Compared to conditions during the global financial crisis, the health of the banking sector and the environment for banking are now significantly different. This presents opportunities for financial credits – on a selective basis.
The world economy has come to a sudden standstill, causing acute liquidity issues. Regulators, monetary authorities and governments have acted much more quickly and decisively these past few weeks than they did during the global financial crisis. And, unlike then, banks are not at the root cause of this crisis. Instead, we believe they are needed as part of the solution. This presents opportunities for financial credits – on a selective basis.
Compared to conditions during the global financial crisis, both the health of the banking sector and the environment for banking are significantly different this time around.
Banks now hold much more capital, are better funded and have more liquidity. From a macro perspective, the overall policy response has been supportive for financial markets. Regulators, monetary authorities and governments have acted swiftly and decisively, and with unusual like-mindedness. In Europe, the ECB has provided a powerful backstop for banks (via LTROs), for southern European sovereigns (through PEPP) and also for corporate bond markets (using CSPP). Furthermore, fiscal authorities have announced extensive support packages for the corporate and SME sector, which in Germany, for example, represents up to 20% of GDP.
This time around, banks are not viewed as being at the core of the crisis. Rather, banks are critical in funneling liquidity into the real economy. Therefore, political and regulatory attitude to the industry is likely to be far more constructive. Given how tough regulators have been on banks since the global financial crisis, we believe there is now plenty of room for a lighter regime on banks.
And indeed, we have already seen several examples of so-called ‘forbearance measures’, benefiting banks. The ECB and local regulators have effectively lowered capital requirements for banks by adjusting capital buffers. Next to that, the ECB has indicated it will allow banks to operate below minimum requirements on a temporary basis. This is an encouraging indication that there is no agenda for bailing in banks. Besides which, our view is that bailing in banks would not serve to improve the current economic situation.
Other forbearance measures relate to the timing of credit provisions in banks’ P&L and the recognition of non-performing loans. Such measures will help spread non-performing loans and provisioning over a longer period and, more importantly, will give banks room to prevent good corporates from failing due to an acute drop in economic activity. In short, banks will be given the necessary regulatory flexibility to act as part of the solution.
Despite this relatively positive assessment amid the overwhelming turmoil, concerns remain. Over the long term, beyond the horizon of the current crisis, the intertwining of sovereigns and banks seems once again to be increasing. The cost of extraordinary support today will likely come tomorrow in the form of more directed lending, and increased holdings of sovereign bonds, for example. There is also an increased risk that today’s containment measures create conditions which are potentially damaging for banks, such as sustained low interest rates. This means that the actions taken now could likely lead to long-term reductions in returns on equity for the sector. This, however, is more of a worry for equity markets than a credit concern.
While there is some hope in the fundamentals, the great speed at which circumstances have changed in the financial sector has raised some crucial questions. Notably, what are the risks of coupon cancellation on Additional Tier 1 bonds (AT1 bonds, also known as CoCos), and will issuers call back their bonds?
In its forecasts for the European economy in 2020, the Robeco Macro team envisages a base case scenario in which real GDP contracts by 5% -- a massive slowdown. Additionally, one also has to factor in the consequences of the dramatically lower oil price. The most notable initial impact from the combined coronavirus and oil price shock will be felt via credit losses, with the most vulnerable sectors being oil & gas, metals & mining, transport & logistics and hospitality. On average, European banks have about 5% of their loan book exposed to these sectors.
A further impact of this slowdown will come from a poor revenue environment, with the biggest negative driver here being lower interest rates. For banks, we expect net interest margins to drop for a prolonged period. Loan growth and fee income will also suffer from a drop in economic activity.
Focusing on European banking risk, the credit analyst team at Robeco assesses the loss-absorbing capacity of banks through stress testing. This means looking at what happens to banks’ balance sheets under very stressed environments. The aim is to determine the break-even cost of risk and compare that to loan-loss scenarios equivalent to the Great Depression. The conclusion is that, in such a stressed scenario, banks fully burn through their first lost piece, which is their pre-provisioning profits. This implies that banks are currently operating at around break-even levels and that they will have to cancel dividends.
But, for bond holders, the important point is that banks have ample distance to their respective Maximum Distributable Amount (MDA). This is the level at which regulators automatically restrict earnings distribution, and is triggered if a bank's total capital falls below the sum of its Pillar 1, Pillar 2 and other buffer requirements.
This implies that, as things are today, European banks can continue to pay AT1 coupons. This analysis was undertaken for most large European banks, with all showing similar degrees of resilience.
Furthermore, political pressure from regulators is to focus on dividend payments and bonuses, and not the cancellation of AT1 coupons, as the latter are relatively insignificant in a bank’s profit and loss statement. So, with AT1 coupon cancellations not on politicians’ radar, they are likely not on regulators’, either.
Credit markets reacted in an unprecedented fashion during March and are currently pricing in a deep recession. Price action has been exaggerated by a lack of liquidity in global credit markets. The speed of the sell-off has been unmatched and spreads are now at levels that are rarely seen. This has created interesting value opportunities across the capital structure of the banking sector. It is essential to be selective, however. Although we do not expect widespread bail-in of financial institutions, idiosyncratic bail-ins cannot be excluded. Therefore, issuer selection is key to benefiting from the extreme value opportunities which have arisen in the bank credit space.