In the wake of the 2008 crisis, European banks underwent years of stress testing to help them survive a hypothetical financial storm, but when Covid-19 hit they realised a pandemic was not quite on their radar. So how well prepared are bank asset finance providers and asset-based finance companies to withstand the difficult times ahead? Alejandro Gonzalez finds outs.
More than a decade after the financial crisis, the resilience of European banks is again being tested as the global economy fights off infection from coronavirus.
As governments across Europe begin easing lockdown restrictions and scaling back emergency funding, bank CEOs are bracing themselves for a wave of company defaults and loan impairments to hit their earnings.
Just how bad could finances get? Nobody knows, but according to the European Central Bank (ECB), GDP in the Eurozone is expected to contract between 8% to 12% in 2020.
But, experts agree, European banks are better prepared financially today than they were at the time of the 2008 financial crisis, in part thanks to the stress testing they have undergone since then to check how their business models, balance sheets and risk positions stack up under given conditions.
To date, these tests have been sponsored not just by state regulators – such as the European Banking Authority (EBA), the ECB and the Bank of England (BoE) – but internally by the banks themselves, although scant evidence exists that pandemic scenarios were high on the agenda prior to March 2020.
“The pandemic as a scenario showed up in the risk inventory of nearly every bank I’ve worked with, but it never really made it to the top and it did not enter the scenario library with such wide-spread and massive economic fallout,” says Til Schuermann, a partner with consultancy Oliver Wyman who advises banks on stress testing, during an online debate organised by the Florence School of Banking & Finance on 2 July.
Also, this last decade has seen regulators force banks to increase their capital buffers, reduce debt on their balance sheets and banish proprietary trading to the fringes.
(Above: Philipp Wackerbeck of Strategy&)
But is it enough?
Despite these prudential measures, risk management of the Covid-19 crisis continues to be beset by uncertainty.
“Unlike the 2008 crisis, the Covid-19 crisis did not start in the financial sector, so what is challenging for banks about this crisis is translating pandemic and epidemiological developments into economic reality,” says Philipp Wackerbeck, a partner with Strategy&, PwC’s strategy consulting business.
“One of the key concerns going into the Covid-19 crisis was liquidity, particularly after the 2008 experience, but thanks to early and decisive action by central banks to do ‘whatever it takes’ these fears were lessened,” he says.
Monetary policy in the Eurozone and in the UK has hit historic low levels, with the ECB’s base rate currently at minus 0.5% and the Bank of England’s at 0.1%, allowing central banks to offer ultra-cheap loans to offset a 2008-style credit crunch.
Meanwhile, government loans and grants tailored to offset mass unemployment and to support businesses have been in vogue across Europe. The Eurozone rescue fund passed at the end of July by the EU stands at €750bn, made up of grants and loans.
Two key planks in the economic bailout have been the relaxation of existing regulatory requirements on forbearance and the temporary suspension of accounting rules governing how credit losses are calculated, both of which have helped banks to “avoid greater procyclicality”, says Wackerbeck.
The consequences of procyclical behaviour in a crisis entails banks building up their reserves against expected credit losses, which reduces their firepower just as the economy needs them to lend more.
Recently adopted accounting standards, such as International Financial Reporting Standard 9 (IFRS 9), are also seen as procyclical, by requiring banks to recognise loan losses much sooner than under past regimes.
According to the Financial Times: “IFRS 9 requires banks to make provisions for loans going bad, especially when they cross key thresholds such as a ‘material change in circumstances’. This forces banks to take provisions for the entire lifetime of a loan.”
In mid-June, the EU amended its banking rules, including a two-year extension on implementing IFRS 9, in an effort to boost banks’ share of lending.
“Regulators want to avoid procyclical behaviour by banks this time around, which is why we have seen more forbearance now than in the past,” says Wackerbeck.
Early in the crisis, the German, French and Spanish governments moved to exempt insolvent firms from an obligation to file for bankruptcy until later this year (and until 2021 in some instances) if businesses can show their troubles were caused by Covid-19.
In the UK, calls for leniency were issued by the Financial Conduct Authority, prompting the Finance & Leasing Association to report that forbearance requests from UK businesses had recently topped 1.8 million (with the FLA’s asset finance members having granted 83% of their requests).
Yet, as the spectre of job losses and insolvencies grow, Europe is yet to enter the full stimulus phase of this crisis.
“In Europe, countries so far just did what is necessary to help their economies to survive: cash payments, helicopter money, government guarantee programmes and, in some instances, equity stakes in companies, so what they did was basically firefighting.
