Greg Sadler, Financials Credit Trader at CQS, sees opportunity in European banking complexity.
CQS: Bank capital securities have less risk than reputation suggests
Writing in the hedge fund’s CQS Strategy Perspectives letter sent to investors, a copy of which was reviewed by ValueWalk, Sadler draws the conclusion that bank capital securities have really less risk than their reputation suggests and that complexity has created wide relative value trading spreads.
Prior to 2007, Sadler notes, bank capital securities were seen as a low risk, low volatility asset class, “which enjoyed implicit government support but offered low yields.” Then losses arising from “massive leverage” and non-core risk-taking changed perception with the financial crisis of 2008.
“From being too big to fail, the industry nearly became too big to save,” Sadler observes. He notes regulators now wish to ensure the banking industry has not only enough, but also the right kind of capital to safeguard the interests of its stakeholders.
“From a regulatory viewpoint, the system needed to change and since the (financial) crisis, wide-ranging, radical changes have been made,” he wrote. Despite these changes and recent strong performance, banks and financials are still considered a risky asset class, “a legacy of the errors of the past,” Sadler says.
CQS: Regulators have many tools to keep banks safe
Sadler is bullish on the banks and notes regulators have many tools at their disposal to keep banks safe, including tougher capital rules targeting leverage and liquidity ratios, and a new bail-in framework. “As a result,banks are better capitalized than ever before and the capital build will likely continue for the next five years as banks comply with the incoming regulations.”
One area Sadler cites is the complexity in new bank capital requirements, an area that brought stronger more protective rules, he believes. Another area is the quality of asset management, he says. The European Central Bank’s (ECB) Asset Quality Review (AQR) has driven the bank capital building process over the last year in a positive direction. “Since spring 2013, when the stress tests were announced, €45bn5 of equity has been raised and other measures have been taken, such as asset sales and increased provisions, which would not have happened without the AQR.”
Senior bank debt remains negative: CQS
Another point Sadler touches is the issuance of senior bank debt, which he says has been negative by about €150bn per annum. “The volume of maturing bonds has far outstripped new issuance.” In similar fashion, outstanding subordinated bank debt peaked in 2008 at €750bn and subsequently fell by 50% by 2012. “The supply side of the equation has been restricted, but the capital available to invest in these securities has increased steadily in each of the last seven years. This has been one of the key drivers of spread compression.”
Sadler concludes that bank capital ratios are improving and will continue to trend in this direction, driven by greater capital requirements and better capitalization. To meet more stringent regulation, complexity is creating opportunity. “In this environment, we believe relative value anomalies within the bank capital space are as exciting as they have ever been.”