Santander delivers a shock

The additional tier 1 (AT1) market for bonds is a relatively new addition into the world of finance. They are a mix between debt and equity, essentially meaning that when a bank’s capital ratio falls below a certain level, the AT1 bonds are converted to equity, or shares in the bank. They were introduced by regulators during the 2008 financial crisis, where worries about both banks’ solvency and liquidity brought the global financial system to its knees [1]. So far, coverage on them has been limited, given that fortunately we have yet to see another major event of the same proportions as the financial crisis. However, last week we saw a relatively unusual event, that had not been seen since more than a decade ago.

The first thing to note is that these AT1 bonds have perpetual maturity; in essence, there is no “maturity date” for these bonds so a sum needs to be paid each year, in theory, in perpetuity, unless the bank pays the whole amount in advance. However, a convention is in place whereby investors in these bonds acknowledge that they will be repaid at the earliest possible date, usually around 5 years after the bond has been sold [2]. However, last week Santander opted to roll over an AT1 bond, which is highly unusual given what has been happening for the past 10 years [3]. The news spooked investors in Santander as they sent Santander’s share price falling lower on Wednesday morning. While the decision makes sense for Santander for purely economical reasons, it jeopardises the global AT1 market as investors no longer can claim almost absolute certainty that these bonds will be called on their redemption date. The bond in question’s value fell two percent rapidly following the news, falling to 96.75 cents on the euro.

Moreso, the news sparks fear in some investors that banks are hoarding capital for longer durations due to falling liquidity. In addition, given that the assets and liabilities of investment banks, being so complex and interconnected, are very difficult to value (let alone quickly in a financial crisis), it is very difficult to determine if a bank is solvent in the event of a financial crisis. Given that Santander is such a large and systemically important bank in the financial system, concerns surrounding it inevitably turn to concerns regarding the financial system as a whole. Since the market for complex financial instruments may only have a few financial institutions in it to begin with, many of the assets and liabilities of major banks are interconnected. Hence concerns understandably amplify, explaining the decline in Santander’s share price but also explaining broader investor uncertainty, especially since we are a decade off the financial crisis and a recession is expected in major economies in the next few years, with Italy already having fallen into one [4].

Overall, then, this case represents an example of why always going for the most purely economical option may not always be the best thing to do for a firm. In their actions Santander upset global investors and, significantly, the AT1 bond market, as yields rose on AT1 debt with falling investor confidence in banks’ ability to repay. While the financial system in at least developed countries is in theory much safer (with more stringent capital requirements), the ability of financial institutions to create complex and murky assets knows no bounds. Given this, valuation of these is inevitably going to prove difficult and so caution still needs to be taken with regards to how banks finance themselves. The AT1 debt instruments were a noticeable step forward in handling this but it also goes to show how quickly the market for these sorts of instruments can change, even in seemingly calm conditions.

In future, given that it seems Santander has no actual issue with paying off their debt the impact of this news will be muted. However, whatever reaction there has been will prove an additional disincentive for other banks to undergo similar kinds of action, for fear of not only unsettling their own investor base but also unsettling the market for AT1 (or CoCo) debt instruments. The news enhances Santander’s own reputation for ruthless frugality but they may indeed regret the move in future.

Bibliography

[1] Euromoney. (2018). AT1 capital/CoCo bonds: what you should know. [online] Available at: https://www.euromoney.com/article/b12kqjlwvsz26k/at1-capitalcoco-bonds-what-you-should-know [Accessed 15 Feb. 2019].

[2] Ft.com. (2019). Santander shocks market with bond decision | Financial Times. [online] Available at: https://www.ft.com/content/8539f7b4-2ad9-11e9-a5ab-ff8ef2b976c7 [Accessed 15 Feb. 2019].

[3] Bloomberg.com. (2019). Santander’s CoCo Bond Creates All Kinds of Trouble. [online] Available at: https://www.bloomberg.com/opinion/articles/2019-02-13/santander-s-coco-creates-all-kinds-of-trouble [Accessed 15 Feb. 2019].

[4] BBC News. (2019). Italy in recession amid sluggish eurozone. [online] Available at: https://www.bbc.co.uk/news/business-47068401 [Accessed 15 Feb. 2019].

