Banks embark on debt buyback spree It is probably not what the UK authorities intended. Britain's banks have taken advantage of the government's "funding for lending" initiative, giving them access to cheap money, to buy back billions of pounds in debt issued to investors. The lending programme announced in June allows banks to borrow money from the Bank of England - inexpensively - in return for a commitment to lend to households and businesses. There is little sign yet that the economy is benefiting. Behind the scenes, though, concerns are growing that "funding for lending" is becoming yet another factor that is skewing the European bank debt market. Bond issuance by banks across Europe has fallen from previous years" levels as lenders have responded to the eurozone debt crisis and tougher regulatory demands by selling assets and shrinking their balance sheets. Now the BoE scheme, as well as the European Central Bank's offer of cheap three-year money under its longer-term refinancing operations, is contributing to the dearth of issues as banks rely more on central bank funding. It is also encouraging banks to buy back debt on which they are paying higher yields to investors. Deutsche Bank estimates that European banks have purchased or swapped at least €46bn of debt so far this year versus about €27bn last year and €41bn in 2010. Spanish banks had already been buying back secured debt to use as collateral to borrow cheaply from the ECB. In the past three months that trend has shifted to UK banks buying back senior debt. Royal Bank of Scotland, Lloyds and Barclays have all offered to purchase sterling, euro and dollar of senior debt from investors. The rationale behind the buybacks, says Lloyds, is to eliminate expensive funding and use up excess cash sitting on the bank's balance sheet. The bank had about £105bn of primary liquid assets at the end of March but is only required to hold about £70bn. RBS says its senior debt buybacks represent the latest stage of its recovery story and an effort to deal with what Stephen Hester, RBS chief executive, has called an "embarrassment of liquidity." Some investors, though, warn that, coming at a time when banks are responding to slowing growth and the eurozone crisis by shrinking their balance sheets, more buybacks will further reduce the amount of senior debt circulating in the market. Christine Johnson, manager of the Old Mutual Corporate Bond fund, says that banks such as RBS have signalled they are now more interested in redeeming bonds than issuing new debt. "If you can fund vastly more cheaply through the central bank to maximise your net interest margin then there is clearly an incentive to do just that," she says. Richard Thomson, senior credit analyst at Henderson Global Investors, expects only a limited supply of senior unsecured debt to be issued from European banks in the coming months as lenders play a form of "carry trade," swapping more expensive debt in favour of cheap central bank funding. In the UK "some banks are clearly buying back senior bonds and instead tapping the government's funding for lending scheme," he says. The upside, for existing investors, is that having less debt in circulation adds a scarcity premium. But analysts point out that such "liability management exercises," where banks offer to buy back or exchange debt often at a discount to par, are carried out for a variety of reasons and across a range of asset classes. In the past three months there has been an uptick in senior bank buybacks, largely coming from UK banks. Citi estimates that European banks have bought back about €14bn equivalent of senior bonds in the past three months, compared with about €1bn of senior buybacks in the first quarter. Graham Bahan, head of liability management for Emea at Citi, argues that the jump in buybacks is not only banks buying back debt purely to take advantage of cheaper central bank funding. He says recent senior debt buybacks have been aimed at cutting interest rate costs as well as, for example, extracting capital gain from unwinding a valuable hedge. Alastair Ryan, banking analyst at UBS, says that in the short term the recent trend to buy back senior debt is likely to remain the preserve of UK banks, which are better funded than their eurozone rivals and are responding to specific UK factors. At the end of 2010 and in 2011 banks were required to issue large amounts of term debt not only to build their liquidity buffers against the risk of another financial crisis but to ensure they could pay back funding support from the BoE. Having issued lots of expensive debt, they are buying it back. Those buybacks will make it easier for banks to use their capital more efficiently, but will not necessarily translate into more lending to households and businesses. "Even with the funding for lending scheme, banks remain constrained by regulatory requirements for higher capital levels, which in practice constrains their ability to lend," says Mr Ryan.