CLIPPING THEIR WINGS
With their enormous balance sheets, universal banks can rake in fee business tied to cheap loans. Smaller banks and investment houses can't compete, and CFOs will feel the pinch via rising capital costs.
By Jasper Moiseiwitsch

In 2000, the usual names led Asian international bond issuance: JP Morgan, Morgan Stanley, Lehman Brothers and Merrill Lynch held the top four slots for deal volume in G3-currency bonds.

In 2002, Morgan Stanley retained its number one position, but the other three slots belonged to universal banks. Citigroup, DeutscheBank and Barclays Capital now dominate international bond league tables much in the way they dominate Asian loan markets and many areas of corporate finance activity. These banks have one thing in common: balance-sheet mass and a willingness to use it. And the investment banks complain bitterly that the universals are buying market share at their expense.

The merging of commercial and investment banks into the so-called universal institutions has stirred concerns that these houses use their cheap bank-deposit dollars to buy their way into investment banking deals. It seems wrong to complain. CFOs' longstanding grievance against banks is that they don't risk their own money in transactions. Banks pester companies to do deals but, if the fundraising goes badly, it is the company not the bank that suffers. If banks are willing to invest directly in companies, so much the better.

But there are already signs that the rise of the universal banks is following in the wake of the exit of dozens of smaller institutions from Asia. This decline in the number of banks will, eventually, mean an increase in the cost of capital for Asian companies. So far that effect is most apparent in loan markets, where syndicates have been winnowing out all but the biggest relationship lenders, and lending margins have started to tighten.

"There is going to be a continued consolidation in Asian banking. So there is cheap money today, but I'm not sure about a number of years down the road," says Diane Lam, Standard & Poor's Hong Kong-based director of structured finance ratings.

Rising Ties

On September 19, 2002, the Korea Development Bank signed a one-year US$400 million loan. Nothing unusual about that - the Korean banks have been some of the few active dealmakers in the region of late. But the deal terms were unusual. The mandated arrangers - ABN AMRO, Barclays Capital, Deutsche Bank and Bank of Tokyo Mitsubishi - offered KDB an exceptionally generous lending rate of 10bp over Libor. By any standard this is cheap money for a one-year maturity. For comparison banks are offering Swire Pacific one-year money at around 30 bp over Libor. Moody's rates the Hong Kong blue chip and KDB at A3.

Two months later, three of those banks were involved in a pair of KDB bond issues. On November 13, KDB closed a US$300 million bond and a US$450 million bond. Barclays Capital acted as a bookrunner for both issues, and ABN AMRO and Deutsche likewise co-managed the deals.

Few will be shocked to read that banks use cheap loans to win other banking business. Certainly the cut-rate loans that have been extended to the Korean banks over recent years, many of which were swiftly followed by bond deals involving the same lending institutions, point to that trend.

What has changed is American regulators' appetite for hemming in such activity. Under a US law called the Bank Holding Company Act Amendments (1970), it is illegal for banks to tie loans to other forms of banking business, be it bond deals, cash management or custody. The law has been lightly enforced and, until now, has been mostly applied to the consumer-banking sector.

But American regulators started getting concerned about loan tying in the corporate market following the repeal in 1999 of the Glass-Steagal Act, which had separated commercial and investment banking activities. The death of Glass-Steagal gave rise to banking conglomerates such as Citigroup, which has been happily leveraging its extensive relationships in Asia to drive its regional fixed-income business ever since.

The Securities and Exchange Commission chief William Donaldson swore to stamp out tying during Senate hearings that confirmed his selection to the SEC. During those hearings, Donaldson said loan tying "rivals the use of research to be a handmaiden to investment banking and the securities industry". Given the fits the US regulators have been having about securities research in recent years, that is a serious charge. Donaldson has been joined by National Association of Securities Dealers and the General Accounting Office - the investigative arm of Congress - in his examination of the practice.

They have much to look at. A survey conducted by the Association for Financial Professionals of large (US$1 billion plus in annual revenue) American companies found that 56 percent of such firms were refused a loan, or found their lending terms changed, because the company did not promise to do other deals with a bank.

In Asia, bankers freely admit that they do relationship lending, or what amounts to loan tying of an implicit, non-contractual variety. Mohsin Nathani, Hong Kong-based head of global loan products Asia Pacific for Citigroup, says his bank loses money on its loans, but recoups its capital from other business spun out of the lending process. "We don't care [what business we capture through lending] as long as the relationship return is adequate," says Nathani. "Whether they [companies] buy a bond or an M&A service or a custodial service ... as long as the required return from the relationship based on the capital used is in line with our own returns."

