The economic consequences of the current COVID-19 pandemic are often compared with the global financial crisis (GFC) of 2008-09. The main difference is that this time banks are not the cause of the problem, but rather they can be an important part of the “economic rescue team”. However, as financiers of the real economy, banks will certainly be affected by the pandemic’s impact. In our new European Banking Study 2020, we are quantifying this COVID-19 induced effects on balance sheets and P&Ls of Europe’s 50 largest banks and set out the implications for bank management, governments and regulators
Overview of the contents of the European Banking Study 2020 on the COVID 19 pandemic:
- Europe’s banks were substantially more resilient and stable when the COVID-19 pandemic broke out
- Credit risk in view of the specific consequences of the COVID 19 pandemic
- Ensuring economic and financial stability requires close cooperation between banks, governments and regulators
Europe’s banks were substantially more resilient and stable when the COVID-19 pandemic broke out than when they entered the GFC
Over the past ten years, Europe’s banks have improved their capital ratios significantly and become more financially resilient. However, they have still not solved their profitability problem. Post-tax return on equity is yet again below the cost of equity and very weak 1Q20 results indicate worse developments on the horizon. Credit risk provisioning has significantly increased compared to the first quarter of 2019. For some banks, the safety cushion that robust profitability could provide to fend off potentially additional credit losses is rather thin.
Although we would attest European banks a significantly improved financial resilience as compared to previous crises, they entered the COVID-19 crisis from diverse starting points, reflected in a wide range of capital and profit cushions as well as differences regarding credit portfolio quality. More important than the definition of the starting point, however, is the analysis of how these banks will measure up against potential losses. This requires a combined analysis of their individual business models and regional setup as well as simulations to COVID-19 induced challenges.
Credit risk is our primary focus, given the COVID-19 pandemic’s specific impact and the RWA distribution of Europe’s banks
Certainly, COVID-19 will impact all aspects of banks and financial institutions. In our study, we first focus on credit risk and loan loss provisioning. This perspective deems most important at the moment since liquidity and other risks are currently not a real issue and credit risk RWAs make up the largest proportion of each bank’s exposure. We have extended our database substantially as well as our tried and tested models and simulation techniques to include COVID-19-sensitive rating shifts which allow us to simulate path-dependent changes of credit portfolio quality. We also factored in geographies and differences in underwriting standards. Our analyses show, that the composition of corporate credit portfolios and the estimated impact of COVID-19 on the credit quality varies significantly across European banks.
Similarly, we looked at retail and private credit portfolios and then calculated loan loss provisions (LLPs) and credit losses for each bank in two different scenarios – a medium and a severe recession scenario. Rather than producing qualitative statements, we calculated quantitative bandwidths for expected LLPs per bank that we potentially see in the next 18 to 24 months. In the event of a severe recession, total LLPs for the corporate and retail banking business in Europe could increase by up to 500 % on average compared to 2019.
Ensuring economic and financial stability requires close cooperation between banks, governments and regulators
Our analysis shows that Europe’s banks will not be able to cope with the impending crisis on their own. To avert another financial crisis, banks need to be supported by regulators and governments. The current “breathing room” regarding capital requirements is particularly important, since RWA inflation can be expected in the short-term due to the increase in lending and the pro-cyclical regulatory calculation methodology.
Nevertheless, individual banks have substantial work to do. In addition to a consistent continuation of the digital transformation process – regarding automation, standardization or customer communication and interaction – as well as the further improvement of the cost and earnings situation, Credit Risk Management is now being added to the agenda.
The pandemic’s aftershock will undoubtedly create a number of daunting operational and management challenges for Europe’s banks. Yet we believe that COVID-19 also represents a major opportunity to find redemption and a sense of purpose again, more than a decade after their fall from grace in the GFC. We anticipate a renaissance of local banks and client relationships which focus more on long-term trust than short-term margins. Such changes might well be in tune with the growing trend towards corporate and environmental sustainability which will re-emerge when the pandemic recedes. COVID-19 might, thus, be a catalyst in this respect as well.
At this critical juncture, as Europe emerges cautiously from the lockdown, we hope this year’s EBS delivers not only much needed quantitative insights into the possible impact of COVID-19 within upcoming months but also points out levers for banks, governments and regulators.
The next release factoring in 2020 results and a detailed look at RWA developments will be made available in July. For more information, details and updated results of the study please see the full text which you can access here:
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