European Banks Come in From the Cold

Shares of European financials sold off sharply from the onset of the coronavirus and price-to-book valuations have dropped to levels not seen since the Global Financial Crisis (GFC) in 2008 (Figure 1). From the market’s point of view, the current health crisis is no different from the GFC.

The key question is whether the banks would emerge from this crisis in good financial standing and be perceived as the “good guys”, facilitating economic recovery and ultimately gaining back the trust of their customers. This is an opportunity the industry should be able to capture, helping it to improve its environmental, social and governance (ESG) scores (especially the social or the “S” component).

ESG factors are key considerations in our investment process as part of our proprietary metric called Confidence Quotient. Therefore, we closely monitor these developments, seeking to capture the re-rating that could result by an ESG inclusion.

A better “S” score can have several positive implications for banks, including better client satisfaction and hence engagement that will improve profitability. An improved ESG score can lead to a decrease in banks’ cost of equity and a re-rating of valuation multiples. The regulators are already asking banks to restrict their dividends and show their solidarity during this crisis and build further buffers to support the economic recovery.

This article examines the key difference in the starting points of the banking sector both in the United Kingdom (UK) and the euro area from the 2008 crisis. Nevertheless, given the extent of the recession expected to occur, we expect asset quality to deteriorate significantly. We show that both the Bank of England (BoE) and the European Central Bank (ECB) expect banks to have enough capital buffers to absorb the credit losses. Finally, through lessons learned from the previous crisis, potential structures are presented to address the role of banks and asset managers in managing the post-COVID economic environment.

Banks Start From a Position of Strength

The BoE highlighted in its May 2020 interim Financial Stability Report (May FSR) that the banking system, supported by various schemes in place, has an important role in providing credit to businesses to help them weather economic disruptions. As a starting point, this crisis is evidently different for banks as it was not started by them and they are now being encouraged by regulators to be part of the solution. Importantly, the starting capital position of the European banks is much stronger than during the previous crisis.

The BoE May FSR highlights that banks entered this period of stress with an aggregate common equity Tier 1 (CET1) capital ratio that is more than three times what was before the GFC, holding approximately £1 trillion of liquid assets (Figure 2).

Similarly, the European Banking Association (EBA) in its May 2020 report highlighted that the CET1 ratio rose from 9% in 2009 to nearly 15% in Q4 2019 (see Figure 3 in the next section). The liquidity coverage ratio was also close to 150% in Q1 2020. As a response to the crisis, regulators have announced several capital relief measures that the EBA estimates would provide an additional €100 bn of capital.

Banks Have Capital to Absorb Expected Pick-Up in Credit Losses

But economies face challenging times ahead and inevitably credit losses will come. The International Monetary Fund (IMF) recently published its forecasts regarding the depth of the expected recession with the euro area GDP expected to drop by 7.3% in 2020 before bouncing back by 4.5% in 2021. For the UK, the IMF projects -5.3% and 4.8% for 2020 and 2021, respectively. With such sharp deterioration in economic growth, it is to be expected that asset quality will deteriorate and credit losses on banks’ balance sheets will rise.

The range of potential losses communicated by banks’ management teams with the first quarter results varied widely. A BoE desktop stress test estimated that banks are projected to incur impairments of around £80 billion in the first two years. Again, the starting point for banks is much stronger than in the previous crisis, and they should be able to better manage the stress ahead. The BoE also judged that the usable buffers of capital built up by banks are more than sufficient to absorb the losses under the economic scenario published in its Monetary Policy Report. With the support of the government’s lending guarantee schemes, UK banks could help the corporate sector finance its cash-flow deficit. It is important to highlight that there are two schemes currently backed by the UK Government: a one-year £50K capped loan scheme that is 100% guaranteed and a longer-term loan scheme that is 80% guaranteed. This means that banks have skin in the game and are applying credit standards accordingly.