This article, along with others from my peers, is on the LSE Business and Finance Guild website.

Could globalisation bring developing countries and their financial systems to their knees?

PHOTO CREDITS: Dieu-Donné GameliPhoto licensed under the Creative Commons Attribution-Share Alike 3.0 Unported license.

If one was to rank recent economic issues by the division and depth of debate they cause, globalisation would surely be up there at the top. Whilst the Republican presidential nominee Donald Trump, amongst others, has spearheaded efforts to thwart the rise of globalisation, liberals around the world argue that the increasing interconnectedness and interdependence of our world today can only be a good thing. However, the actual answer to the question of the impacts of globalisation is not so clear-cut; if any answer exists at all, it would lie firmly in the grey area. But what is globalisation? In essence, globalisation is the process by which economies around the world become more closely and deeply integrated with one another. In a way, it can be thought of as a border-killer, bringing countries that are physically thousands of miles apart firmly together,. Is this desirable, though? A point frequently made is that the effects of the 2008 financial crisis in developing markets were magnified to a great degree by the increased integration between the financial systems of different countries, and without this, the effects would have been far more localised to developed markets. Is this true? Perhaps, although it has to be said that those who use this point as a catch-all of sorts are perhaps not thinking broadly enough. In this article, we can begin by analysing the effect globalisation has on the financial system of developing economies in the context of regulation.

One way in which globalisation has impacted the global economy is an increase in the velocity of international capital flows. While this can entail an increase in money put in to financial markets in developing countries, what it can also do is facilitate an increase in capital flows out of these developing markets, resulting in an increase in uncertainty and volatility in their financial markets. A direct impact of this is that a shock in one country that, at first glance, wouldn’t affect the developing market too much, could result in irrational behaviour and herd mentality driving money out of developing capital markets in bucketloads. The control that these countries so desperately need over their own destiny, is as a result forfeited to a degree due to globalised economic activity; a small shock in the United States could result in large percentage swings in some African markets, for example. This drives away the certainty needed for a long-term sustainable financial system to develop; in this way, it could be argued that the increase in the velocity of cross-country cash flows could actually serve to the detriment of developing economies.

However, a positive impact of the aforementioned variability in foreign direct investment (FDI) is also that the pressure of foreign buyers acts as an economic incentive for the governments of developing countries to solidify their financial system in order to attract and keep foreign capital. The threat of financial contagion should a global shock take place would, in theory, incentivise key individuals within developing countries to make sure that their underlying fundamentals are solid enough to withstand a global depression without too much long-term damage. If key markets are solidified soon enough, a virtuous cycle of investment and further growth could potentially be triggered, blurring the lines between these developing countries and their developed counterparts. Whilst the element of uncertainty and doubt will still be present, if the country is foresighted enough to secure their future prospects, the risk from this should be offset by the potential influx of foreign direct investment that could occur. Even if it does not work out, the meritocratic aspect of this scenario is still something to be commended and looked upon as a positive; countries will gain foreign direct investment if they see it as a rational economic decision to strengthen their financial system.

With the increase in available capital for corporations operating within developing countries to use, it is also important for regulation to be put in place such that the prevalence of moral hazard with regards to the risk/reward ratios of banks reduces. In a developing country, with arguably less financial infrastructure present than a developed one, it is somewhat easier to sign legislation that ensures that banks cannot operate in an unreasonably risky manner. As shown by the political lobbying of banks in the UK, USA and elsewhere, once a massive financial system has been built up, it is extremely hard to get major financial institutions to change their ways. Hence, if government puts its foot down quickly enough, it is possible that the developing countries of today could potentially have less of a glasshouse of a financial system than even the developed countries of today possess. The question of this article initially was “Could globalisation bring developing countries to their knees?”, and the answer to that is a resounding yes. Replace the “could” with a “will”, and you have an answer which depends on a multitude of factors, including primarily the quality of the country’s governance. If government manages itself correctly, globalisation could bring about rapid economic development and the bolstering of financial systems across the developing world. If not? Well then, we’ve all got ample reason to worry.