This underlines a basic difference between the universal banks and the pure investment banks. The universals look carefully at their returns on capital. So do the investment banks, but they are more professional services operations that look at their returns on a cost base (45-50 percent of an investment bank's revenues will go on salaries, for example, which is much more than the commercial houses).

The universal banks can take a view on how a relationship loan will boost their total returns on capital extended to a given client, whereas an investment bank will be more interested in how the fees on a given deal will cover the costs of a particular department. And when the universal banks cross-subsidize their fee business with relationship loans, the investment banks see that their fee structures are getting knocked out of whack, and they get upset.

One increasingly popular technique used by universals in Asia to lower fees and snatch business is to create curious special purpose entities (SPEs) called conduits. Conduits allow them to take risky assets off their books and create capital against them. The proceeds from this activity are lucrative enough to allow them to charge less for the loans in the first place.

The irony of all this, of course, is that the US regulators recent obsession with tying seeks to protect that class of institution that has been so vilified by US authorities of late: the stand-alone investment banks. Morgan Stanley, Merrill Lynch, Lehman Brothers et al are the most threatened by the universals, and would benefit most by action against the universals' loan tying.

The Thin Green Line

Most CFOs are comfortable with loan tying to the extent that it lowers their cost of capital. Bankers go as far as to say that CFOs exert the most pressure for loan tying: they demand cheap loans as a reward for provision of fee-based business. "Corporate treasurers often make it clear when awarding ancillary business that they will favor those banks that make credit available," says Philip Cracknell, global head of loan syndications at Standard Chartered.

But those CFOs that take relationship loans come into these deals with a keen sense of obligation. CFOs know they have to manage their bankers' expectations of upcoming business with some delicacy.

"Most banks, if not all, will know how much in total they make from the relationship, and what that represents on a return percentage basis," says Nicholas Sims, CFO of Hong Kong-based shipping company Orient Overseas International. "If you are already dispersing your wallet on an equitable basis, the recipients are able to be a little kinder in their lending margin, because of course they have an additional and alternative source of income from that relationship."

Sims, a former HSBC banker who knows exactly how the banks operate, describes an ongoing trade-off between banks' lending and his company's mandating of fee-based business, with the tying between lending and mandating being "something that goes on tacitly, implicitly. There is a fine line at the limit at which integrity stops. It's a very, very fine line."

The fine line is the degree of explicitness in the tie between the loan and the deals that may follow. Bankers may not overtly tie cheap loan capital to other business, but they do make detailed calculations on the dollar value of the recurring revenue they earn from a given corporate client. They compute their loan discount accordingly to a precise dollar estimate of what their future business is worth and, after granting a cheap relationship loan, they beat that CFO up to get what they believe is their rightful share of upcoming business.

There is also an ethical fine line on the CFO side. Management has a duty to shareholders to maximize company returns. But if they engage in a complex bartering with their bankers of trading loans for fee business, then that process loses transparency. When CFOs are making a decision about the allocation of a given piece of fee business, the decision won't be based on straightforward criteria such as pricing and execution - it will be a hazy estimation of how much that CFO "owes" his relationship bankers, and what that means in terms of his mandating.

The result could be disastrous. For example, the relationship discount to a loan would be measured in basis points. But the difference between good and bad execution on a bond deal, for instance, would be measured in percentage points. The universal banks claim superiority in commerical banking and a host of fee-based businesses but they don't necessarily have the distribution or markets expertise of the pure investment houses. So, a CFO might favor a universal bank, for example, for an IPO mandate in return for a cheap bridge loan. But if that bank fouls up the listing, or just does a poor job relative to how an investment bank would have handled it, then that CFO has grossly misserved his company.

Universal Gain

The American anti-tying laws do not apply to the activities of the non-US banks in Asia, and the US banks in Asia are careful not to explicitly tie their relationship loans to future business. US regulators, consumed by reform in their home market, don't seem concerned about what's happening with tying in Asia.

Nevertheless, the US regulators' general charge, that loan tying is anti-competitive, has resonance over here.

Regional universals such as HSBC and Standard Chartered have always commanded large slices of the corporate market. What's changed in Asia is that three years of lousy capital markets have put the emphasis back on lending. Asia's loan volumes in 2002 surpassed volumes of equity and equity-linked issuance combined, and corporate loan volume is higher than corporate bond issuance. This has given the advantage back to the universal banks thanks to their grander balance sheets, wider branch presence and more numerous relationships.