In the euro area, the EBA conducted a sensitivity analysis around the 2018 stress test scenario. This showed that COVID-19’s impact of credit risk losses on CET1 ranges between 230 bp and 380 bp without considering the potential beneficial effect of loan payment moratoria and guarantees. On non-performing loans (NPL), euro area banks have made significant progress. According to the EBA, the NPL ratio has contracted to 3.1% after having peaked at 7.1% in 2014. However, the 3% NPL ratio with a total volume of €529 bn is a higher level than what was prior to the GFC.

As with the BoE, the EBA highlighted that the banks would hold, on average, a management buffer of about 1.1 percentage points above the overall capital requirements, even after absorbing those hypothetical losses.

Lessons Learned to Support Economies in Transition Post the Crisis

Small- and medium- sized enterprises (SME) are the drivers of growth in Europe. In the UK, they make up 50% of GDP and get 85% of their debt funding from banks. The BoE highlights that the UK has around 5.8 mn smaller businesses, each with less than £10 mn in annual turnover. These businesses account for 25% of UK turnover. The smaller businesses are likely to be concentrated in sectors vulnerable to the COVID-19 shock. It took seven years for net bank lending to SMEs to recover from the GFC shock. Therefore, it is critical that banks continue to service this segment. For the banks to have the capacity to do so, post the pandemic, several options could be utilized and optimized with public support:

• First, governments can help clear the stock of non-performing debt as a consequence of the COVID-19 crisis to allow banks to continue to provide credit to stimulate economic growth, creating a virtuous cycle.
• Second, improved securitization markets with public support could help both the banks and the SMEs diversify their sources of funding.
• Third, a longer-term goal is to continue to build a capital markets union in the euro area.

In the UK, the Open Market Platform initiative would be an opportunity to ease credit provisions to SMEs. Banks need to facilitate its full implementation.

On the first point, it is important to continue to facilitate longer-term financing to SMEs and to ring-fence any NPLs. The EBA has discussed the establishment of Asset Management Companies, which can be particularly effective if there is public support. Securitizations can be used to complement outright NPL sales and allow governments to participate. According to the ex-ECB vice president Vitor Constancio, government participation can jump-start the NPL market, for example by co-investing with private investors in junior or mezzanine tranches. Therefore, setting up such an instrument in a post-COVID-19 environment would allow banks, supported by public funds, to ring-fence and off-load NPLs related to the crisis.

Incentives of all participants are aligned: banks have the incentive to use these schemes to offload the NPLs as they have a high cost to carry and manage. Governments benefit from resolving NPL issues thereby increasing the financial stability of their economies and allowing more credit to flow to SMEs, advancing economic growth.

To be effective, these instruments need to be optimized by kickstarting the secondary market of NPL sales. Also, such schemes need to be part of a reform agenda for the SME operating environment, including preferential funding to support SME recovery. Overall, these schemes should improve the risk/reward trade-off for investors taking on NPLs and make the asset class open to a wider investor base – i.e., asset managers.

Asset-backed securities (ABS) are another option that allows large pools of institutional funds to be channeled to SMEs. A well-functioning securitization market for SMEs will allow banks to diversify their funding and get capital relief that will provide further resources for other productive borrowers. The structured nature of ABS allows for a wider range of investors to participate, depending on their risk profiles, and this can include insurance companies and institutional asset managers. The benefits of ABS could be extended beyond the banks and investors to the SMEs themselves if in the transaction there is public participation that comes with a commitment from the originating banks to extend new loans to SMEs.

A final lesson learned is the need to develop deeper capital markets for SMEs. As mentioned above, bank lending makes up 85% of the stock of outstanding debt of SMEs. SMEs need to be able to diversify their sources of funding and find an effective alternative to bank financing.

Conclusion

The key takeaway is that banks are clearly part of the solution to the crisis caused by COVID-19. This is a real opportunity for the banking sector to improve its image with the public as well as with investors who are increasingly focused on ESG considerations. Lessons learned from the past suggest that the public sector needs to be ready to implement schemes that will facilitate this process but also achieve its macro-prudential objectives. As ESG-focused investors, the potential improvements are considered in sector allocations.