A company’s relationship with its banks is key. Banks supply working capital finance and services that are critical to the day-to-day operations of business. They also enable growth through the provision of finance for capital investment and acquisition.

But aspects of such relationships may be about to change. According to Dave Rome, strategic director of corporate lending at international law firm Ashurst, the challenges facing the banking sector are shifting once again in a way that could have a real impact on corporate borrowers across Europe, as the next refinancing cycle approaches.

Rome believes that a cocktail of factors could well combine to make refinancings more challenging than they have been recently, and possibly more expensive for borrowers. Corporates tend to refinance their core working capital facilities every three to four years, but may well go to their banks for incremental finance in the interim periods if looking to expand, either organically or through acquisitions.

“The banking landscape is changing and banks are recalibrating their strategies. The loan market faces strong headwinds, which could affect liquidity and may affect loan pricing. Companies will need to approach their next round of refinancing with care if they want the best possible deal,” says Rome.

A borrowers’ market

The future for refinancing could be in stark contrast to the recent past. In 2011 and 2012, the European Central Bank, fearful of a fresh credit crunch across the eurozone, kicked off its long-term refinancing operation which, alongside other subsequent monetary policy measures, flooded the banking system with billions of euros in liquidity.

According to Rome, with banks across Europe and the UK awash with funds and keen to lend, corporates were in a position to negotiate longer tenures (the usual three-year terms extended to five and then effectively to seven years with some contract innovation). Also, as a result of supply outstripping demand, the price of borrowing started to fall significantly.

“Market conditions were, and still to a large extent are, very conducive to getting a deal done,” says Rome. “Banks were lining up to pitch for business, which made for a highly competitive environment.”

Along with those benefits borrowers were also frequently able to negotiate increased flexibility in terms of covenants—both financial and non-financial. Terms that would normally place tight controls over a borrower’s activities, such as additional borrowing, disposals and acquisition activity, were often relaxed.

Change afoot

The environment that created this so-called “borrower’s market’’ is changing, and various headwinds are placing greater pressure on banks and their balance sheets, says Rome.

Firstly, there is general macroeconomic and geopolitical uncertainty. The Brexit vote leaves a huge question mark over the future relationship between the UK and the EU, and the result of the US presidential election casts further uncertainty over trade and the global economy. Economic growth across the eurozone is expected to be modest for 2016, while the UK may well see increased supply chain pressures, led by inflation, given the weakness of sterling.

Such uncertainty is further fuelled by other factors such as fluctuating oil prices, slowing economic growth in China, and more political uncertainty in Europe—including elections due in France and Germany next year. As important a factor, and one that is beginning to influence banks’ strategic thinking, is the regulatory landscape. A raft of new measures are beginning to take effect, with more to come over the next few years.

New rules introduced by the Basel Committee on Banking Supervision to strengthen bank balance sheets are already in place, including what are known as the leverage ratio and the liquidity coverage ratio. Banks will soon have to contend with the Basel Committee’s net stable funding ratio, which must be implemented by 2018.

Additionally, further “too big to fail’’ measures to guard against the need for future bailouts will also take effect over the next few years. And if that wasn’t enough, 2018 will also see banks grappling with a new accounting standard, IFRS9, which will govern the way they provision for expected losses.

As well as the need to conform with these regulatory requirements, continued loose monetary policy activity at central banks across Europe has kept interest rates at historically low levels, with the effect that banks’ traditional reliance on net interest income (the difference between the amount paid for deposits and charged for loans) has been eroded.

Because these measures combine to put significant pressure on banks across Europe to maintain stronger capital bases, they have prompted a critical look at return models and have led to banks revisiting strategic priorities in terms of markets, asset classes and sectors. It is clear that this is not just a UK issue but, exacerbated by the retrenchment of certain banks back to their domestic markets, it is a scenario that will be played out across the European, and broader, landscape.

“We expect to see German banks continue to undertake strategic reviews, as markets get more competitive and increased regulatory activity puts further pressure on their balance sheets,” says Anne Grewlich, head of Ashurst’s German banking team.

The next refinancing cycle

How might this affect a borrower’s ability to refinance or raise incremental bank funding in the future? The evidence of the past few months suggests banks’ behaviour is starting to change, as senior managers who are responsible for allocating capital and approving pricing focus on a bank’s relationship and its lending to corporates with more of an eye to future returns.

Lee Doyle, global head of bank industry at Ashurst, says that tighter controls on capital will force banks to look more critically at ancillary services as a way of making their returns. However, that raises its own issues.

Bank financing typically involves a syndicate of banks, with the number of banks varying from a small club to syndicates of 20 to 30 banks serving a single corporate client. Inevitably there are lead banks that are awarded significant fee-based business that will continue to support borrowers. However, banks that are smaller or have less of a relationship with the borrower may find there isn’t enough opportunity to provide ancillary services for them to earn the required returns, or reach their “return on equity hurdles”.

Doyle’s view is that some banks may walk away from refinancing deals if they are unable to see where their returns will come from. “Relationships are going to be governed much more by capital constraints and a more realistic view of the likely return on the broader relationship,” says Doyle.

According to Rome, one way for many banks to make their returns is to increase the cost of borrowing. At the moment bank lending supply is greater than demand, and there is sufficient liquidity to mitigate against such increases; but given the broader macroeconomic uncertainties and the regulatory headwinds discussed, this may not always be the case. All this means that corporates need to start thinking now about their next round of refinancing and begin preparing the ground ahead of the time that their banks are expected to experience the full impact of the regulatory squeeze.

Managing expectations

With the next refinancing cycle expected to peak from 2019 through to 2021, this means finance departments will need to come to terms with the possibility of refinancing early and understand what drives their banks in terms of strategic and business priorities. Some banks will be focused on ancillary business, others more on the price of the financing. Expectations, on both sides, will need to be managed.

“Borrowers should think carefully about the timing of their next deal,” says Rome. “You need to know and understand your banks, be aware what particular business is of interest to them and how much you may have to give them.”

With much uncertainty still to play out in the European and global economy, a close relationship between corporates and their banks will be as important as it ever was.

This article has been prepared in collaboration with Ashurst, a supporter of Board Agenda.