pacific

Secured funding, such as covered bonds, securitisation and ABCP, is very common in North America and Europe – nearly every bank will regularly access these markets. By contrast, in Asia-Pacific the picture is very fragmented. ABCP is virtually non-existent. In Japan, Australia and Korea you will find some banks raising funding through covered bonds and the largest banks in Singapore have covered bond programmes too. Securitisation is used in a very limited number of jurisdictions, such as India, Australia and Korea. On that front, however, one market has seen dramatic growth in the last five years –China. The Chinese securitisation market has grown to be the second largest in the world in a short period of time. However, there are no covered bonds in China.

A need for diversity

In the wake of the global financial crisis, the European Central Bank noted that banks which had the least diversified funding profiles suffered most. They proposed that banks should be supported by, not just one or two, but, three fully functioning legs – senior unsecured debt, covered bonds and securitisation. The Capital Markets Union project in the EU has continued to pursue this aim, with law and regulation being continually assessed and updated to stimulate these three market segments. Research undertaken by the IMF after the global financial crisis also showed that market-based economies, with diversified, deep capital markets funding a significant portion of the economy (eg, the United States), recovered far more quickly from financial shocks than bank-based economies, where banks predominantly provide private credit (eg, many southern European economies).

Clearly, bank lending alone is not able to provide an economy with the variety and depth of funding needed to rebound buoyantly and rapidly from financial stress.

Regional stresses

The Asian Development Bank reported in 2019 that there had been a decade of growth in non-performing loans across Asia. In April 2020, S&P said “The economic storm created by COVID-19 will test the ratings resilience of the region's twenty banking sectors… We estimate an additional US$300 billion spike in lenders' credit costs and a US$600 billion increase in nonperforming [loans] in 2020.”

In these market circumstances, it may prove particularly difficult for banks to raise new funding for lending to help economies recover. The reality is that economies with fragmented and underdeveloped capital markets will probably struggle to emerge from the current economic downturn, and will emerge far more slowly, when compared to other economies with better diversified funding structures.

With looming stress on the horizon, options for strengthening bank resilience in Asia-Pacific should be at the top of the economic policy agenda. Making use, or even better use, of secured wholesale funding markets will be instrumental to this.

Covered bonds

Covered bonds allow banks to engage the capital markets in a hybrid fashion – they provide investors with dual recourse, being recourse both to the issuing bank itself and a ring-fenced pool of assets identified by the bank. The ring-fencing operates so that the assets are available only to the investors in the bonds, even if the bank later becomes insolvent. Covered bonds have lower yields than senior unsecured bank bonds because of this dual-recourse feature.
The assets which banks traditionally fund with covered bonds include residential mortgages and public sector projects. There are, however, discussions in the market about other types being included, such as SME loans.

Securitisation

Securitisation moves the risk of bank originated assets into the capital markets and provides banks with cash to engage in new lending. Bank assets commonly used in securitisation include residential mortgages, corporate loans, credit cards, auto-loans, SME loans and commercial mortgages.

ABCP

ABCP programmes connect investors like money market funds and pension funds with short-term assets, such as trade receivables, credit cards and auto-loans. ABCP programmes tend to be “fully supported” by banks, that is to say that the bank will pay out under the commercial paper irrespective of how the underlying assets perform. While structured differently to covered bonds, they provide a similar dual-recourse to investors, but on a very short term basis. For instance, ABCP tends to mature within 30 to 60 days, in contrast to covered bonds which may have maturities of a number of years.

Small structural shifts, burly benefits

The EU Capital Markets Union project is a good example of how relatively small adjustments in the structure of markets can bring significant benefits to wholesale funding markets and result in an increase in financial stability. For instance, allowing covered bonds and securitisations to be used in central bank funding schemes and allowing covered bonds and securitisations to count as “liquid assets” in liquidity ratios encourages banks to use these funding tools. Elaborating on rules for “significant risk transfer”, contemplated by the Basel framework, will provide more clarity to banks seeking to use securitisation and putting in place a framework for simple, transparent and standardised securitisation as well as high quality covered bonds, which benefit from lower risk-weightings, can also motivate banks to open themselves far more broadly to the capital markets.

Central banks and regulators in Asia-Pacific should take note of how small structural changes like these can bring significant benefits to bank resilience and financial stability. Banks in Asia-Pacific should make sure they are fully aware of the diverse wholesale funding options available in the wider capital markets which can not only fortify their resilience, but also bring down their funding costs and allow them to be more efficient with their regulatory capital and other prudential metrics.