It has been a topsy-turvy year for Italian assets – shunned by international investors, still popular at home – and other aspects of the derivatives markets are also being shaken up. Pricing practices are changing, with credit and funding costs coming to the fore, and central clearing is on its way
Along with liberal helpings of hardship and anxiety, the eurozone debt crisis has also produced moments of dark irony. It was investor aversion to peripheral government bonds that drove up funding costs for the banks holding them – now, in an attempt to deal with the resulting margin compression, Italian banks are turning to the very assets that caused their problems in the first place, dealers say. That means buying higher-yielding Italian sovereign bonds – which have a low risk weighting and therefore consume less capital – or, in some cases, selling protection on them.
“To boost their net interest margin in this low rate environment – while minimising capital absorption and risk weighting – Italian banks have been buying Italian government bonds and credit risk. Banks are familiar with this risk and are confident of its creditworthiness,” says Matteo Ferrario, head of distribution for Italy and Greece with Barclays Capital in London.
Yields on Italian 10-year bonds are now higher than they were during the eurozone crisis - trading at 4.4% on December 2 - well above the 2.8% that could be earned on German bonds on the same date. Of course, chasing yield isn’t usually a smart strategy, but Vincenzo Corsello, head of the institutional client group Italy with Deutsche Bank in London, says domestic investors generally feel Italian assets are viewed too negatively by the wider market.
“It’s important to highlight that the Italian sovereign risk is perceived as lower by local investors than by the international community. This is due to a better knowledge of very peculiar drivers of Italian gross domestic product, such as the private sector saving rate, the current account situation and the amount of the total output represented by the black economy,” he says.
Exposure relative to capital
As of August 2010, according to an Organisation for Economic Co-operation and Development report, Italian banks had a total of €144.9 billion in exposure to their domestic sovereign debt – equal to 157% of the sector’s tier one capital. Of the peripheral banking sectors, only Greek banks have a higher exposure relative to capital – 226% - while Spanish and Portuguese banks have 113% and 69%, respectively.
Italian banks haven’t been alone in buying domestic assets: dealers say they’ve also seen strong demand from insurers and pension funds, which are also convinced the relatively high yields on domestic assets are an opportunity rather than a threat: “All these types of clients that were searching for yield considered Italian government bond risk a fair bet, considering the return that was offered. They did not believe in any extreme loss scenario,” says Roberto Pecora, head of sales in the cross-asset solutions group with Société Générale in Milan.
The bond-buying trend has had knock-on effects for other asset classes, he says: “The main question that institutional clients asked themselves during 2010 was: ‘why should I invest in equity and endure the very high volatility of that market, when I can earn 150-200 basis points above the risk-free rate by investing in Italian government bonds?’ In terms of new investment, both institutional and retail clients showed risk aversion to increasing their equity linked portfolio, preferring fixed income investments.”
Institutional investors’ search for yield hasn’t been confined to domestic opportunities, however. According to Gianluca Cugno, head of capital markets at Banca IMI in Milan, “Since the beginning of this year there has been a huge amount of money invested in high-yield instruments. In the first place, high-yield emerging market bonds and loans, and then, with a relatively lower appetite, the European sovereign bonds, including Italian bonds.”
Despite the wild ride that Italian assets have been on, there has been little change in this year’s Risk Italia rankings – the top four positions remain the same. JP Morgan retains top spot with 13% of the vote, after winning three of the overall categories; BNP Paribas is a narrow second with 12.8% and two top spots in the overall categories. Barclays Capital and Société Générale finished third and fourth, respectively. The only new entrant in this year’s top five is Italy’s Banca IMI, which jumped from seventh place last year.
Dealers say that investors’ somewhat bolstered risk appetite has encouraged fiercer competition for client business – and there’s some disagreement about the tactics being used to win business. As a rule, wider post-crisis credit spreads and a keener awareness of counterparty risk has encouraged dealers to include a bigger credit charge in their derivatives prices up-front – in many cases, it is seen as a way of paying for the position to be risk-managed when it’s on the books and is calculated, in part, by referring to credit default swap spreads. Every bank approaches it slightly differently, however – by taking into account offsetting trades in other books, or even anticipating future offsets, for example. As a result, dealers often complain that some competitors are turning a blind eye to credit when pricing new trades.