What's followed is a rise in the league tables for the universals at the expense of the stand-alone investment banks, and a thinning out of loan syndicates of the pure (non-relationship) lenders. What this suggests is that universal banks have been able to take advantage of current markets to secure a relationship gain from their lending.

Basle requirements that demand a higher risk weighting for companies compared to sovereigns have led to a tendency among the stand-alone banks to restrict their lending to sovereign or OECD corporate names. It is left to the universals, which can cross-sell against their lending, to absorb capacity in the Asian corporate market.

How Long Will It Last?

Syndicate numbers are running down because the returns on the deals standing alone are very poor. And the banks that cannot exploit a relationship angle have noted they get much better yields in the bonds and credit derivatives markets. In Hong Kong the average spread for high-yield lending can be as low as 120-150bp, compared to 350-400bp for similarly rated credits in the US.

"People are much more aware of discrepancies in the value of the assets that they hold on their commercial loan books and the available assets they can purchase in the secondary market. So, if you put the relationship issues aside, there is pretty much no rationale for holding onto a loan at a price that may be 100-200bp from what you can pick up [in the bond or derivatives market]," says John Flint, HSBC's head of regional fixed income and derivatives trading.

Across the region, the universal institutions HSBC, Citigroup and Standard Chartered have increasingly dominated loans markets, with ABN AMRO, BNP and Barclays taking up much of the remaining slack.

The stand-alone investment banks don't have access to a commercial bank's mass of deposits to lend from, and tend to take a much keener look at their returns on equity. UBS, which does have a massive balance sheet, has nevertheless become increasingly selective about its lending in the region. Even Deutsche, a universal, is rumored to be scaling down its lending in Asia as it comes under pressure in its domestic German market.

"The big banks are trying to get out of the lending business, and have been for a number of years," says Piers Hartland-Swann, the managing director of Stockbridge Consulting. "For example, UBS and banks such as Deutsche, which have been big syndicated lenders in the past, these days are much pickier about the type of lending that they do - there is a much greater focus on return on capital, even for relationship loans."

"There are fewer banks, fewer lenders and smaller deals [than before]," complains Ramon Opulencia, the senior assistant treasurer at Manila-based Ayala Corp.

The Gangs of Basle

Nevertheless, banks seem to picking up their relationship lending to the best and fattest companies, and the investment banks will come under increasing pressure to lend money the way the universals do. In January, Goldman Sachs announced a US$1.27 billion investment in Japanese bank Sumitomo Mitsui, a fixture in regional loan markets, and the deal is likely to boost Goldman Sachs' relationship business in Asia.

But bankers have also become increasingly wary of lending risk and, when they don't see a relationship advantage, they will price loans accordingly. An ongoing Asian recession has sharpened everyone's sense of the effect of a business or ratings downgrade, and the short slippery slide of the Aholds, Enrons and Worldcoms of the world from investment-grade status to massive credit default. In Asia, a three-year collapse of equity markets is making its impact on corporate capital structures, which has severely crimped capacity for debt. Companies have seen their market cap slide by 90-plus percent through this recession, and these companies now borrow on dearer terms.

"When you've got a market cap of US$5 billion, then US$1.5 billion in debt is perfectly manageable. But when your market cap has fallen to US$500 million, that amount of debt starts to cause sweaty palms, particularly for the bankers - there is isn't the same equity cushion if the borrower gets into trouble," says Hartland-Swann of Stockbridge Consulting.

There are regulatory considerations, too. Following implementation of Basle II's capital requirements in 2006, banks will have to risk weight their entire portfolio, a de facto marking to the market of their loan books. While the higher rated credits will require less capital allocation, the banks that lend to the more marginal credits will have to allocate more capital for these loans, which will reduce overall capacity and raise margins.

To the extent that Asian corporate finance has revolved around loan markets, regional treasurers will increasingly find themselves in one of two camps: the creditworthy, and the credit-damned; the companies that can lever ancillary business considerations into loan pricing, and those that can't. The lesser credits and the smaller companies may soon find their cost of funds taking a steep rise upwards, which would confirm many bankers' views that margins are showing signs of swinging back up. Add to that mix banks' rising capital reserve requirements and the ongoing consolidation in Asian loan markets, and the outcome could be that CFOs soon find that today's cheap-debt party becomes tomorrow's funding headache.