European Corporate Finance: Preparing for Life Under Basel III
Faced with reduced margins on loans and other core businesses as a result of the strict capital reserve requirements included in Basel III, European banks are conducting bottom-up reviews of how, when and with which clients they deploy balance sheets – a process that could have significant repercussions for corporate borrowers, according to the results of Greenwich Associates 2011 European Corporate Finance Study.
“Many of Europe’s large companies are cash rich and not in a hurry to make expansionary investments,” said Greenwich Associates consultant John Colon. “As a result, most companies to date have experienced little or no trouble in securing enough credit to meet their very moderate levels of demand. But there are signs that credit conditions are beginning to tighten in response to pressures facing the banks, and there is virtual certainty that bank lending practices will change substantially with Basel III and other new rules. We are advising our corporate research participants in Europe to act now to prepare for this new environment – even if their current credit needs are being fully met.”
Slack Corporate Demand for Credit
Large companies across Europe have been largely insulated from the tremors shaking European banks over the past 12 months. The reason: companies have had little demand for new capital due to uncertainty about future economic conditions and the fact that, since the global crisis, many companies have taken aggressive steps to ensure adequate supplies of cash and credit.
Approximately 85% of large European companies say their demand for funding for capital expenditures has remained unchanged from the relatively depressed levels of 2010. Comparable proportions of companies report no pickup in demand for financing for ongoing operations, acquisitions or structured finance. This lack of demand – coupled with relatively favourable credit conditions – kept companies at arm’s length from any funding disruptions throughout the simmering European sovereign debt crisis.
Coming Soon: Credit Haves and Have-nots
However, banks across the region are already reassessing the economics of corporate lending. Banks both small and large have begun segmenting their clients based on profitability – a measure that in itself is often a function of a bank’s ability to cross-sell additional products to its corporate borrowers. Because providers that hold spots as a company’s lead or number two bank are generally best positioned to cross-sell, many banks in the future will concentrate their resources on companies with which they hold these top roles. To that end, many banks are now in the process of grouping their clients into segments based on factors such as credit rating, current or potential profitability, and amounts of other business solicited from banks.
“We anticipate that over time these divisions will become evident among European companies,” said Greenwich Associates consultant Jan Lindemann. “At the very least we expect that companies will become bifurcated into one group of large companies whose relatively heavy use of advisory services, capital markets, treasury services, and other bank products make them ‘profitable’ enough to banks to warrant credit provision, and a group of less attractive companies that experience disruptions in existing lending relationships, less consistent access to credit in the future, and significantly higher prices.”
Market-based Funding
Over time, increases in credit pricing and more limited availability of bank credit under the new Basel III rules will force some large companies to diversify their funding bases by making more use of alternative forms of financing – particularly the debt capital markets. It should be noted that smaller companies, which form a vital backbone in many European economies, continue to rely on bilateral debt as access to capital markets is limited.
Overall, three-quarters of large European companies receive funding through bilateral bank loans. In comparison, only 56% employ syndicated loans and 49% tap debt capital markets for funds. Those funding practices are radically different than those employed by companies in the US, where three-quarters of large companies are active in debt capital markets, 79% receive syndicated loans and only 43% employ bilateral bank loans.
Corporate finance practices have diverged between the two regions largely due to the fact that Europe maintains a relatively large stratum of mid-tier banks that are active lenders at a national or regional level, both within and outside the eurozone. Unlike large global and pan-European banks, these mid-tier banks do not view corporate lending as a loss-leader. To the contrary, for most of Europe’s national banks, corporate lending is a primary source of revenues and profits, and the credit capacity they create allows large companies to fund the bulk of their operations with bilateral credit from long-time lenders.
However, new capital reserve requirements will have a dramatic impact on these mid-tier banks, eroding profits in a corporate lending business in which margins are already razor thin. “In the past credit crisis, when the global and pan-European banks were forced to retrench, European companies in need of credit were able to turn to national and regional banks that still had relatively strong credit ratings,” said Greenwich Associates consultant Dr Tobias Miarka. “It is unclear if the mid-tier banks would be able to step up in the same way under the new capital reserve rules. More generally, it is still an open question whether Europe’s smaller national and regional banks will be able to compete and survive as significant active lenders to large corporates under Basel III.”