“There are some international players out there, including Italian banks, that seem to be taking some heat, from what we can see, in terms of credit charges, but they would rather take it and try to buy market share, and just lend to the market. But among the most established players, I can tell you that credit charges are reasonably priced in the same way, among different players,” says Cristiano Committeri, head of flow at BNP Paribas in London.
Others echo the latter point: “Perhaps in 2009, some banks may have had a competitive advantage on that front but, as time goes by, most of the international banks are looking at risk and counterparty credit risk in pretty much the same way,” says Francesco Lavatelli, co-head of financial institutions derivatives marketing with JP Morgan in London. “More than anything, we have observed a compression in actual bid/offer spreads, especially in vanilla products, rather than competition on credit charges.”
In an attempt to mitigate these charges, some clients have been happy to sign the credit support annex (CSA) to standard derivatives documentation, which enables both sides in a bilateral trade to post collateral to each other – and these agreements also have a significant impact on dealers’ funding requirements.
If a trade is conducted using a two-way CSA, and the mark-to-market value shifts against the dealer, it will need to rustle up collateral to post – but if the dealer has hedged by putting on a second, offsetting, trade it should be receiving collateral from its hedge counterparty at the same time as it coughs up collateral in the original transaction. The net result is a trade with low counterparty risk, low capital requirements and little, if any, additional funding required. But these dynamics break down where there is no CSA or in cases where the CSA requires only the dealer to post collateral – in which case the counterparty could be hit with both credit and funding costs.
The result is that clients that haven’t used CSAs this year have either traded less or have had to pay more, says Barclays Capital’s Ferrario: “We have been forced to price and charge funding costs in non-collateralised transactions because, in the event that the corporate or other client owed us money but didn’t post collateral, we would have owed money on our hedges to the hedging counterparty, and would have had to post collateral, creating a liquidity gap.”
In this environment, clients have been looking harder at how to weigh up pricing across their dealers, and have been looking for ways to reduce the costs they face. This hasn’t necessarily helped dealers. “In a situation where credit and funding charges have increased enormously, unsophisticated clients – rather than doing the right thing and signing a CSA to minimise those charges – have been able to cherry-pick which counterparty to trade with, depending on whether the trade had positive or negative funding implications, and choosing banks that were more or less sophisticated with regards to their approach to funding and credit charges,” says Ferrario.
New pricing practices
New pricing practices are not an issue specific to Italy – but the wave of municipal derivatives mis-selling complaints that has been sweeping the country is a more local phenomenon. Towns and cities from Milan down are up in arms about the payoff profiles on trades, which – in many cases – have been restructured multiple times already. Inevitably, the bad publicity has spilled over, creating broader scepticism about complex products.
“There are other client segments that have stepped away from all the non-liquid or complex business, namely public pension funds, which have dramatically reduced their activity in everything that was structured and complex,” says BNP Paribas’ Committeri.
Separately, as a member of the Group of 20 nations, Italy is committed to centrally clearing all over-the-counter derivatives by the end of 2012. Big dealers already clear a large portion of their interbank activity in the rates and credit space, but many buy-side firms will also be required to use clearers – and will have to access this service through their dealers. Progress on this front has been sluggish, but in September this year MPS Capital Services, a subsidiary of Banca Monte dei Paschi di Siena, became the first firm globally to start full-scale client clearing. Barclays Capital is the primary clearing broker for MPS’s interest rate swap transactions, which will be cleared through LCH.Clearnet.
“We put a lot of effort and months of work into that,” comments Barclays Capital’s Ferrario. “The agreement includes the backloading of a significant portion of MPS’s historical interest rate swap transactions, which is a first for client clearing. The good relationship and dialogue that we have with MPS Capital Services allowed us to get that first clearing agreement.”
It remains to be seen whether this will inspire other clients to follow suit – in the near term, at least. “It’s not about whether people are receptive or not - if you meet their CEOs and CFO’s face to face of course they are – but then to actually get it done is a totally different matter,” says Ferrario.
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Topics: Risk Italia, Italy, JP Morgan Chase, BNP Paribas, Banca Nazionale del Lavoro (BNL), Barclays Capital, Société Générale (SG), Banca IMI, Deutsche Bank, Goldman Sachs, Citi, Sovereign bonds, Counterparty credit risk, Credit support annex (CSA), Credit valuation adjustment (CVA), Collateral, UniCredit, mediobanca
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