The market performance of European bank equity appears to contradict the performance of bonds issued by banks. While equity markets are pricing in a deep recession and a rise in default rates, the fixed income market, known for its caution, seems to have a much more positive stance towards banks this time around.
In our view, the performance of financial credits is justified. Our reasoning is that, while weakening economic growth is an earnings event for European banks, it is not a capital event. In particular, our analysis suggests that banks’ balance sheets can withstand the squeeze in earnings margins. This explains the current difference in valuation between financial equity and bonds.
We had said at the end of the first quarter of this year that banks would be part of the solution to this crisis and would not be the root cause of it – in contrast to their role in the 2008 global financial crisis. The negative stigma associated with banks had dissipated after the implementation of a strong regulatory framework in 2011. These regulations ensured European banks entered this crisis in much better shape than in the period leading up to the global financial crisis.
Furthermore, regulators, monetary authorities and governments acted much more quickly and decisively this time than in 2008. Thanks to a sweeping range of policy support measures that were implemented immediately after the March sell-off, banks have been able to withstand a marked slowdown in economic activity. Moreover, given how tough regulators have been on banks since the global financial crisis, there is now plenty of leeway for a lighter touch.
Central banks have stepped up their funding efforts to support banks. The ECB launched TLTRO 3 in June, giving European banks the opportunity to borrow a further EUR 1 trillion at very attractive rates, over a four-year horizon. Many banks, especially those in Southern Europe, are also benefiting from government guarantees on new loans.
These measures have enabled banks to continue lending to the corporate and household sector. Moreover, a number of governments have implemented direct measures, including furlough schemes, to support companies by shouldering a portion of their payrolls, thus sustaining the viability of these businesses. Loan default rates have been contained as a result, which in turn has tempered credit losses. This has meant European banks have been able to continue to act as conduits of liquidity, sustaining activity in the real economy and being part of the solution.
We expect banks, on average, to put aside 1% of their loan book this year, as provisioning for credit losses; this is three times higher than what we saw last year. Although credit losses are rising, these losses are much smaller than they were in the global financial crisis, even though the economic contraction is more severe this time. This is all thanks to the shock-absorbing effect of the government support measures currently in place.
Our view, based on our stress testing, is that banks are able to absorb these higher loan losses. The 100 basis points of credit costs that we forecast for this year could increase to around 200 basis points over the three years up to 2022. We estimate this to represent, on average, about three-quarters of banking operating profits. So, while this represents a significant rise in costs, most banks will still operate profitably over this three-year horizon.
Not all banks will be able to maintain profitability, of course, and we expect large discrepancies across banks. Issuer selection is therefore very important. Scrutiny at the issuer level will entail examining the composition of the loan book, to determine the nature of exposure to economic sectors. For example, while the retail sector, leisure and tourism are hard hit by the Covid-19 recession, other sectors are doing well – and are able to repay their loans.
The economic environment is very negative for earnings, with lower interest rates being the biggest negative driver. For banks, we expect net interest margins to drop for a prolonged period. Loan growth and fee income will also suffer from a decline in economic activity.
While it is clear that banking earnings will deteriorate, our view is that banks’ capital buffers are in good shape. European banks – and, in fact, banks globally – have built up their capital buffers over the past decade since the Basel lll regulation was implemented after the global financial crisis.
While these buffers were adequate going into this crisis, it is critical that the quarterly development of capital ratios is tracked as loan losses increase.
Our analysis of the larger European banks shows that capital buffers have held up well over the months since March. These buffers, or excess capital, represent the extent to which the banks’ capital to credit risk-weighted assets ratio exceeds the regulatory requirement. We find that, despite the rise in credit losses in the second quarter, capital buffers have, in most cases, increased slightly. This is due to the extensive support provided to banks, including the easing of the regulatory requirements.
Although the economic contraction has been sizeable and default rates are expected to rise further, our view is that banks will survive this setback. Many banks have already taken hefty credit losses in anticipation of all of this, which means higher default rates will not necessarily translate into higher credit losses.
Moreover, some positive triggers are possible in that banks could be permitted to resume dividend payments again, which would boost sentiment in both equity and credit markets.
One very important theme for credit markets generally is the search for yields. Government bond yields are low and will remain so for the foreseeable future. In this very low interest rate environment, those portions of the market that offer yield – such as subordinated financial credits – will continue to attract interest from investors.
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