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* Money-market regulations push up cost of dollar funding
By Frances Yoon
HONG KONG, Aug 22 (IFR) - Japanese megabanks are emerging as the biggest victims of a worsening squeeze in the U.S. $1 trillion commercial paper market, as high swap costs leave them with few satisfactory alternatives for dollar funding.
Investors have pulled billions out of prime money-market funds ahead of new Securities and Exchange Commission (SEC) regulations aimed at preventing a repeat of the liquidity crisis following the collapse of Lehman Brothers in 2008.
From October 14, prime funds will be able to charge liquidity fees and have the option to restrict redemptions, among other changes. In anticipation, investors have slashed their allocations to prime funds, the main buyers of commercial paper and certificates of deposit from corporations, including Japanese lenders.
Three-month CP rates have jumped more than 10bp since June, while three-month dollar Libor - the key benchmark for short-term bank borrowing - hit a seven-year high of 0.818 percent on August 12.
The higher funding costs and shrunken market are hitting Japanese banks particularly hard, analysts say, as they have been sourcing as much as a third of their U.S. dollar liquidity in the short-term U.S. market.
Citigroup estimates Japanese banks have about $125 billion to $150 billion of CP and CDs maturing before the end of September.
Rising U.S. dollar funding rates pose a further threat to profitability at Japanese banks, which are already wrestling with negative domestic interest rates. Corporate clients are also at risk, as lenders look to pass on the higher costs. ALTERNATIVES Japanese lenders have been trying to pre-empt the blow from the reforms. Sumitomo Mitsui Financial Group cut its global CP and CD funding by $7 billion in the year to June, while a $28 billion jump in deposits outpaced a $19 billion increase in lending globally, Deutsche Bank analysts said in a report published this month.
As a result, its loan-to-deposit ratio shrank from 149.6 percent in March 2015 to 135.5 percent at end-June. Mitsubishi UFJ Financial Group also saw its ratio fall to 115.1 percent from 117.8 percent in March 2015 on the back of a rise in deposits.
In the short term, however, Japanese lenders will be unable to raise enough from deposits to replace the U.S. money markets.
Prime money-market funds slashed their holdings of Japanese securities to $115 billion at the end of July, down 25 percent from $153 billion two months ago, according to the Investment Company Institute. Previously second to only the U.S. by country of issuer, Japan has now fallen to third behind France.
Beyond paying up for U.S. dollars, Japanese banks have few options. Leverage requirements mean global banks are reluctant to provide repos, while foreign-exchange swaps would be a more expensive way to access U.S. dollar funding, said Koichi Sugisaki, a rates strategist at Morgan Stanley MUFG Securities.
Three-month CP and CDs now cost roughly 80bp-90bp on an annual basis, but three-month FX forwards have also become more expensive at around 1.5 percent per year, he said.
FX hedging costs are at their highest since the financial crisis. The three-month JPY/USD forward is now at -39 pips, the lowest since December 2008, according to Thomson Reuters data. The more negative the reading, the more expensive it is for Japanese issuers to swap yen to U.S. dollars.
Rising Libor rates could push FX swap rates out further by the end of this year, Sugisaki estimated.
“An increase of the cost of funding in CP and CDs would be definitely negative for the banks,” he said. “For the Japanese banks, it’s going to be very tough.”
FROM CP TO BONDS? Bankers suggest that the U.S. dollar bond markets could provide Japanese banks with some respite from short-term dollar funding pressure.
“Japanese banks could consider issuing short-end bonds from the operating bank level in the future to meet short-term liquidity needs as an alternative to CP/CDs,” said Masanori Kato, head of debt capital markets for J.P. Morgan in Tokyo.
“Short-term notes would be a possible alternative avenue, and demand would be there for it as Japanese banks are seen as a safer haven due to Brexit concerns.”
He suggested that, although it was difficult to say whether issuing U.S. dollar bonds could be cheaper than using FX forwards, the possibility remained that U.S. dollar bond funding might become more competitive.
Some high-rated European banks have already taken this approach, finding that two-year or three-year bonds offer similar funding costs to CP.
However, this option will have to be tested first, as Japanese banks have rarely issued U.S. dollar bonds at tenors of less than three years.
The strain on short-term funding is not expected to end soon, with Citigroup estimating that three-month Libor could rise another 5bp-10bp before October 14.
In the absence of cost-effective alternatives, Japanese banks will have to continue issuing CPs at a higher cost. (Reporting by Frances Yoon; Editing by Steve Garton and Vincent Baby)