“The recently passed laws still need to prove if they can jump-start the economies and provide the stimulus-response,” says Wackerbeck.
Against this backdrop, July saw a large number of European banks issue negative profit predictions for 2020.
According to S&P Global, 46% of European banks in its portfolio hold a negative outlook, up from just 14% at the end of 2019.
With banks required to set aside higher capital provisions to account for anticipated rising company defaults, around a quarter of Europe’s top 35 banks posted losses in the first quarter of 2020, while the remainder saw pre-tax profit decline by a third on average year-on-year, S&P Global says.
While European banks may have been well capitalised coming into the Covid crisis, many were not very profitable.
Profitability has never recovered since 2008, with significant differences across banks and countries, but generally return on equities (ROE) is poor (6%) and for many banks is not sufficient to cover the cost of equity, Mario Quagliariello, director of economic analysis and statistics at the EBA, told an online debate on 2 July. Wackerbeck agrees: “Many European banks face, in the long run, challenges for their commercial viability, which poses a threat for shareholder value.”
“Going into the crisis many EU banks were already challenged, but how the European banks survive the crisis will depend on the individual markets the banks operate in and the effectiveness of government countermeasures to support the real economy and the banking sector,” he adds.
Success is likely to be reliant on key medical developments, such as the finding of a vaccine, effective medicine to address Covid-19 symptoms and the application of disease testing and ‘track and trace’ systems.
The speed of the recovery – be it V, U or W-shaped – will also affect bank profitability and their ability to finance businesses coming out of the recession.
A recent report on European banking, published by consulting firm McKinsey, found that although banks entered this crisis from “a position of significantly greater capital strength than in 2008” significant challenges lay ahead. “Even if we accept a high degree of uncertainty over the precise outcome, there are plausible scenarios where credit losses will significantly exceed those of the global financial crisis and of supervisory authority stress tests,” the report, published in May, says.
The McKinsey report, based on a survey of over 2,000 executives around the world, found that credit downgrades and increased volatility will weigh on banks’ CET1 ratios – a measure that compares a bank’s capital against its assets.
According to McKinsey, after taking risk costs into account, bank revenues could be down by more than 40%, with recovery to pre-crisis levels “only in 2024”.
As an early step to fight the crisis, banks have applied forensic attention to any exposures and risks on their lending book, with particular attention to troubled industries – such as travel, car manufacturing, OEMs [original equipment manufacturers] and hospitality, says Wackerbeck.
“Credit risk is the biggest risk for the banking sector. For many European banks, we expect 70-80% of the Covid-19-related contraction of core capital ratios to be caused by credit impairments and an increase of risk-weighted assets for credit.
“Credit managers will need to show a great understanding of credit portfolios and the development of their customers’ industries.”
“During the 2008 crisis, banks needed to understand their trading book – in particular, difficult-to-value assets, derivatives and structured credit – but during Covid-19, the attention is more about understanding the core loan book,” says Wackerbeck.
(Pictured: Steffen Hoppe of Strategy&)
PwC’s Strategy& team, which published a paper entitled Five Priorities for European Banks to tackle Challenges from Covid-19 earlier this year, forecast tough times ahead for specialised lenders and asset-based finance companies with non-performing loan ratios potentially more than doubling.
Steffen Hoppe, director with Strategy&, says: “In the short term, it is proving a disadvantage to not have a diversified business portfolio, so specialised lenders focused on road transport, shipping or aviation financing will likely struggle given the underlying dynamics of those industries as we don’t know how quickly they will recover or what level they will recover to.”
“In the long term, the underlying industries themselves will change the longer the effects of the pandemic are felt, so the business model of the specialised lender is not getting any easier after the crisis, even for those businesses able to master their current risks. Only a few innovative specialised lenders, who are able to keep their key stakeholders alive and develop their ecosystems, will be able to emerge stronger from this crisis.”
(Pictured: Lindsay Town of IAA-Advisory)
Lindsay Town, chief executive of IAA-Advisory, agrees with the need for a diversified business portfolio, but stresses that in asset finance there has always been a degree of specialisation, offset by considerable risk diversification, which has stood the sector in good stead.
“Yes there is a risk from specialisation, but there is a higher risk of not understanding the asset due to a lack of specialisation,” he says. “In asset finance, there is merit from in-depth asset knowledge and specialisation with end-user diversification.
“This requires people who understand the economic dynamics and use of their assets, and who can redeploy to different industries or geographies in a crisis,” he says.
“With asset specialisation, you’re always looking at alternative use,” says Lindsay.